Real exchange rate misalignment and financial stability: The role of capital movements in Türkiye

The development of foreign trade as a consequence of globalization has made the exchange rate one of the most important indicators reflecting the competitiveness of economies in foreign markets. In recent years, there has been a widespread view that exchange rate evaluations should not only be based on the actual exchange rate but also on the misalignment of the exchange rate with the equilibrium level. Overvaluation of the real exchange rate may weaken the competitiveness of the country in question in international markets and adversely affect the foreign trade balance. A permanent deviation of the actual exchange rate from its equilibrium value, known as exchange rate misalignment, can cause serious problems for economies, adversely affect the stability and sustainability of financial conditions, and cause financial crises. Financial stability, which refers to the financial system's resilience against various risks and shocks, is a crucial concept for national economies and social welfare. Along with financial liberalization, short-term capital movements to developing countries have increased rapidly. Sudden inflows and outflows of short-term capital movements, which are highly sensitive to interest rate and exchange rate fluctuations, may cause excessive fluctuations in exchange rates, and these sudden movements may create uncertainties and fluctuations in the financial system and pave the way for financial crises, especially in countries where the financial system is not sound. This study aims to examine the dynamic relationship between exchange rate misalignment, financial stability, and short-term capital movements for the Turkish economy. For the purpose of the study, a macro-financial stability indicator for Türkiye covering the period 2006:01 – 2024:05 has been constructed consisting of four sub-indicators: financial development indicator, financial vulnerability indicator, financial soundness indicator and world economic climate indicator. The equal weighting method was used in the calculation of sub-indicators, each of which consists of five components. The weights of the sub-indicators used in the formation of macro-financial stability indicator were determined empirically. In order to measure the percentage of real exchange rate misalignment which constitutes another pillar of the study, the equilibrium exchange rate was calculated with the help of four different models: the interest parity model, the Balassa-Samuelson model, the behavioral equilibrium exchange rate (BEER) model and the pure statistical model. In this context, to examine the relationship between these variables, four different models were established for each exchange rate misalignment percentage measured within the framework of four different models and the relationship between these measured misalignment percentages and the constructed macro-financial stability indicator and short-term capital movements was investigated through the VAR model. The estimation results show that the exchange rate misalignment in the face of short-term capital movements responds statistically and theoretically in line with expectations for all models except the pure statistical model. A one-standard deviation positive shock in short-term capital inflows leads to real exchange rate misalignment and overvaluation of the real exchange rate. This study concludes that when the overvaluation of the exchange rate is evaluated in terms of its possible effects on a country's international competitiveness, foreign trade deficits and thus current account deficits, sudden net short-term capital movements should be taken into consideration for the Turkish economy.