CAN OVERVALUATION PRELUDE TO CRISIS AND
HARM GROWTH IN TURKEY?
Murat Alper* and **İrfan Civcir
*Central Bank of Turkey
**Ankara University
Abstract: This paper estimates the equilibrium real exchange rate of the Turkish lira to
evaluate whether or not the overvaluation results in currency crisis and low growth rate over the
period from the first quarter of 1987 to the fourth quarter of 2009. We follow the behavioural
equilibrium exchange rate model proposed by Faruqee (1995) and Alberola et al. (1999), where the
equilibrium real exchange rate depends on both the balance of payments approach and the BalassaSamuelson hypothesis. The results indicate that although large and persistent overvaluation
contributes to a financial crisis in Turkey, a relatively small overvaluation, contrary to both the
Washington Consensus view and the Rodrik view, promotes the growth of Turkish economy.
Keyword: Equilibrium real exchange rate, behavioral equilibrium exchange rate,
misalignment, Turkey
I. Introduction
In the last few years, the real exchange rate misalignment, which is defined as the
difference between the actual real exchange rate and equilibrium real exchange rate, has
gained great prominence in economic policy discussions because overvaluation is argued to
have been the cause of the currency crises and the lower growth rate in the developing
countries. Indeed, it is believed that the recent experience with economic crisis in Turkey,
Mexico, East Asia, Brazil and Argentina is the result of the persistent overvaluation of the
real exchange rate. In addition, the consistent avoidance of overvaluation has seen as a
distinguishing feature of East and Southeast Asia countries’ success with sustainable growth
in recent years. However, there are at least two difficulties in estimating real exchange rate
misalignment since equilibrium real exchange rate is not only an unobservable variable, but
also a dynamic indicator and moves over time as its fundamentals change.
In the literature, various approaches dealing with the equilibrium exchange rate can
be collected under two main groups, the traditional and modern equilibrium exchange rate
models1. Traditional models can be listed as purchasing power parity, uncovered interest rate
parity and monetary models. However, these models are found to be lacking in their
explanations. The lack of explanatory power of the traditional models has facilitated the
emergence of the modern equilibrium exchange rate models performing more sophisticated
approaches in estimating the equilibrium exchange rate as a function of the fundamentals,
1
MacDonald (2000) and Driver and Westaway (2004) review the alternative approaches to modelling
the equilibrium exchange rate.
1
such as FEER (Fundamental Equilibrium Exchange Rate) and BEER (Behavioral
Equilibrium Exchange Rate).
In the FEER approach advocated by Williamson (1983, 1994), the equilibrium real
exchange rate is defined as the real exchange rate which is consistent with simultaneous
internal and external balances. Internal balance is defined as achieving the level of output
consistent with both full employment and low inflation. External balance is identified with
the current account balance being at not only sustainable but also appropriate level when the
economy is in internal balance. The macroeconomic equilibrium principles of the FEER
approach are also strongly similar to the equilibrium concepts of the DEER (Desired
Equilibrium Exchange Rate) approach suggested by Bayoumi et al. (1994) and Artis and
Taylor (1995), the NATREX (Natural Real Exchange Rate) approach put forward by Stein
(1990, 1994), the DARER (Debt Adjusted Real Exchange Rate) approach introduced by
Fabella (1996) and Frait and Komárek (2002, 2008), and the FRER (Fundamental Real
Exchange Rate) approach proposed by Bulíř and Šmídková (2005).
The BEER approach as a second part of the family of the modern equilibrium
exchange rate models was popularized by Clark and MacDonald (1998). It can be considered
as a predominantly empirical approach estimating the equilibrium real exchange rate based
on the econometric long-run relationship between the real exchange rate and its
fundamentals. In this approach, the process of econonometric estimation is composed of two
phases: At first phase, once a long-run relationship amongst the variables is identified, the
equilibrium real exchange rate is estimated by substituting the actual or long-run values of
the explanatory variables into that relationship. For the second phase, short-run and long-run
misalignments of the real exchange rate are computed by the difference between the actual
and fitted values of the real exchange rate. Short-run misalignment is derived on the basis of
the actual values of the fundamentals rather than their long-run values as in the case of longrun misalignment. Employing the same econometric procedure but different theoretical
frameworks, some alternative variations of BEER approach have recently been developed by
Edwards (1989, 1994), Elbadawi (1994), Faruqee (1995), Alberola et al. (1999, 2002, 2004),
Baffes et al. (1999), Montiel (1999), Wadhwani (1999), Alberola and López (2001),
Alberola (2003), Rubaszek (2004), and Alberola and Naiva (2007).
We considers the variant of BEER approach proposed by Faruqee (1995) and
Alberola et al. (1999) using the time series data of Turkey to estimate the equilibrium real
exchange rate and the associated of the short-run and the long-run real exchange
misalignments from the first quarter of 1987 to the fourth quarter of 2009. Therefore, this
paper differs from the earlier researches estimating the equilibrium exchange rate of the
2
Turkish lira in several aspects: Firstly, we rely on the BEER approach of Alberola et al.
(1999) rather than other approaches. Secondly, we use a new data set including the recent
quarterly data. Thirdly, we compute both short-run and long-run misalignments of the real
exchange rate. Finally, we evaluate whether overvaluation contributes to the crisis and the
lower growth rate.
The remainder of the paper is organized as follows. Section II sets out the theoretical
framework, Section III discusses the data set and the empirical results, Section IV presents
the estimation results of real equilibrium exchange rates and analyzes the impact of long run
misalignment on the financial crisis and the growth, and Section V bears the conclusions.
II. Theoretical Framework
The theoretical framework used in this study follows that advanced by Faruqee
(1995) and extended by Alberola et al. (1999) and hinges on the conventional open economy
macro model with a sectoral extention. The real exchange rate, defined as the relative price
of domestic goods in terms of foreign goods, is given by

qt  pt  et  pt*

(1)
where qt is the logarithm of the real exchange rate, et is the logarithm of the nominal
exchange rate, which represents the foreign price of domestic currency, and pt is the
aggregate price levels, corresponding foreign price levels are denoted by an asterisk. Thus,
an increase in qt denotes a real appreciation of the domestic currency.
We assume that the aggregate price levels can be decomposed into the prices of
traded and nontraded goods both at home and in the foreign country with weights α and
1  α , respectively  0 < α < 1 . For simplicity, let the weights be the same in both countries,
such that
pt  αpT ,t  1  α  pN ,t
(2)
pt*  αpT* ,t  1  α  p*N ,t
where pT ,t and pN ,t are the logarithms of traded and nontraded goods price levels,
respectively. By substituting (2) into (1), a general expression for real exchange rate with
presence of traded and nontraded goods can be obtained as




qt   pT ,t  et  pT* ,t   1  α   pN ,t  pT ,t   pN* ,t  pT* ,t 
(3)
Equation (3) states that the real exchange rate is expressed as the sum of two
components: The first component, the relative price of traded goods between countries, is
referred as external real exchange rate  qT ,t  , and the second one, proportional to the ratio
3
of the domestic to foreign relative price of nontraded goods, represents internal real
exchange rate  qN ,t  . Thus we get from (3)
qt  qT ,t  qN ,t
(4)

qT ,t  pT ,t  et  pT* ,t


(5)

qN ,t  1  α   pN ,t  pT ,t   α* pN* ,t  pT* ,t 
(6)
External real exchange rate is derived from the balance of payments approach in
which current account  CAt  can be defined as the sum of the trade balance  Bt  and the net
payments on net foreign assets  Ft  :
CAt  Bt  rt .Ft
(7))
where rt is the real international interest rate. A country with negative net foreign assets
 Ft  0 
is net debtor while Ft  0 identifies the country as a net creditor. Given this
expression, the current account in terms of gross domestic product (GDP) can be thought of
as being determined in following way:
cat  bt   rt  gt  ft
(8)
where cat , bt and f t stand for the relatives of respectively the current account, the trade
balance and net foreign assets to GDP, and gt is the growth rate of domestic real GDP.
Suppose now that the external real exchange rate has an adverse influence on the trade
balance, and then current account can be rewritten as
cat  δqT ,t   rt  gt  ft
(9)
where δ denotes the elasticity of trade balance with respect to the real exchange rate  δ > 0  .
When current account is zero in equilibrium 2 , the external real exchange rate is
expressed as a function of net foreign assets:
qT ,t 
rg
. ft
δ
(10)
where real international interest rate and the growth rate of domestic real GDP are assumed,
for simplicity, to be constant. Equation (10) states that the effect of net foreign assets on the
external real exchange rate is ambiguous: The sign of the difference between the real
2

Current account can also be defined as cat   f  ft

where f is the desired level of net foreign
assets and  is the adjusment speed of the net foreign assets. When net foreign assets is below
(above) its desired level, current account is in surplus (deficit). In equilibrium, ft  f , and then
cat  0 .
4
international interet rate and the growth rate of domestic real GDP is usually assumed to be
positive. However, developing countries can grow above the real international interest rate
due to using advanced technologies.
The internal exchange rate is derived from the Balassa-Samuelson, or productivity
bias hypothesis, which is based on a two country model with one factor assumed where labor
is internationally immobile but perfectly mobile across sectors within the economy. Thus,
nominal wages in both traded and nontraded sectors are equalized, and then the real wages
paid by profit maximizing firms are adjusted for productivity (Strauss, 1995, 1996 and
1999):
pT ,t  wt  aT ,t ,
pN ,t  wt  aN ,t ,
pT* ,t  wt*  aT* ,t ,
p*N ,t  wt*  aN* ,t
(11)
where wt denotes the logarithm of the nominal wage, and aT ,t and aN ,t are the indices of
productivity in traded and nontraded sectors in logaritmic form. By substituting (11) into (6),
an expression for the internal real exchange rate in terms of productivity differentials is
obtained as


qN ,t  1  α   aT ,t  aN ,t   aT* ,t  aN* ,t 
(12)
Equation (12) implies that there is a connection between the internal real exchange
rate and the relative sectoral productivity differential. According to Balassa-Samuelson
hypothesis, a country with relatively higher productivity in the traded sector compared to
nontraded sector has a lower price of traded to nontraded goods and experiences an internal
real exchange rate appreciation. By combining (10) and (12) with (4), the real exchange rate
can be expressed as a combination of the balance of payments approach and the BalassaSamuelson hypothesis in such a form:
qt  λf t  θat
(13)
where the sign of λ is not clear-cut and θ is expected to be positive λ   r  g  δ ,


θ  1  α  and at   aT ,t  aN ,t   aT* ,t  aN* ,t  . Thus, three well known special cases are

nested within (13): In the balance of payments approach, θ is constrained to be zero because
the Balassa-Samuelson effect is not considered as a determinant of the real exchange rate. If
we assume that λ  0 , the equation (13) reduces further to Balassa-Samuelson approach.
Purchasing power parity, which assumes that the real exchange rate is stationary, imposes
the additional constraints λ  θ  0 . This equation will motivate the empirical work.
This variant of BEER approach is applied to industrialized countries by Alberola et
al. (1999, 2002), and Alberola and López (2001), to transition economies from Central and
5
Eastern Europe by Rahn (2003), Babetskii and Égert (2005), and Alberola and Naiva (2007),
to Latin American countries by Alberola (2003) and Alberola et al. (2004), to G20 countries
except Russia and Saudi Arabia by Bénassy-Quéré et al. (2004, 2006) and to 35 countries
including 15 industrialized OECD countries, 8 emerging countries of Asia and the Americas,
11 transition economies in Central and Eastern Europe and Cyprus by Égert et al. (2004).
Table 1 shows that although the productivity improvements always causes the real
exchange to appreciate, it is possible that an increase in the net foreign asset leads contrary to
expectations to a depreciation of the real exchange rate. In fact, increasing net foreign assets
are found to give rise to a depreciation of the real exchange rate in the transition economies
from Central and Eastern Europe by Égert et al. (2004), in Canada, Japan, South Africa and
the UK by Bénassy-Quéré et al. (2006), and in the Czech Republic by Alberola and Naiva
(2007).
Table 1 Signs of the Estimated Coefficients
Authors
Countries
Time Periods
Alberola et al. (1999)
CA, DK, EU, FR, DE, GR,
IT, JP, ES, SE, GB, US
Alberola and López (2001)
Fundamentals
f
a
1980-1998
+
+
ES
1975-1998
+
+
Alberola et al. (2002)
CA, EU, JP, GB, US
1980-1999
+
+
Alberola (2003)
AR, BR, CH, CO, MX,
PE, VE
1960-2001
+
+
Rahn (2003)
CZ, HU, EE, PL, SI
1990-2002
+
+
Alberola et al. (2004)
AR
1960-2001
+
+
Bénassy-Quéré et al. (2004)
AR, AU, BR, CA, CN,
EU, GB, ID, IN, JP, KR,
MX, TR, US, ZA
1980-2001
+
+
Égert et al. (2004)
AT, AU, BE, BG, BR, CA,
CL, CY, CZ, DK, EE, ES,
FI, GR, HR, HU, ID, IE,
KR, LT, LV, MX, MY,
NL, NZ, PL, PT, RO, SE,
SG, SI, SK, TH, TR, ZA
1970-2002
+/−
+
Babetskii and Égert (2005)
CZ
1993-2004
+
+
Bénassy-Quéré et al. (2006)
AR, AU, BR, CA, CN,
EU, GB, ID, IN, JP, KR,
MX, TR, US, ZA
1980-2004
+/−
+
Alberola and Naiva (2007)
CZ, HU, PL
1993-2004
+/−
+
Notes:
(1)
f: net foreign assets, a: productivity
(2)
AR: Argentina, AT: Austria, AU: Australia, BE: Belgium, BG: Bulgaria, BR: Brazil,
CA: Canada, CL: Chile, CN: China, CO: Colombia, CY: Cyprus, CZ: Czech Republic,
DE: Germany, DK: Denmark, EE: Estonia, ES: Spain, EU: Eurozone, FI: Finland, FR: France,
6
GB: United Kingdom, GR: Greece, HR: Crotia, HU: Hungary, ID: Indonesia, IE: Ireland,
IN: India, IT: Italy, JP: Japan, KR: Korea, LT: Lithuania, LV: Latvia, MX: Mexico,
MY: Malaysia, NL: Netherlands, NZ: New Zealand, PE: Peru, PL: Poland, PT: Portugal,
RO: Romania, SE: Sweden, SG: Singapore, SI: Slovenia, SK: Slovakia, TH: Thailand,
TR: Turkey, US: United States, VE: Venezuela, ZA: South Africa
(3)
+(−) means that an increase in the given variables brings about an appreciation (depreciation)
of the real exchange rate.
Relatively few studies are also available that estimate the BEER of the Turkish lira
compared to the currencies of the other emerging economies. In addition, almost all studies
(Alper and Sağlam, 2000; Achy, 2001; Doroodian et al., 2002; Atasoy and Saxena, 2006;
Dağdeviren et al., 2009) rely on the BEER approach put forward by Edwards (1989, 1994)
instead of that introduced by Alberola et al. (1999). Table 2 provides an overview of these
studies on the time periods, and the long-run and short-run fundamentals. Alper and Sağlam
(2000) are among the first to apply the BEER approach to Turkey using Johansen
cointegration technique and quarterly data for the period running from the first quarter of
1987 to the first quarter of 1999. In this study, comparing the fitted values of the estimated
equation with the actual bilateral real exchange rate, the real exchange are found to have
been undervalued before 1990 and following the crisis in 1994. Using yearly observations
from 1970 to 1997, Achy (2001) employs Johansen cointegration method to detect possible
long-run relationship between the real exchange rate and its determinants. Long-run values
of the fundamentals are obtained employing the approach suggested by Cottani et al. (1990)
and Baffes et al. (1999). The author comes to the conclusion that the Turkish lira was
overvalued during the last years of his sample period. Doroodian et al. (2002) estimate a
single equation over the period covering January 1987 to June 1996 and implement the
moving average method to uncover the long-run fundamentals. The results show that the real
effective exchange rate was undervalued prior to the second quarter of 1989 and mostly
overvalued between the second quarter of 1989 and 1994, but these misalignments were
disappeared in the long-run. Further, a study by Atasoy and Saxena (2006) estimate five
reduced-form equations with the help of Johansen cointegration analysis over the period
covering the first quarter of 1980 to the second quarter of 2003. Permanent component of the
long-run fundamentals is estimated by the methodology proposed by Gonzalo and Granger
(1995). They concludes that although the real exchange rate was overvalued on the eve of
the crises in 1994 and 2001, this overvaluation was eliminated until the second quarter of
2003. The most recent study by Dağdeviren et al. (2009) employs two measures for the real
exchange rate and applies Johansen cointegration test over the third quarter of 1998 to first
quarter 2008. The misalignment determined based on Hodrick-Prescott filter indicates that
the Turkish lira was overvalued before the 2001 crisis, but this misalignment has been
7
corrected in the post-crisis period. Kibritçioğlu and Kibritçioğlu (2004) adopt different
BEER approach than the approach that was put forward by Edwards (1989, 1994). They
estimate several models using different explanatory variables which capture fundamentals,
the ratio of government consumption to GDP, terms of trade and openness ratio by using
Johansen and Engle-Granger cointegration methods over the first quarter of 1987 to the third
quarter of 2003. The authors also explore the sensitivity of estimation results to the
alternative combinations of different real exchange rate and equilibrium real exchange rate.
Altogether, 16 different specifications for the misalignment show that the degree of
misalignmet is highly sensible to the combination of real exchange rate and its equilibrium
level.
Table 2 Studies Implementing the BEER Approach for Turkey
Authors
Time Periods
Fundamentals
Long-Run
Short-Run
Alper and Saglam (2000)
1987-1999
TOT, OPEN, INT
TECHPROGRESS,
KFLOWS
Achy (2001)
1970-1997
TOT, OPEN, GOV,
KFLOWS
DEPRECIATION
Doroodian et al. (2002)
1987-1999
TOT, GOV, INV,
CAPCONTROL,
EXCCONTROL,
TECHPROGRESS
DEFICIT,
DEPRECIATION
Kibritcioglu and
Kibritcioglu (2004)
1987-2003
TOT, OPEN, GOV
Atasoy and Saxena (2006)
1980-2003
TOT, OPEN, GOV, INV,
CAPCONTROL,
EXCCONTROL,
TECHPROGRESS,
DEFICIT, EXCREDIT,
CONFIDENCE,
CURRENT
Dagdeviren et al. (2009)
1998-2008
TOT, OPEN, INV, INT
TECHPROGRESS,
KFLOWS, GOV
Note:
CAPCONTROL: capital controls proxied by the lagged ratio of capital flows to GDP,
CONFIDENCE: a change in the composite confidence index, CURRENT: current account,
DEFICIT: fiscal policy measure proxied by the ratio of fiscal deficit to lagged high powered money,
DEPRECIATION: depreciation rate, EXCCONTROL: trade and exchange controls proxied by the
ratio of custom revenues to import, EXCREDIT: monetary policy measure proxied by the rate of
growth of domestic credit minus the lagged growth of GDP, GOV: the ratio of government
consumption to GDP, INT: international real interest rate, INV: the ratio of investment to GDP,
KFLOWS: capital flows, OPEN: openness ratio as a proxy for import tariffs,
TECHPROGRESS: technological progress proxied by productivity levels, TOT: terms of trade
8
There are also three studies which used different approaches to estimate the
equilibrium exchange rate of the Turkish lira. Civcir (2003a) investigates the validity of
purchasing power parity to shed light on whether the real exchange rate was overvalued prior
to the 2001 crisis. Using the Johansen cointegration approach and the monthly data
stretching from January 1987 to December 2000, he finds that both the CPI-based bilateral
real exchange rate and the WPI-based trade weighted real exchange were overvalued while
the WPI-based bilateral real exchange rate was undervalued before the crisis in 2001.
Employing the augmented monetary exchange rate model, Civcir (2003b) seeks to determine
the nominal equilibrium exchange rate. Based on Johansen cointegration method and
monthly data spanning from January 1987 to December 2000, a cointegration relationship is
estimated including the nominal exchange rate, relative money supply, relative real income,
relative nominal interest rate, relative inflation rate and relative price differential. He
suggests that the nominal exchange rate was substantially overvalued prior to the 2001 crisis.
Özlale and Yeldan (2004) use a time varying parameter model to estimate the real exchange
rate in a single equation framework and monthly data for the period running from January
1992 to December 2001. The ingredients of the empirical relationship are the real exchange
rate, exchange rate volatility, short-run capital movements, industrial production index,
inflation based on consumer price index, budget balance of the public sector and openness
ratio. The authors find that the real exchange rate was overvalued after the crisis in 1994
until 1998, and undervalued in the last eight months of 2000 contrary to the expectations
because an overvaluation was targeted at the early stages of the 2000 disinflation program.
III. Data and Estimation Results
The empirical analysis of the real exchange rate of the Turkish lira makes use of a
quarterly data spanning from the first quarter of 1987 to the fourth quarter of 2009. Times
series are compilied from the Central Bank of Turkey’s Electronic Data Delivery System, the
IMF’s International Financial Statistics and the OECD Statistics. There are three variables:
the real exchange rate  qt  , the net foreign assets in ratio to GDP  ft  , and the relative
sectoral productivity differential  at  . Taking 2005=100 as the base year, the real exchange
rate is constructed from the nominal exchange rate expressed in units of US dollar per unit
Turkish lira and the GDP deflators of Turkey and the US. Thus, an increase in the real
exchange signifies an appreciation. We use the net foreign assets of the Central Bank of
Turkey obtained by the difference the foreign assets and the liabilities to non-residents. This
series also is expressed as a share of GDP. Regarding the relative sectoral productivity, we
employ average labor productivity as a proxy, due to the lack of availability of sectoral data,
by expressing it as a ratio of GDP to the the total employment. We also a set of dummy
9
variables to the currency crisis in the first quarter of the year 1994 (D94), the two-tier crisis
in the fourth quarter of 2000 and the first quarter of 2001 (D00), and the harsh impact of the
global financial turmoil in Turkish economy in the first quarter of 2009 (D09). All these
dummies take the value of one on the defined quarters and zero otherwise.
Figure 1 illustrates the real exchange rate and explanatory variables. Before moving
from the theoretical model to the empirical implementation, the relationships between the
real exchange rate and its fundamentals can be determined as follows: There is a close link
between the real exchange and the relative labor productivity although the effect of net
foreign assets on the real exchange rate is unclear. However, it depends on a very simple
analysis. The statistical analysis is presented below.
Figure 1 The Real Exchange Rate and Fundamentals
4.9
4.8
.6
q
.32
f
a
.28
.4
4.7
4.6
.24
.2
4.5
.20
4.4
.0
4.3
.16
4.2
-.2
.12
4.1
-.4
4.0
88
90
92
94
96
98
00
02
04
06
08
.08
88
90
92
94
96
98
00
02
04
06
08
88
90
92
94
96
98
00
02
04
06
08
Prior to attempting to estimate the long-run relationship between the real exchange
rate and the two fundamentals, we apply the standard unit root tests, that is, the augmented
Dickey-Fuller (ADF) and Phillips-Perron (PP) tests to investigate the integrated order of the
time series. The results are reported in Table 3, which clearly indicates that both the ADF
and the PP unit root tests fail to reject the presence of a unit root for all series in the level
forms, but not in the first differences. Therefore, all series in our sample are integrated order
one.
Table 3 Tests of Integrated Order
Levels
First differences
Constant
Constant & Trend
Constant
Constant & Trend
-2.004 (0)
-2.158 (0)
-8.152 (0)*
-8.107 (0)*
*
-7.285 (0)*
-8.104 (0)*
ADF (k) test statistics
q
f
-1.658 (1)
-3.691 (1)
-7.307 (0)
a
-1.475 (0)
-1.953 (0)
-8.147 (0)*
PP (k) test statistics
q
-2.004 (0)
-2.158 (0)
-8.152 (0)*
-8.107 (0)*
f
-1.661 (1)
-3.104 (1)
-7.307 (0)*
-7.285 (0)*
a
-1.475 (0)
-1.953 (0)
-8.147 (0)*
-8.104 (0)*
Notes:
(1)
The ADF test (Dickey and Fuller, 1979, 1981) is based on estimating the test regression
10
xt  α  βt  δxt 1  i 1 γi xt 1  ut where  represents the first difference operator, α is
k
constant, β is the coefficient of a time trend  t  , k is the lag order of the autoregressive
process, and ut is the white noise error term. Under the null hypothesis that xt has a unit root,
δ = 0 . The PP test (Phillips and Perron, 1988) estimates the non-augmented form of this
regression and directly modifies the t-ratio of the δ coefficient to correct for any serial
correlation and heteroscedasticity in the error term.
(2)
The superscript * signifies the rejection of the null hypothesis at 1 percent critical values.
Critical values are taken from the tables compiled by MacKinnon (1996).
(3)
Numbers in parantheses denote the lag length and are determined by using the minimum value
of Schwarz information criterion. The maximum lag is taken as 8.
(4)
Sample period is 1987Q1−2009Q4.
The first step in investigating the long-run relationship amongst the variables
integrated order one is to decide the appropriate lag length of the unrestricted VAR system.
We choose the proper lag length as 6 because it is the minimum lag sufficient to eliminate
serial correlation, heteroscedasticity and non-normality in the residuals. In order to test the
absence of serial correlation, heteroscedasticity and non-normality in the residuals of VAR
(6), the Breusch-Godfrey LM test (Breusch, 1978; Godfrey, 1978), the Ljung-Box Q test
(Ljung and Box, 1979), the White heteroscedasticity test (White, 1980) without cross terms
and the Jarque-Bera normality test (Jarque and Bera, 1987) are implemented. The results of
Table 4 reveals that the residuals do not display any serial correlation, and are homoscedastic
and multivariate normal.
Table 4 Residual Misspecification Tests for Unrestricted VAR (6)
Tests
Test Statistics
p-value
Serial Correlation
Breusch-Godfrey Test
LM(1)
13.73
0.13
LM(4)
14.68
0.10
42.60
0.21
Ljung-Box Test
LB(10)
Heteroscedasticy
White Test
240.8
0.37
Normality
Jarque-Bera Test
4.761
0.57
Skewness
0.795
0.85
Kurtosis
3.966
0.27
Notes:
(1)
The null hypotheses of residuals tests are that the residuals do not display any serial correlation,
and are homoscedastic and multivariate normal. The multivarite tests are based on Cholesky
decomposition of the covariance matrix.
(2)
The estimation period is 1987Q1−2009Q4.
11
(3)
Unrestricted VAR includes six lags on each variable, a constant, and D94, D00 and D09
dummy variables while there is only a separate drift in the cointegrating vector.
As a second step for our econometric analysis, we examine whether the variables
used are cointegrated with each other on the basis of the trace and maximal eigenvalue tests.
The results of both test statistics presented in Table 5 allow us to reject the null hypothesis of
no cointegration in favor of one cointegration relationship at a 95 percent significance level.
Therefore, we have a strong support that there is just one cointegrating relationship in the
chosen set of variables.
Table 5 Johansen Cointegration Test
Trace test
Rank
Eigenvalue
r 0
Maximal eigenvalue test
λtrace
p-value
λmax
p-value
0.258
30.62
0.04**
25.32
0.01**
r 1
0.052
5.300
0.78
4.549
0.80
r2
Notes:
0.009
0.751
0.39
0.751
0.39
(1)
The methodology of Johansen (1988, 1991, 1995) estimates the vector error correction model
which can be specified as xt  xt 1 + i 1 i xt i  ut where xt is an n x 1 vector of I(1)
k
variables. If  has less than full rank, but the rank of  is not equal to zero, then  can be
written as   αβ  where α is an  n x r  matrix of weights interpreted as a speed of
adjustment towards equilibrium, and β is an  n x r  matrix of parameters determining the
cointegrating relationships. The numbers of cointegrating vector are determined by the trace
and maximal eigenvalue tests.
(2)
The statistics λtrace and λmax are the trace and maximal eigenvalue statistics, respectively.
(3)
VAR includes six lags on each variable, a constant, and D94, D00 and D09 dummy variables
while cointegrating vector has only an intercept.
(4)
The superscript ** signifies the rejection of the null hypothesis at 5 percent critical values.
Critical values are extracted from MacKinnon et al. (1999).
(5)
The estimation period is 1987Q1-2009Q4.
Table 6 reports the cointegrating coefficients with associated t-statistics
corresponding to (14). All coefficients in the cointegrating vector are found to be statistically
significant at 1 percent level. Thus, we can express the cointegration relationship with a
constant term as follows:
qt  3.756  0.424 ft  5.181at
(14)
The normalized cointegrating equation exhibits that the relative labor productivity is
correctly signed, but the sign of net foreign assets is not predicted but expected because the
12
result of negative relationship between net foreign assets and the real exchange rate is
consistent with previous findings of Égert et al. (2004), Bénassy-Quéré et al. (2006) and
Alberola and Naiva (2007). The underlying cause of this result is probably the difference
between the real international interest rate and the growth rate of domestic real GDP. In fact,
average long-term real interest rate of the US is calculated to be 3.42 percent and average
real growth rate of Turkey is computed as 3.75 percent throughout the period under
investigation.
Table 6 also illustrates the speed of adjustment parameters. The adjustment
coefficient on the real exchange rate is highly significant and negatively signed. It indicates
that the real exchange rate moves to close the gap of a disequilibrium. The percentage of the
total adjustment offset in each successive quarter is 50 percent for the real exchange rate.
However, we find the adjustment coefficient of the net foreign assets is modestly significant
and that of the relative labor productivity is insignificant.
Tablo 6 Estimation of Cointegrating and Adjustment Coefficients
Normalized cointegrating coefficients
Coef.
Std. Err.
Adjustment coefficients
t-Stat
Coef.
Std. Err.
t-Stat
Δq
−0.501
0.175
−2.862*
q
1.000
f
0.424
0.072
5.848*
Δf
−0.218
0.112
−1.950***
a
−5.181
0.397
−13.06*
Δa
−0.032
0.035
0.907
*
Note: The superscripts and
values, respectively.
***
signify the rejection of the null hypothesis at 1 and 10 percent critical
We also implement exclusion, weak exogeneity and multivariate stationarity tests.
All test results are summarized in Table 7. Recall that in Balassa-Samuelson hypothesis, net
foreign assets are not considered as one of the fundamentals while the balance of payment
approach ignores the effect of the relative labor productivity on the real exchange rate.
Purchasing power parity entails that both net foreign assets and the relative labor
productivity are excluded from the cointegrating vector. The exclusion test results show that
net foreign assets and the relative labor productivity are not only individually but also jointly
significantly different from zero. This result demostrates that purchasing power parity does
not hold, and the real exchange rate is determined by both the balance of payment approach
and Balassa-Samuelson hypothesis.
Johansen cointegration analysis permits us to conduct tests for weak exogeneity of
the variables with respect to the parameters of cointegrating relationship. The weak
exogeneity test results notes that the weak exogeneity of all variables, apart form relative
labor productivity, can be rejected at least at 5 percent significance level. The weak
exogeneity of relative labor productivity is not a surprising result because it is mainly
13
determined outside the system by the conditions of labor market in Turkey and the US.
However, the weak exogeneity of net foreign assets can not be rejected at 1 percent
significance level. It is conceivable that the net foreign assets of the Central Bank of Turkey
may, independently from the exchange market conditions, be based on its monetary policy
programming. Furhermore, the joint weak exogeneity test indicates net foreign assets and the
relative labor productivity are weakly exogenous at 1 percent significance level.
Finally, we employ the multivariate stationarity test proposed by Johansen and
Juselius (1990) to determine the order of integration of the variables within the multivariate
context because there is only one cointegrating relationship. The multivariate stationarity test
result indicates the nonstationarity of all the variables, confirming the univariate unit root
test results.
Tablo 7 Exclusion, Weak Exogeneity and Multivariate Stationarity Tests
Exclusion Test
Weak Exogeneity Test
Multivariate
Stationarity Test
χ2 Stat
p-value
Χ2 Stat
p-value
χ2 Stat
p-value
q
19.70
0.00
9.091
0.00
19.18
0.00
f
17.26
0.00
4.432
0.04
21.22
0.00
a
19.11
0.00
1.000
0.32
22.00
0.00
f&a
19.18
0.00
6.621
0.04
Note: The likelihood ratio statistic for the exclusion, weak exogeneity and multivariate stationary
tests has an asymptotic χ2 distribution.
Finally, we estimate the error correction model using the result that the relative labor
productivity is a only weak exogenous variable at 5 percent level and deleting step by step
insignificant lags of the variables. Thus, the parsimonious model for short-run real exchange
rate is given as follows:
qt  0.0005  0.258ect 1  0.257 qt 3  0.089qt 5  4.397 at  1.604at 3
0.095D94  0.030 D00  0.005D09
(15)
where ect 1 denotes the lagged error correction term. The negative and significant coefficient
of the lagged error correction term indicates how quickly variables return to equilibrium
when an exogenous shock distrubs the equilibrium condition; as well R2 is 0.86. The
magnitude of this coefficient shows that approximately 26 percent of the adjustment towards
the equilibrium takes place per quarter, which implying that, in the absence of further shocks,
50 percent of the gap would be eliminated within about 10 months. In the short-run, the real
exchange rate is affected by its third and fifth lags. The relative labor productivity still plays
an important role on the movements of the real exchange rate, but its effect decreases. As
14
opposed to the long-run relationship, the impact of net foreign assets on the real exchange
rate is eradicated.
If we consider both net foreign assets and the relative labor productivity as weakly
exogenous variables at 1 percent level of significance, the short-run dynamics of the real
exchange rate can also be written as
qt  0.002  0.239ect 1  0.258qt 3  0.100qt 5  4.469at  1.585at 3
0.154ft  0.078D94  0.035D00  0.006 D09
(16)
The short-run parameters now estimated are roughly the same as that of the first
error correction model with R2 is 0.87. However, net foreign assets enters with positive sign
in the new error correction model on the contrary to the long-run relationship, but consistent
with the theoretical prediction.
IV. Estimation of the Equilibrium Exchange Rates and Misalignments
In the BEER appoach, there are two basic equilibrium real exchange rate concepts,
short-run equilibrium real exchange rate and long-run equilibrium real exchange rate. The
first one is the real exchange rate given by the current values of the fundamentals, and the
second one is defined as the real exchange rate determined by the long-run values of the
fundamentals. It is highly possible that these two equilibrium concepts are differentiated
from each other because the current values of fundamentals can depart from their long-run
levels. Therefore, we also have two different real exchange rate misalignment concepts,
namely short-run misalignment and long-run misalignment if the misalignment is defined as
the sustained deviation of the actual value of the real exchange rate from its equilibrium level.
Following Clark and MacDonald (1998), the real exchange rate can simply be
characterized as
qt  αZt  βTt  ut
(17)
where Z t is a set of fundamentals which have persistent effects on the real exchange rate,
such as the relative labor productivity and net foreign assets, Tt is a set of transitory factors
which have a short-run effect on the real exchange rate and include current and lagged
variables as well as dynamic effects from the fundamentals, and u t is unexpected shocks.
Both the short-run and the long-run misalignments, which are denoted by mistSR and mistLR ,
are obtained as
mistSR  βTt  ut
(18)
mistLR  mistSR  α  Zt  Z 
(19)
15
where Z represents the long-run values of the fundamentals. It is obviously seen from
(18)−(19) that short-run misalignment is simply the sum of the transitory factors and
unexpected shocks while the long-run misalignment is composed of the short-run
misalignment and the extent to which the fundamentals are away from their long-run values.
Thus, the differences between these misalignments arise actually from the second component
of the long-run misalignment.
Figure 2 shows both the equilibrium real exchange rates and the real exchange rate
misalignments for the whole period of study. The left-hand side illustrates the short-run and
long-run equilibrium real exchange rates by along with the actual real exchange rate while
the right-hand side plots the short-run and the long-run misalignments in the real exchange
rate. Positive value of the misalignment means that the real exchange is overvalued.
Figure 2 Equilibrium Real Exchange Rates and Real Exchange Rate Misalignments
5.2
.2
q
q_SR
q_LR
5.0
.1
4.8
.0
4.6
-.1
4.4
-.2
4.2
-.3
4.0
-.4
mis_SR
88
90
92
94
96
98
00
02
04
06
08
88
(a) Equilibrium Real Exchange Rates
90
92
94
96
98
00
02
04
mis_LR
06
08
(b) Real Exchange Rate Misalignments
Note: q_SR and q_LR denote the short-run and long-run equilibrium real exchange rates, and mis_SR
and mis_LR represent the short-run and long-run misalignments in the real exchange rate,
respectively.
Looking first at the equilibrium real exchange rates, the real exchange rate follows
more or less the same path of its equilibrium levels although it moves closer to the short-run
equilibrium real exchange rate. However, the long-run equilibrium real exchange is more
stable than short-run equilibrium real exchange rate because the former is derived from the
long-run values of the fundamentals estimated using Hodrick-Prescott filter. The long-run
equilibrium real exchange rate can be analyzed in three sub-periods: a appreciation from the
first quarter of 1987 to the second quarter of 1992, a depreciation from the third quarter of
1993 to the fourth quarter of 2000 and a appreciation from the first quarter of 2001 to the
fourth quarter of 2009.It is noteworthy to point out that the fundamentals account for most of
the long-run equilibrium real exchange rate. The appreciations at the first and the end of the
sample period appear to be associated only with upward trend in the relative labor
productivity whereas a rise in net foreign assets may in part account for the depreciation
period in addition to declining relative labor productivity.
16
Turning to the real exchange rate misalignments, we can say that there is a
connection between the short-run and the long-run misalignments until the early 2006 except
for 1993. At the beginning of 1987, the real exchange rate was undervalued by about 10
percent and this initial undervaluation lasted until the third quarter of 1989 owing to
unsuccessful disinflationary efforts and debt financing policies. With the advent of capital
account liberalization in August 1989, the period of overvaluation started at the end of 1989
and lasted until the second quarter of 1993. Although short-run misalignment was inferior to
zero in the rest of 1993 as opposed to long-run misalignment, the monetization of fiscal
deficits in the last months of 1993 because of rapidly rising public sector borrowing
requirement during 1992-1993 led eventually to the currency crisis in 1994. In the aftermath
of the crisis, the Turkish lira was sharply undervalued since it was devalued more than 80
percent against the US dollar in the second quarter of 1994. In the start of 1995, the real
exchange rate converged back to its equilibrium levels and was mildly overvalued until the
end of this year. However, the currency in real terms was slighty undervalued in 1996 and
1997, this resulted from political uncertainties arising from the early elections held in
December 1995 and the contagion effect of the Asian crisis broke out in 1997. Disinflation
programs of 1998 and 2000, which were conducted under the supervision and technical
support of the IMF, decreased the level of anxiety about Turkish economy and overvaluation
occurred from 1998 to 2000 although neither of the programs lived long and Turkey
witnessed a serious capital outflow after the Russian crisis of 1998. In the run up to the twotier crisis in December 2000 and February 2001, the real exchange rate was overvalued by
11 percent in 1999 and 7 percent in 2000. Following the twin crises, the real exchange rate
was undervalued for two consecutive years because no sooner had Turkey switched from the
crawling peg to a floating exchange rate regime in February 2001 than the currency
depreciated massively. With the favorable economic environment provided by the political
stability following the November 2002 elections, overvaluation started in second quarter of
2003 and came to an end as of the second quarter of 2006 although the Federal Reserve
started to increase policy rates in the second half of 2004.
After 2006, it is worth noting that not only has the link between the short-run and the
long-run misalignments been broken down for the last three years, the short-run
misalignments have also started to move in the reverse direction from the long-run
misalignments because the relative labor productivity as a main fundamental of the real
exchange rate has significantly been departed from its long-run levels. In fact, the positive
difference between the relative labor productivity and its long-run level has triggered off
undervaluation of the real exchange rate in the short-run and overvaluation in the long-run
17
while negative difference has brought about overvaluation in the short-run and
undervaluation in the long-run since 2006. Considering only the long-run misalignment, we
can see that undervaluation in 2006 was a result of the deterioration in global risk perception
in the post-May period of the year. Since this shock was short-lived, the real exchange rate
was overvalued in the second quarter of 2007 and remained overvalued until the last quarter
of 2008. However, undervaluation appeared once again in the last year of the sample with
the global financial turmoil spreading to Turkey after the last quarter of 2008. Together with
annual growth rate, the magnitudes of the misalignments reported in Table 8, where the
long-run misalignments indicate that the real exchange rate was overvalued by more than 7
percent on average for at least three years prior to the crises of 1994 and 2000/01. Therefore,
large and persistent overvaluation can serve as an early warning indicator for potential crisis
in Turkey.
Tablo 8 Short-Run and Long-Run Misalignments and Growth Rate
(annual averages of quarterly values, in percent)
Year
Misalignment
Growth
Rate
Year
Misalignment
Short-Run
Long-Run
1987
−11.7
−9.24
1988
−10.8
−16.2
2.98
2000
7.22
6.88
7.16
1989
−3.13
−10.1
−0.02
2001
−5.53
−15.4
−6.95
1990
2.73
11.4
10.3
2002
−3.70
−10.4
7.57
1991
5.60
6.91
0.36
2003
0.74
1.93
6.07
1992
3.05
3.44
5.09
2004
1.78
5.62
8.87
1993
−2.76
8.12
7.64
2005
2.25
5.45
7.54
1994
−7.16
−18.2
−4.19
2006
4.16
−3.54
6.14
1995
1.45
1.74
8.27
2007
−5.51
2.87
5.33
1996
−0.97
−1.84
7.30
2008
−8.66
6.75
1.74
1997
−2.83
−0.72
7.42
2009
5.19
−9.35
−4.88
1998
1.62
7.01
3.56
1999
Short-Run
10.6
Long-Run
Growth
Rate
10.6
−4.74
We also compare the long-run misalignment with the annual growth rate of real
GDP. In the literature, there are two different views related to the role of misalignment on
the growth; one view is the Washington Consensus view and the other is the Rodrik view
(Berg and Miao, 2010). The first view argues that any misalignment in the real exchange rate
has adverse effects on the growth rate while the second view asserts that only overvaluation
hurts the growth, but undervaluation facilitates the growth. As evident from Figure 3,
however; it is found that, contrary to both views, there is a mildly positive relationship
between the long-run misalignment and the growth; the more overvalued the Turkish lira, the
18
higher the growth rates and the more undervalued the Turkish lira, the lower the growth
rates3. In fact, overvaluation led to the economic contraction only in 1999 while economic
growth was associated with undervaluation only in the years of 1988, 1996, 1997, 2002 and
2006, as can be seen in Table 8. This result emanates from the strategy of the import-led
growth: Overvaluation cheapens the costs of imported machinery and equipment and
intermediate products which are vastly necessary for Turkey to stimulate higher growth
before completing the process of economic development. However, this strategy does not
seem to be sustainable because, again, the real exchange rate is undervalued and economic
performance is flawed when a financial crisis bursts out after overvaluation reaches a
dangerous level.
Figure 3 Growth Rate and Long-Run Misalignment
20
10
0
-10
-20
-30
g
mis_LR
-40
88
90
92
94
96
98
00
02
04
06
08
Note: g is the annual growth rate of real GDP and
mis_LR is the long-run misalignment in the real
exchange rate.
Finally, we attempt to compute the equilibrium nominal exchange rates because the
nominal exchange rate is more easily controlled by policymakers and more observable to
others than the real exchange rate. Using a highly simplified approach, equilibrium nominal
exchange rates are calculated by dividing an index of the ratio of Turkish prices to US prices
by the real equilibrium exchange rates, and the results are given in Table 9.
Tablo 9 Short-Run and Long-Run Nominal Equilibrium Exchange Rates
(annual averages of quarterly values, in percent)
Nominal Exchange Rate
Year
Nominal Exchange Rate
Equilibrium
Actual
ShortRun
LongRun
Year
Equilibrium
Actual
ShortRun
LongRun
1987
0.0009
0.0008
0.0008
1999
0.4188
0.4665
0.4653
1988
0.0014
0.0013
0.0012
2000
0.6252
0.6713
0.6693
3
Growth equation estimation results can be obtained from authors upon request.
19
1989
0.0021
0.0021
0.0019
2001
1.2256
1.1405
1.0311
1990
0.0026
0.0027
0.0029
2002
1.5072
1.4528
1.3555
1991
0.0042
0.0044
0.0044
2003
1.5009
1.5087
1.5248
1992
0.0069
0.0071
0.0071
2004
1.4255
1.4505
1.5056
1993
0.0110
0.0107
0.0119
2005
1.3436
1.3742
1.4191
1994
0.0296
0.0277
0.0245
2006
1.4285
1.4883
1.3770
1995
0.0458
0.0465
0.0468
2007
1.3029
1.2368
1.3373
1996
0.0814
0.0806
0.0799
2008
1.3015
1.2076
1.3829
1997
0.1519
0.1475
0.1511
2009
1.5500
1.6343
1.4106
1998
0.2607
0.2659
0.2813
V. Conclusion
In this paper, we aim to investigate the impact of overvaluation on the financial
crisis and the growth rate for Turkey using the quarterly data from 1987 to 2009. For that
reason, we estimate the short-run and the long-run equilibrium real exchange rates along the
lines of Faruqee (1995) and Alberola et al. (1999). Our empirical results indicate that the
equilibrium real exchange rate appreciates with positive shocks to the relative labor
productivity whereas an increase in net foreign assets yields a depreciation, which is contrary
to what the model predicts. However, this result is expected because there is a negative
difference between average long-term real interest rate of the US and average real growth
rate of Turkey during the period under investigation. It is also found that purchasing power
parity does not hold, and the real exchange rate is determined by both the balance of
payment approach and Balassa-Samuelson hypothesis in Turkey.
Comparing the real exchange rate with the equilibrium exchange rates, we can draw
two important policy implications: First, large and persistent overvaluation, which is more
than 7 percent on average for at least three consecutive years, can serve as an early warning
indicator for potential crisis in Turkey. Second, a relatively small overvaluation, contrary to
both the Washington Consensus view and the Rodrik view, stimulate the growth of Turkish
economy due to the strategy of import-led growth.
20
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