Imbalances in foreign trade and characteristics of net capital inflows

The relationship between the imbalances in current accounts and financial accounts is of crucial importance in the stability of economies. This study models this relationship for Turkey by focusing on the interactions between foreign trade imbalances and net capital inflows. Components of net capital inflows are classified according to certain characteristics: types and maturities of borrowings, and types of resident sectors as borrowers. Monthly data are used starting from 2007.  Stable vector autoregressive (VAR) models include the exchange rate, Emerging Markets Bond Index for Turkey (EMBI-TR) and petroleum prices (since Turkey's trade deficits emanate from high energy expenditures) in addition to foreign trade imbalances and net capital inflows. The findings of VAR models show that trade credits and long-term net loan borrowings of banks in foreign currencies have significant effects on foreign trade deficits. Interestingly, the capital inflows stemming from banks' short-term net borrowings abroad do not increase imports, but they increase international reserves. This may be attributed to the reserve option mechanism (ROM) policy of the Central Bank of Turkey, which allows banks to hold their required reserve liabilities in foreign currencies instead of the domestic currency. Also external debt indicators, like the ratio of foreign trade deficit to gross domestic product (GDP) and the ratio of other sectors' long-term net loan borrowings to GDP, have significant positive effects on EMBI-TR (yield gap between treasury bonds of Turkey and the United States). This implies that an increase in the yield gap is taken as an indication of a rising country risk for Turkey. Hence upward movements in EMBI-TR cause depreciations in Turkish liras and increases in foreign capital outflows. This study also analyses the effects of exchange rate volatility on the foreign trade balance. One striking finding is that exchange rate volatilities decrease the ratio of non-energy imports to GDP. This may be helpful in guiding macro-prudential policies aiming to reduce the available domestic credits to target large foreign trade deficits.