The Relationship between Dollarization, Portfolio Flows and Exchange Rate Volatility for the Turkish Economy during the 2003-2018 Period

Abstract

Foreign currency usage (as deposits and loans) of the Turkish banking system (dollarization) has gradually decreased from 50 percent in 2003 to 30 percent in 2010. Yet, in the second half of 2011 dollarization in the Turkish banking system began increasing and reached to 50 percent. During the same period, volatility of the Turkish lira US dollar exchange rate has also elevated in a parallel fashion. Adverse effects of volatility on the economy such as discouraging investments, causing higher exchange rate passthrough to inflation are known. Analytic information regarding the determinants of conditional exchange rate volatility is important for monetary policy. In this paper, we investigate determinants of the Turkish lira US dollar exchange rate volatility EGARCH-M. Our results indicate that dollarization of the banking system, particularly credit dollarization has increasing effects on conditional exchange rate volatility. On the other hand, portfolio capital flows both to debt and stocks have reducing effect on conditional exchange rate volatility. At the same time, country risk measure, rise in Turkish government debt default insurance premium (CDS) has increasing effect on conditional exchange rate volatility. Elevation of conditional volatility and increase in interest spreads on Turkish lira US dollar loans lead to depreciation of the Turkish lira, while increase in interest rate spreads on Turkish lira US dollar deposits lead to appreciation of Turkish lira. As policy recommendation of this paper, dollarization in the banking system must be reduced by using appropriate tools while capital flows to the country must be encouraged.