Exchange Rate Risk and Interest Rate:A Case Study for Turkey.

Presented By-

Pravneet Kaur (11403528)Rishav Raj (11401746)Priya Bansal (11401563)Priyanka Bajaj (11401740)

Introduction

A Comprehensive package was provided for the same which included:

Devaluation of Turkish Lira

Institution of flexible exchange rates

Maintenance of Positive real interest rates

Tight control of money supply and credit

Elimination of subsidies

Freeing of prices charged by the state enterprises

Reform of tax systems

Encouragement of foreign investment

1980- Reform program to shift Turkey’s economy towards export led growth.

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Liberalization program in 1983.

It enabled Turkey to borrow in International capital markets.

But, rise in merchandise exports was less than that of Merchandise imports.

Between 1981 and 1985,

Real GNP grew 3 percent per year, led by growth in the manufacturing sector.

Output in manufacturing sector rose by an average rate of 9.1%.

Devaluation of Lira made Turkey more competitive.

As a result exports of manufacturers increased by avg. rate of 45% p.a.

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Unemployment and Inflation were serious problems.

Turkish economy was also impacted upon by Persian Gulf war. Loss of pipeline fees resulted in loss of USD 3 billion in trade with Iraq.

Saudi Arabia, Kuwait and UAE helped Turkey and the economy rose again by 1992.

Budget deficits were covered due to high credit rating by Wall Street’s Credit rating agencies in 1992 and 1993.

Accelerated Dollarization of economy (1994).

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To recover from its economic problems, government announced certain measures:

Sharp increase in prices the public-sector enterprises.

Decreases in budgetary expenditures.

Commitment to raise taxes.

Accelerate privatization of state economic enterprises (SEEs).

However, slowdown in government spending resulted in sharp loss in business confidence and decline in tax revenues.

Combined with stronger private sector, the economy was expected to bounce back to a pattern of faster growth.

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Factors Affecting Exchange Rate Differentials in Inflation: Those countries with higher inflation typically

see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.

Differentials in Interest Rates: Higher interest rates attract foreign capital and cause the exchange rate to rise & lower interest rates tend to decrease exchange rates.

Current-Account Deficits: The excess demand for foreign currency lowers the country's exchange rate.

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Public Debt: Nations with large public deficits and debts are less attractive to foreign investors. In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation.

Terms of Trade: Increasing terms of trade shows greater demand for the country's exports. If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners.

Political Stability and Economic Performance: Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.

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CONTINUED…

Effect of Exchange Rate Risk on Interest RatePositive relationship between the exchange rate risk and interest rates.

• Exchange Rate fluctuations

Introduces

• Risk on return of an asset in foreign currency

Compensated with • Higher risk

premium

Positive relation

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Interest Rate Parity Assumption :

capital mobility perfect substitutability

 No-arbitrage condition representing an equilibrium state.

A theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.

When domestic interest rate > foreign interest rate, domestic currency is expected to depreciate.

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Results…

Table A

Explain the relationship between interest rate and exchange rate.

RESULT Exchange rate depreciation risk increase the interest rate.

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Results…

Table B

There is a positive relationship between exchange rate risk and interest rates.

Table C

Shows the result from the post crisis period.

Again, Positive relation between exchange rate risk and interest rates.

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Conclusion…Study explain the effect of the exchange rate risk on the interest rate.

Data from Turkey suggests that a higher exchange rate risk increases the interest rate.

Data from Jan 1995 to 2001 supporting an evidence.

Result become robust after considering the inflation risk.

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THANKS

ANY QUESTION?