Lessons from the Financial Liberalization Experience of Turkey, A. Erinç Yeldan Bilkent University IDEAs Network

With the completion of capital account liberalization in 1989, Turkey is trapped into high real rates of interest and an overvalued exchange rate (cheap foreign currency)

Worsening of macroeconomic fundamentals led by capital inflows: The Dornbusch-Taylor cycle Rise in the domestic interest rate: Stimulate capital inflows Domestic currency appreciates Imports expand, current account deficit widens To finance the foreign deficit, invite even more capital inflows, raise the interest rate

Inflation is on a falling trend, yet the real interest rate proves to be inertial...

Macroeconomic Prices of the IMF Programme Inflation Nominal Rate of Interest on Domestic Debt Ex Ante Real Interest Rate on Domestic Debt

Speculative Financial Arbitrage on the Interest Rate and Depreciation (%) (1+R)/(1+e)-1

Large scale of Capital Inflows lead to currency Mis-alignment...

Large Current Account Deficits: 2003 Total: $8.0 billion (3.4% of GNP) 2004 Total: $15.7 billion (5.2% of GNP) 2005 First 9 months: $15.8 billion (6.2% of GNP)

The current account deficit problem emerges not because of its sheer size, but because of the mode of financing

Characteristics of new varieties of crises International capital market has been the major source of shocks Flows have largely originated from and been received by the private sector The financial crises have mostly hit emerging market economies that were considered to be highly credible and successful The rise of capital inflows has been characterized by a lack of regulation, on both the supply and the demand sides.

In the summarizing words of the UNCTADs 1998 Trade and Development Report, Economic crises are often associated with deterioration of the macroeconomic fundamentals in the recipient country. However, such deterioration often results from the effects of capital inflows themselves as well as from external developments, rather than from shifts in domestic macroeconomic policies.

the ascendancy of finance over industry together with the globalization of finance have become underlying sources of instability and unpredictability in the world economy. (…) In particular, financial deregulation and capital account liberalization appear to be the best predictor of crises in developing countries (pp.v and 55).

Policy implications Prudential regulation and new financial architecture (though necessary, will not suffice to break the Dornbusch-Taylor cycle) The Role of the Central Bank (Independent or Irrelevant?) Management of capital inflows Management of the real exchange rate