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Financial System Development Lecturer : Prof. Dr. Heike Joebges

Research Paper on: 2001 Currency Crisis in Turkey:

Could the IMF Have Influenced Turkey In a Way to Prevent From Currency Crisis?

Volkan Emre, 534436

Berlin, February 2012

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TABLE OF CONTENTS

Page

1.Introduction 04

2. General overview of the Turkish Economy before the financial stability 04 . agreement

3.Main causes and features of the crisis 06

4. Design and implementation weaknesses of the IMF Financial Stability 07 Program and the potential actions of IMF to prevent the negative outcomes

4.1 Preparation and timing 07

4.2 Inflation targeting and pre-announced path of exchange rates 08

4.3 Monetary policy 09

4.4. Number of structural reforms and privatization goals 10

4.5 Amount of money injected to the financial system during the crisis 11

5.Conclusion 11

LIST OF TABLES & CHARTS

Table 1 Selected Macroeconomic Indicators, 1996 – 2001 04

Table 2 Selected Central Bank Figures & Crisis in December 2000 and February 2001 05

Table 3 Selected Macroeconomic Indicators, 1998 – 2001 06

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“Turkey's program is strong and well balanced. The large adjustment in the primary fiscal balance will help re-establish fiscal solvency and reduce inflation. With full implementation,

the program should restore Turkey's credibility vis-à-vis markets” 22.12.1999

Stanley Fisher1

1. Introduction

The Turkish Economy was seriously hit by two crises which resulted in a deep recession at

the beginning of the new millennium. It took almost a decade for Turkey to recover.

Although Turkey had structural problems in that particular time period, the main cause of

both crisis was the collapse of the IMF-directed economic stabilization program within the

first year of its implementation. The first crisis was a liquidity crisis in November 2000. The

second came three months later, this time as a currency crisis. This paper aims to analyze

whether the IMF could have influenced Turkey to prevent the February 2001 Currency

Crises. With that regard the research paper divided into three main chapters . The first

chapter gives a quick overview of the Turkish Economy before the standby agreement with

the IMF which was signed in December 1999. The second chapter briefly underlines the

causes and features of both crises with some graphical explanations. The third and last

chapter focuses on the design and implementation weaknesses of the IMF Financial

Stability Program and the potential actions which IMF could have taken to prevent or

relieve the negative outcomes of the currency crisis.

2. General overview of the Turkish Economy in late 90’s and the financial stability agreement

The entire 90’s is called as a lost decade for Turkey by some scholars. In 1994 Turkish

Economy was hit by the biggest crisis of its history. Country spent the rest of the decade with

recovering from the deadly outcomes of the past crisis. However it is hard to claim that

there was a nice picture in pre 2000’s. Real GDP growth was very volatile. High inflation,

weak currency and increasing government sector debts were harming the macroeconomic

stability (Table 1). Undisciplined fiscal policies were decreasing the credibility and

reputation of the treasury and therefore increasing the real interest rates and thus cost of

borrowing (Table 1). Budget and current account balances had been continuously growing

on deficit between 1996 and 1999 (Table 1). In addition to all of the mentioned structural

problems two shocking external factors; first the 1998 Russian Crisis and then August 1999 1 First Deputy Manager of IMF, Stanley Fisher’s quote was retrieved from http://www.imf.org/external/np/sec/pr/1999/pr9966.htm

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Earthquake and exacerbated the worsening of the Turkish economy. Russia was the second

biggest trade partner of Turkey at that time and the Marmara Earthquake hit the highly

industrialized zones and led to the negative GDP growth. In September 1999 it was clear

that the situation was not sustainable anymore and Turkey knocked IMF’s door once again.

Table 1. Selected Macroeconomic Indicators, 1996-2001

Source: Central Bank of Turkey, State Planning Organization of Turkey, World Bank Development Indicators, Own extractions and calculations

Turkey and IMF signed a 4 billion US$ stand-by credit agreement on 22’th of December in

1999. The new program aimed at tackling interest rates and inflation with a strategy based

on a new monetary policy which Turkey had not experienced before. Preannounced

exchange rates were supposed to be used as an anchor to stabilize the exchange rate. This

approach was in line with the money rule, which refers to provide liquidity to the markets

parallel to the volume of the existing foreign exchange reserves. By doing so, IMF wanted to

increase the credibility of Turkey in the mid-term and reduce its cost of borrowing and

create primary surplus. On the other this method actually aimed to reduce the inflation at

the same time . Success of the new IMF directed policy was mainly relying on the credibility

Annual Increases (%) 1996 1997 1998 1999 2000 2001

Reel GDP 7,1 8,3 3,9 -6,1 6,3 -9,4CPI Inflation 79,8 99,1 69,7 68,8 39,0 68,5Money Supply(M2) 109,7 84,0 79,4 101,5 42,5 80,0Net Domestic Credits 110,7 113,5 55,8 52,7 62,6 24,8

Billion US$ 1996 1997 1998 1999 2000 2001

GDP (Current US$) 181,5 189,8 269,3 249,8 266,6 196,0Foreign Debt Stock (Short Term+Long Term) 79,6 84,6 94,8 102,6 119,0 118,1Short Term Debt Stock 17,3 17,7 20,8 22,9 28,3 20,1Mid - Long Term 62,3 66,9 74,0 79,7 90,7 98,0Debt to International Institutions 8,9 8,1 8,0 7,8 11,4 20,9Trade Balance -10,6 -15,4 -14,2 -10,0 -22,4 -4,8Current Account Balance -2,4 -2,6 -2,0 -1,4 -9,8 3,3Net Capital Inflows 5,6 7,0 -0,8 4,9 9,6 -13,9Changes in Reserves -4,5 -3,4 -0,5 -5,2 3,0 12,9Net Errors and Omissions 1,4 -1,0 -0,7 1,6 -2,8 -2,3

Index (1995=100) 1996 1997 1998 1999 2000 2001

Reel Exchange Rate Appreciation 101,80 115,9 120,9 127,3 147,6 116,2

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of Turkey supported by IMF itself. Political and institutional credibility of the country were

getting ready for an important test in the international arena.

3. Main causes and features of the crisis

Everything seemed to be on track within the first months of the implementation after

January 2000. There was a significant increase in net capital inflows, appreciation in the reel

exchange rate, decrease in the domestic interest rates and increase in the domestic credit

stock. Government’s borrowing opportunities abroad had been increased due to the

improvements in the primary balance. However some other indicators are ringing the alarm

bells. Current account deficit was the most important one. With the negative effects of the

domestic currency appreciation, the current account had risen five times than in 1999 while

trade deficit had doubled (Table 1). The open positions of commercial banks which had

risen significantly were showing the exchange rate risk. and the liquidity need of the state

owned banks were also strengthening the crisis infrastructure. Additionally, the total

amount of the foreign debt were exceeding the Turkish Central Bank’s exchange reserves

which made the system more vulnerable against speculative attacks.

Table 2. Selected Macroeconomic Indicators, 1998 -2001

Source: Central Bank of Turkey, State Planning Organization, Own Extractions

Under that fragile economic conditions one major private bank which heavily invested in

government securities came to a point at which it could not refinance itself anymore and

demanded loans from the Turkish Central Bank. Central bank’s refusal to lend and

1998 1999 2000 2001Rate to Money Supply (%)

Total Domestic Debt / M2 57,5 57,1 65 118,7Domestic Debt in Cash / M2 47,1 50,3 52,5 56,7

Commercial Banks (%)

Total Domestic Debt / Total Liabilities 35 34,1 35 70,1Domestic Debt in Cash / Total Liabilities 28,7 30,1 28,3 33,5Credits to Government 85,6 139,7 123,6 181Sector / Credits to private sectorDeposits longer than 23 28,2 15,1 11,6

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enforcement to sell the bank its government securities started the liquidity crisis in

November 2000.

Table 3. Selected Central Bank Figures & Crisis in December 2000 and February 2001

Source: Central Bank of Turkey, Own Extractions

At that point IMF stepped in and injected money to the central bank reserves which

helped markets to calm down and prevent interest rates from jumping to the sky. But

IMF’s intervention was too little to change the main dynamics of the economy. The main

problems remained constant and the appreciated domestic currency continued to harm

the current account. And the credibility of the Turkish Authorities had been continued to

decrease. External positions of government and especially private sectors weakened day

by day due to the increasing foreign debt. Weak fiscal position of the public sector led to

the ultra high level of interest payments and unhealthy maturity conditions of debt.

Under these unsustainable circumstances the debt roll over capacity of the ministry of

treasury tested by the high interest rates respectively in January and February 2000.

Finally the currency crisis started after a public dispute between the prime minister and

president. Speculative attacks on Turkish Lira started on 19.02.2012. Overnight interest

rates were skyrocketed in one day (Table 3). Soon after the exchange rate system

collapsed and Turkish authorities had to led the exchange rate float.

Overnight Interest Rates(%) Exchange Rate (TL/$)Monthly Average Monthly Average Reserves (Billion US $)

2000July 26,5 630,3 24,5

August 42,6 648,2 24,5September 47,4 666,9 24,2

October 38,5 679,8 23,5November 95,4 686,2 18,8December 183,2 680,4 22,2

2001January 42,7 674,1 24,8

February 400,3 750,4 21,4

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4. Design and implementation weaknesses of the IMF Financial Stability Program and the potential actions of IMF to prevent the negative outcomes

Some design and implementation weaknesses of the IMF seriously caused damages on the

credibility of the financial stability program and led Turkish economy to end up with a

serious currency crisis. Especially the increasing current account deficit and growing public

debt were serious clues for the upcoming crisis. In this chapter some of the important design

and implementation weaknesses of the IMF are discussed as in the following.

4.1 Preparation and timing

One of the most important weaknesses was the lack of time spent for the design of the

financial stability program. IMF and Turkish authorities agreed on a program in less than

five months. Although Turkey’s immediate crisis situation, IMF could have spent more

time in designing the program by negotiating details in a slower pace. This could have

helped to increase the commitment of the members of the program and by providing a

better harmony between them which would led to a more consistent and careful

management. All of the mentioned improvements would increase the credibility of the

program which was clearly one of the most important reasons behind the failure of IMF’s

program which ended up with a currency crisis after the speculative attacks on Turkish

Lira.

Some important structural problems of the banking sector were neglected which later

became obstacles to the success of the program during its implementation. Balance sheets

of the state owned banks were dominated by duty losses. Since those state owned banks

could not get sufficient funds from the general budget due to the tight fiscal policy aspect

of the program, state owned banks tend to finance their short term debt obligations from

domestic market loans. Those loan seeking activities were heavily dependent on

overnight funds which avoided them from their actual banking activities and triggered the

inflation and created a maturity mismatch risk to the banking system. In my opinion this

vicious circle could have been prevented to some extent if IMF have forced and helped

Turkish authorities to inject more capital to the state owned banks which were suffering

from the duty losses before the implementation of the financial stability program. With

that regard IMF could have even directly provide funds in order to strengthen the balance

sheets of the state owned banks. The second option would be to force Turkish authorities

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to structure the balance sheets of the state owned banks as a precondition of the standby

agreement.

On the other hand there was a contradictory situation in private banking sector. IMF

forced Turkish government to support the highly indebted, risky private banks and hence

encouraged the establishment of Saving Deposits Insurance Fund of Turkey in 23 June

1999. This local fund aimed to strengthen the balance sheets of the seven selected banks

by establishing a direct control in them and to introduce new implementations. But

market interpreted that action as a negative sign considering the credibility of the

program and the general hesitation has increased among the economic agents in terms of

trust in the IMF program. At that point it can be claimed that IMF could have changed its

priorities between state owned and private banks other way around. Thus this could have

helped to the credibility of the program in the eyes of the local and foreign economic

agents in a more positive way.

Another vulnerability of Turkish banking sector which was almost neglected in the IMF

program at the preparation period was the lack of regulation. IMF did not have any

serious enforcement towards regulation in its agenda despite the fact that crisis triggered

elements strongly related to the both private and state owned and government banks’

dangerous activities which were mentioned before. State owned banks were object to

interest rate risks and maturity mismatch on the other hand private banks were carrying

the exchange rate risk with currency mismatch. IMF subsequently realized its mistake, as

evidenced by its post-crisis increase in regulatory measures. In my opinion, if IMF could

have given that interest before the implementation of the program, the crisis triggering

threats within the banking would have reduced significantly. I think Turkey’s Banking

Sector’s success during the 2008 global financial crisis heavily depends on the regulatory

enforcements of IMF after the 2001 currency crisis and this fact might support my initial

argument to some extent.

4.2 Inflation targeting and pre-announced path of exchange rates

In the preparation period, IMF projected the 2000-2001 fiscal years inflation as 20

percent and set its exchange rate peg in accordance with its estimation. Short after the

implementation it was clear that there was something wrong. According to Miller2 price

2 Miller, 2006. Pathways Through Financial Crisis: Turkey

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and wage stickiness in particular sectors which were not object to the foreign trade and

their effects on the appreciation of Turkish Lira and hence on the deterioration of the

competitiveness of the country were clearly showing the deviations from IMF’s

estimations. But there was no revaluation of the exchange rate determination process at

IMF’s side. An exogenous oil price shock (increase in world crude oil prices) made things

worse and threatened the success of the program. If IMF would not insist on its

estimations and be more flexible in changing the exchange rate announcement

mechanism, the destructive damages of the TL appreciation on the trade balance and

current account could be prevented till a certain degree.

4.3 Monetary Policy

With an approach similar to currency board, IMF put some limits on the net domestic

assets in the Central Bank of Turkey and let interest rates determined by the market. IMF

aimed at keeping central bank reserves at a certain level while interest rates are going

down. The expected result was disinflation in a more predictable macroeconomic

environment. The key element to success was again the credibility of the central bank in

the eyes of market players.

According to the Yenal3, such restrictions might be very risky if there is a bottleneck in the

capital inflows since the number of instruments would be restricted in order to keep

domestic and foreign assets in balance under the preannounced exchange rate regime.

And what observed between the first and second crisis was very much in line with Yenal’s

thoughts. Turkish central bank could not resist to the capital outflows after the

speculative attacks on Turkish Lira. IMF could have given more autonomy to the central

bank authorities especially after the first liquidity crisis hit the Turkish Banking Sector in

December 2000. An exit from the preannounced exchange rate regime and letting the

rates to float would automatically give the interest rate tool to the central bank which

would be much more useful to deal with the capital flows in order to prevent the

upcoming crisis. Such an exit could be possible right after the first crisis in December

2000.

3 YENAL 2002

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4.4 Number of structural reforms and privatization goals

Structural reforms are designated to make the fiscal adjustment implemented in 2000

sustainable over the medium term, to lower the burden of interest payments on public

sector debt, to improve transparency and economic efficiency, and to reduce the contingent

liabilities of the public sector (IMF)4. Despite IMF’s ambition towards structural reforms and

privatization, most of the structural reforms formed in line with the inappropriate priorities.

As already discussed in previous sections , lack of importance given to the regulation in the

banking sector might be a good example. Adverse selection problems in the priorities

stemmed partly from the lack of time spent in the preparation period.

Despite the success in the short term primary surplus creation in the budget, failures in the

implementation structural reforms which were very important in the eyes of the financial

investors led to a loss in programs credibility within first months of the financial stability

program. Including numerous structural reforms with high level of implementation

uncertainities increased the fragility of the program and led to the deteriorations in the

expectations of the economic agents.

IMF’s expectations in the privatization were also too ambitious. According to the IMF’s

experts, Turkey could get roughly 7.5 billion US$5 through privatization in year 2000. This

meant roughly 3% of the Turkey’s GDP in 19996. Such high expections were definitely extra

risk factors for the stability program’s credibility. Especially for the investors who were

questioning the long term debt repayment capability of the Turkish government. Once

privatization attempts started to fail, investors who were holding government bonds

believed that the value of the bond is going to decrease .

To sum up, IMF’s expectations in structural reforms and privatization before the

implementation of the financial stability program were too ambitious and this picture could

be easily captured by the majority of the financial investors. Additionally, failures in both

reforms and privatization led further deteriorations in the credibility of the program among

the other market players too . There was no intermediate revision of the goals during the

4 Online press release at: http://www.imf.org/external/np/sec/pr/1999/pr9966.htm 5 Celasun,2002: 2001 Krizi Öncesi ve Sonrası at : http://www.econ.utah.edu/~ehrbar/erc2002/pdf/i053.pdf 6 According to World Bank Development Turkey’s GDP in 1999 was 249,654,780,792 US$. This data is obtained from : http://databank.worldbank.org/ddp/home.do

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implementation and especially after the first crisis the credibility of the program hit to the

ground and led the speculative attacks start on the Turkish Lira. What IMF could have done

to prevent or to reduce the effects of the crisis was firstly to take more time in cooperation

with Turkish authorities in defining the priorities. Revising the ongoing privatization

processes during the implementation and reducing the number of structural reforms would

be the further actions of the IMF.

4.5 Amount of money injected to the financial system during the crisis

After the Turkish banking sector hit by the liquidity crisis in November 2000, IMF stepped in

and injected money to the system. But it might be claimed that IMF was already too late and

the amount of money which was injected to the system was significantly less than it was

actually required7. In my opinion if IMF would have injected the same amount of money

during the liquidity crisis in November 2000, the lack of credibility based currency crisis

could have been delayed or even prevented to some extent.

5. Conclusion

To conclude, the IMF showed serious weaknesses in the preparation and implementation

periods of the financial stability program of Turkey. Those weaknesses decreased the

credibility of the program which was the key component of the success. IMF could have

influenced Turkey to prevent the February 2001 Currency Crises in five different ways . First

of all, IMF could have spent more time on the design of the program by negotiating details in

a slower pace. Secondly, if IMF would not insist on its inflation targeting and pre-announced

path of exchange rates the the destructive damages of the TL appreciation on the trade

balance and current account could be prevented to some extent. Moreover, IMF had the

chance to give more autonomy to the Turkish Central Bank authorities at some different

points, especially during the massive capital outflows were happening. This could have a

direct influence on the upcoming currency crisis. Additionally, if IMF could have realized the

exaggerated ambition of their structural reforms and unrealistic privatization agenda for

Turkey, they would have had the chance to gain the commitment of Turkish authorities and

establish the trust of the economic agents in the fiscal sustainability of the program again.

Finally, the IMF could have influenced Turkey to prevent the currency crisis if it provided

7 After the public conflict between prime minister and president, Turkish Central Bank lost 3,4 billion US$ in one day but IMF could provided 2,8 billion US$ as an immediate injection

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enough amount of liquidity for the needs of the Turkish Central Bank during and after the

November 2000 Liquidity Crisis.

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References

Celasun, 2002, 2001 Krizi,Öncesi ve Sonrası, available at:

http://www.econ.utah.edu/~ehrbar/erc2002/pdf/i053.pdf

Miller, 2006. Pathways Through Financial Crisis: Turkey,

Global Governance, Volume 12, Pages : 449 - 464

Özatay, 2002, Bank of Albania in the Second Decade of Transition Confrenece

Dufour at al, 2007, The 2000 – 2001 Financial Crisis in Turkey: A Crisis for Whom?,

available at: http://mpra.ub.uni-muenchen.de/7837/

Macovei ,2009, Growth and Economic Crises in Turkey: leaving behind a turbulent past?

European Commission, Economic Papers Volume 386

International Monetary Fund, 1999, Press Release No. 99/66, available at:

http://www.imf.org/external/np/sec/pr/1999/pr9966.htm

Alper, 2001, The Turkish Liquidity Crisis of 2000: What Went Wrong…

Russian and European Finance and Trade, Vol. 37, No.6, Pages: 51-71