The Turkish current account, real exchange rate and sustainability: a methodological framework

Abstract

Embarked on an accession path to the European Union (EU), Turkey needs higher investment ratios to sustain high growth rates for a prolonged period so as to sustain convergence with the EU. In a fast medium-term growth scenario, pressures on the current account are likely to emerge as investment will need to increase while fast income growth will also boost consumption and imports. However, in the case of Turkey, large current account (CA) deficits are also likely to be combined with an appreciating real exchange rate, as in the past few years, in response to robust capital inflows as Turkey gets closer to EU accession. A "convergence play", similar to those seen in other EU accession countries and Eurozone members, where expected declines in domestic interest rates to levels closer to the EU average generate expectations of significant capital gains, is likely to make portfolio investments to Turkey particularly attractive. This could intensify pressures on the current account and leave the country vulnerable to possible swings in market sentiment and capital flow reversals. In this context, it is important to keep the current account deficit at sustainable levels. During the last three and half decades Turkey has experienced four balance of payments crises. These crises highlighted the danger of having excessively large current account deficits which are associated with a high probability of a balance of payments crisis.