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In an interview with Daron Acemoglu, he says "the hot money which was floating through Turkey has stopped after FED's declaration that we are going to give much more attention on monetary policy". Basically I know some fundamental things like monetary policy interests with the foreign currency but dont get exactly how does it effect directly. Why or how do foreign investments get scared by monetary policy?

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migrated from Dec 24 '14 at 16:19

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@ChrisW.Rea - I asked at the Econ chat room if they'd like this one. No response yet. I understand etiquette is to ask before migration. – JoeTaxpayer Dec 23 '14 at 1:53
@JoeTaxpayer Understood. FWIW, my note was more for the OP. I suggested "Consider" to the OP as in: go there, read their FAQ & meta, ask at meta if still unclear, post only if on-topic. – Chris W. Rea Dec 23 '14 at 2:31

2 Answers 2

Monetary policy affects the value of a country's currency (e.g. interest rate & money supply changes affect the value of cash).

Foreign investment is made by purchasing that country's currency (via currency exchange), then purchasing financial instruments in that country (stocks, exchange traded funds, bonds, etc.)

If a country decides to lower their currency's value over time (to make their goods cheaper to foreigners, for example), then any foreign investment would be exposed to currency devaluation.

A concrete example…

  1. Turkish commodity market, sells 1 ton of cotton for 230 Lira (~$100USD) on January 1, 2015.

  2. US investor exchanges $100USD into 230 Lira, buys 1 ton cotton on 1/1/2015.

  3. Turkey decides to lower currency value by decreasing interest rate, increasing money supply, reduce reserve requirements. Value of Lira drops from 230 Lira for 100 USD to 270 lira for 100 USD.

  4. US investor sells 1 ton cotton a year later for 250 Lira. Exchanges Lira to USD. Receives $92.60USD.

What would normally be a modest ~9% gain from price appreciation of the cotton from 230 to 250 turns out to be an ~8% loss due to currency devaluation which occurred from monetary policy changes.

If a foreign investor isn't confident that monetary policy will drive up a country's currency value (in which they will be investing), then they should rightly be scared by monetary policy changes a government plans to make.

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The investor can buy an option at Step 2. In this example, it would work. – Anton Tarasenko Dec 27 '14 at 0:51

Conceptually, US monetary policy affects the US/Turkey exchange rate because of interest rate parity. Exchange rates and interest rates obey the following identity (where all quantities are specified in logs, and "tomorrow" is meant loosely as some future date): $$\text{USD per TRY today} = \text{Expected USD per TRY tomorrow} \\ + (\text{TRY interest rate}-\text{USD interest rate})-\text{TRY/USD return premium}$$ This is an arbitrage condition. If the return premium is zero, it is equivalent to the statement that if I borrow at the US dollar interest rate today and invest in Turkish lira at the Turkish interest rate, then convert back to dollars tomorrow, I should expect to break even. (This is called uncovered interest parity, and it generally does not hold, though it can be a decent approximation in some settings.) The "return premium" is thrown in as a fudge factor, reflecting the fact that there might be some risk or other premium on lira investments -- for investors to be indifferent between dollar and lira, they demand a positive expected return on lira over dollars.

Now, suppose that the Fed raises the USD interest rate (or signals that it will do less QE than anticipated, etc.). Then, all else equal, the identity above implies that the lira will weaken today relative to the dollar. This is the sense in which a tightening monetary policy in the US pushes down other currencies relative to the dollar. This weaker lira will be accompanied by a smaller net capital inflow into Turkey, since Turkey's net imports will decline.

Now, all else might not be "equal", since central banks (particularly in developing economies) will often try to limit currency fluctuations; in this case, we might expect the Turkish central bank to raise rates to partly offset the Fed's action. These higher rates will lead to diminished investment, and a somewhat weaker Turkish economy.

An aside: the quote mentions "hot money", a term that I dislike because it's so vague. If we define "hot money" to be "international investors' capital moving at high frequencies", hot money doesn't necessarily leave the country when the currency weakens. Indeed, possible central bank interventions in the foreign exchange market aside, if "hot money" is the only private capital moving around quickly, then total hot money flows must net out to zero in the short run: the net capital inflow must equal the current account deficit, which is trivial over the span of a few days. The key point is that although "hot money" doesn't leave in equilibrium, the exchange rate might have to fall substantially for the market to equilibriate.

For instance, if investors holding "hot money" collectively get jittery about a currency and want to hold dollars instead, the currency might collapse until it reaches a value where (in the aggregate) they remain willing to hold the same amount. In the identity above, this would be reflected in a dramatic rise in the TRY/USD return premium. This is a common story of crises in developing countries with open but fragile capital markets.

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