15/3/2007 FINANCIAL CRISIS OF in TURKEY Ismail ARDIC Ozgur BAL Himmet PARMAKSIZ May 2007

25/3/2007 OUTLINE 1- A Decade Before The Crisis  International Environment  Domestic Circumstances 2- The Context of The Exchange Rate Based Stabilization Program 3- The Outbreak of The Crisis  November 2000  February Conclusion

35/3/2007 A Decade Before The Crisis  International Environment Politics: Collapse of the Soviet Union and the Eastern Bloc Reunification of Germany The Kuwait Crisis and the Gulf War Economics: Recession in Europe Asian Crisis in 1997 Russian Crisis in 1998

45/3/2007  Domestic Circumstances Politics: The Decade of Populist Coalition Governments Integration to the EU Economics: Recession in Europe The Customs Union with the EU Unstable Growth Rates

55/3/2007 MACROECONOMIC VARIABLES

65/3/2007 Source: EIU Market Indicators and Forecasts. The Characteristics of Real GDP Growth: Too Much Volatility Artificial Growth

75/3/2007 Source: EIU Market Indicators and Forecasts. The Characteristics of Trade Balance: Somewhat stable, but persistent trade deficit Exports heavily rely on imported raw and semi-finished materials Negative effects of recession in Europe Temporary effects of the customs union

85/3/2007 Source: EIU Market Indicators and Forecasts The Characteristics of Public Dept: Increasing trend from 33.2% in 1990 to 53.5% in 1999 Domestic borrowing rather than international borrowing High interest payments; almost all of the government revenues in 1999 paid for high interest payments

95/3/2007 Source:Ministry of Finance The Characteristics of Public Finance: Persistent budget deficits Expansionary fiscal policies

105/3/2007 Source: Central Bank, the IMF-International Financial Statistics (IFS) The Characteristics of Monetary Variables: Chronic high inflation; average around 77%, starting from % Expansionary monetary policies Somewhat stable nominal exchange rate, except in 1994 (167%) High interest rates; average around 82%, starting from %

115/3/2007 The Context of the Exchange Rate Based Stabilization Program Main Aim of the Program; “decreasing the inflation rate to a single digit by the end of 2002 associated with economic growth” Three pillars of the program; 1.Determination of exchange rates under a pre-announced crawling peg arrangement 2.Fiscal discipline encompassing both of the central government budget and the rest of public sector 3.Implementation of structural reforms, especially an acceleration in privatization

125/3/2007 The Context of the Exchange Rate Based Stabilization Program The Measures of the Program; Adopting of the exchange rate basket of the US dollar and the Euro as a nominal anchor Increasing tax revenues Controlling government spending Decreasing interest rates Increasing non-interest fiscal surpluses

135/3/2007 AT THE BEGINNING OF THE PROGRAM There was optimism in the markets about the new economic program. There were two main reasons for this “initial optimism”: Positive expectations about the Program Improvements in the Turkey-European Union relations.

145/3/2007 SOME POSITIVE ECONOMIC SIGNALS Net capital inflows: $15.2 billion for first ten months of Decrease in interest rates: Interest rate of Treasury bills decreased from 106% to 37% per annum by January Government budget primary surplus: Reached at 2.8% of GDP despite the target of 2.2% within first ten months. Economic growth: Reached at 6.5-7%, whereas, -6.1% growth rate of 1999.

155/3/2007 OUTBREAK OF THE CRISIS

165/3/2007Problems Prices were stickier than expected Inflation rate was converging to the devaluation rate very slowly and the end- year target was overshot. r => C + I =>AD => P

175/3/2007

185/3/2007Problems Significant appreciation of the currency in real terms The inflation rate was converging to the predetermined devaluation rate very slowly and the end-year target was overshot.

195/3/2007 Problems Drastic deterioration of the trade deficit. Expansion in import had reached to 35% in 2000 while export growth remained at 7 %. Current account deficit/GDP ratio reached nearly to 4.9% level at the end of the 2000 whereas it had been 0.7% at the end of the Appreciation of the currency reduced the competitiveness of domestic goods in international markets and increased the trade deficit Thanks to low interest rate investment, consumption and therefore imports increased. And because of the over valued currency exports decreased.

205/3/2007Problems Drastic deterioration of the trade deficit (II). The rise of the US dollar against the Euro also had resulted in a deterioration of the current account deficit.

215/3/2007Problems Structural problems and fragilities in the financial sector Some difficulties in the privatization of state owned enterprises

225/3/2007 November 2000 The first signs of trouble appeared in September when net capital flows turned out to be negative. At the end of October banks tried to close their open foreign exchange positions due to regulatory and balance sheet purposes. This move created a liquidity squeeze and caused interest rates to increase. Central banks can sterilize the effects of this seasonal outflow through expansionary open market operations. However, the Central Bank (CB) had to act as a semi-currency board.

235/3/2007 November 2000 The initial optimism has worn out. The rapid flight of capital from country started. Because of: Disappointing inflation results for October, Unexpectedly high monthly trade deficits, Political difficulties faced in privatization, Worsening relations with the EU, The economic crisis in Argentina, Rising the US official interest rate,

245/3/2007 November 2000 The outflow was followed by the rise in the interest rates at the last week of November and the market risk in Turkey increased. The banks in need of short-term funding began to sell government securities. Rush to liquidity was inflamed because of the competitive maneuvering among some private banks. The decline in the value of government securities and the rise in the sovereign risk because of the fragility of the financial system led foreign investors to accelerate their exit from the Turkish markets by selling their securities.

255/3/2007 November 2000 Overnight interest rate were at an average of 72.4% in November and 223.8% in December.

265/3/2007 November 2000 The CB faced with a dilemma; either to stick by the program and monetary rule “at the expense of a deep financial crisis”, or to inject liquidity to the market exceeding its defined target for net domestic assets in order to rescue the financial system. After some hesitation it started providing extra liquidity to the troubled banks.

275/3/2007 November 2000 On November 22 nd and following days, foreign exchange reserves of the CB declined rapidly. Within a few days, on November 30 rd, 2000 the CB reversed its policy and announced that it would no longer fund the commercial banks in the interbank market and this announcement skyrocketed the overnight interest rates to four-digit levels.

285/3/2007 November 2000 On December 6 th, the IMF announced that it was going to support the program by opening a new credit line with the extension of a $7.5 billion Supplementary Reserve Facility to Turkey. Government reached a new agreement with the IMF, the new Letter of Intent was announced on the 18 th of December, and the CB announced its new monetary program in December 22 nd. The original limits on the balance sheet of the CB were revised; but the path of the rate of depreciation of domestic currency remained same.

295/3/2007 After November Turmoil At the end of 2000 the markets seemed to have calmed down and the erosion of international reserves stopped. By mid- January international reserves had been refilled, exceeding their pre-crisis level, and interest rates had fallen below 60%.

305/3/2007 After November Turmoil However, maturities in government security started to shorten drastically in late-January and interest rates started to shoot up, reaching 70% in mid-February. These gave rise to serious doubts on the sustainability of public debt. Rising public debt, high inflation and the continuing appreciation of the Turkish Lira (TL) brought considerable doubts about the sustainability of the crawling peg system.

315/3/2007 February 2001 On February 19 th, 2001 political crisis between the Prime Minister the President seriously hit the markets. Over-night interest rate rose abruptly up to 2058% on the 20 th of February, and to 4019% on the next day. Rising interest rates, with overnight rates reaching 5000%, could not stop the rapid flight from the TL. Not only non-residents but also residents and especially the banking sector rushed to foreign currency (dollarization). The CB lost big part of its foreign reserves in defending the currency peg.

325/3/2007 February 2001 The government could not bear the pressures of the markets any more and was obliged to abandon the peg and set exchange rates to float on February 22 nd, again with the consent of the IMF. Within a single day the currency lost about one-third of its value against the dollar.

335/3/2007 Inferences from the Crisis The problems associated with exchange rate-based stabilization Fiscal problems Maturity structure of the debt Structural weaknesses in financial markets

345/3/2007 Problems associated with exchange rate based stabilization Risks of exchange rate based stabilization  Fragility of pegged exchange rate overvalued currency growing external deficit reliance on capital inflows  Difficulty of abandoning it without causing a crisis fear of loosing credibility in this context, fear of capital outflow and recession in this context, fear of capital outflow and recession

355/3/2007 Fiscal Problems Lack of fiscal dicipline in the past Incomplete implementation of fiscal structural measures during the program

365/3/2007 Maturity structure of the debt The ratio of short-term foreign debt to the CB’s international reserves reached at 112% in June 2000 and 145 % in December 2000.

375/3/2007 Transition to the Strong Economy Program In May 2001 an agreement was reached with IMF on a new program Main aim was to minimize short-term macro economic impact of recent crisis and to provide disinflation and growth Tools of the program were;  Continuing to floating currency  CB’s focusing on the control of monetary aggregates  Transparency of policies and implementations  Restructuring of financial sector and fundamental reforms of the state and the SDIF owned banks

385/3/2007 As a result; Structural weaknesses of financial sector, crawling peg, downward inflexibility of prices, problems in fiscal discipline, the maturity structure and magnitude of the foreign and domestic debts led to the occurrence of the crisis. It can be seen that the “Transition To The Strong Economy” program, implemented successfully since 2001, has also pointed out these factors and tried to cope with them.