the turkish financial crisis of 2000-01 -- logan cooper

The Turkish Financial Crisis of 2000-01

Logan Cooper

Econ 196: Financial Crises – Morals and Markets

Eric Fischer

11 June 2015

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Introduction

Turkey occupies an important place in the world. It is a pillar of relative stability in a tumultuous

region, a major emerging market, an important strategic partner to the United States and Europe, and a

prospective European Union member. Turkey’s situation is not quite so rosy though: it is economically fragile

(as many emerging markets are) and there are worries that it is on a path towards an oppressive, authoritarian

governmental structure. Both that economic fragility and slide into autocracy can be traced, at least in part, to

the Turkish banking crisis of 2000-01.

This paper will attempt to provide an overview of the development and unfolding of the crisis and

seek to explore how this crisis affected Turkey. Specifically, I will look at its effects on the Turkish

macroeconomy; how the government responded to the crisis; and how the crisis contributed to the rise of

Recep Tayyip Erdogan and his Adalet ve Kalkınma Partisi (“Justice and Development Party,” or for short,

AKP). Section one will provide an overview of Turkey’s situation in the years before the crisis. Section two

will describe the IMF-backed stabilization and disinflation program that is closely entwined with the

development of the crisis. Section three will provide a timeline of the crisis and its immediate economic

effects. Section four will look at the aftermath of the crisis, specifically, subsequent economic reforms, and

the crisis’ effects on Turkish electoral politics. Section five concludes.

1. A Brief Economic History

The 1970s in Turkey were a decade of hyperinflation, payment imbalances, and debt problems. In

1980, a coup d’état brought a military government under General Kenan Evren to power. This government

pursued liberalization and stabilization policies that cut inflation from triple-digit levels to 30% over the

course of 1980, at the expense of a small recession. The current account and government budget deficits were

also greatly reduced, as the government promoted a program of export-led growth (Akyüz and Boratav, 2002).

The adoption of a new constitution by referendum in 1982 brought military rule to an end, and

ushered in a series of populist coalition governments. These governments saw the return of large budget

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deficits and high inflation; especially after 1987 (see fig. 1). In response, the nominal interest rate on Turkish

sovereign debt shot up, normally outstripping inflation by 10-20%. Despite this, GDP growth remained

steady and high until 1987 (see fig. 2) (Akyüz and Boratav, 2002). The slowdown in the late 1980s made

Turkey’s debt harder to service as more and more of tax receipts went to simply paying interest on preexisting

debt. The government responded with a program of further liberalization, completely freeing the capital

account, which allowed residents to buy any foreign assets and vice versa. This program backfired, worsening

the government’s fiscal position as a slew of low-risk dollar assets flowed into Turkey, essentially changing

Turkey’s risk-free rate. Over the course of the 1990s, inflation and the interest rate on Turkish sovereign debt

continued to rise.

Fig. 1

In the late 1990s, Turkey suffered a recession brought on in part by fallout from the Asian crisis of

1997 and Russian crisis of 1998. Investors worried that Turkey might be the next domino to fall, and capital

inflows began to dry up and reverse. The situation was made worse by the 7.6 İzmit earthquake in August

1999, which devastated Turkey’s densely-populated industrial heartland near the Sea of Marmara. This was

enough to push the country into recession (see fig. 2.) The combination of a recession and the government’s

earthquake relief program caused the budget deficit and debt-GDP ratio to rise sharply (Brinke, 2013).

0

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4

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-96

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-97

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-98

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9

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(%

)

Inflation in Turkey 1983-99

Source: Central Bank of the Republic of Turkey

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Fig. 2

Elections in December, 1999 – against the backdrop of a recession – brought an unlikely coalition to

power. It was composed of the center-left Democratic Left party, and its junior collation partners, the far-

right Nationalist Movement Party and the center-right Motherland Party. They were united only by their

economic policies, and several days after elections, the new government and the Central Bank of the Republic

of Turkey (CBRT) announced an IMF-backed economic program to stabilize the economy and curb the high

inflation that had plagued Turkey for the past ten years.

2. The Disinflation Program

There were three main components to this program, as laid out in Turkey’s 1999 Letter of Intent to

the IMF:

Our program rests on three pillars: up-front fiscal adjustment, structural reform, and a firm exchange rate commitment supported by consistent incomes policies. Up-front fiscal adjustment is necessary because the weakness of public accounts is the ultimate factor behind high inflation. Structural reform is needed to make the fiscal adjustment sustainable, improve economic efficiency, and, through increased privatization receipts, facilitate the decline of public debt. A firm exchange rate commitment and consistent incomes policies are needed to lead inflation and interest rates down more rapidly, particularly in the first phase of disinflation. IMF, Turkey Letter of Intent, December 9, 1999

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12/

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2001

Lir

a

Turkish Real GDP 1980-99

Source: Global Financial Data

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The fiscal adjustment component was to comprise of spending cuts, tax hikes, and public pension

reform, all aimed at moving the government from a budget deficit to a surplus, and lowering Turkey’s debt-

GDP ratio in the shorter-term. Long term, the program was supposed to bring down interest rates to reduce

the burden of Turkey’s debt servicing. However, it was expected that Turkey’s inflation rate would fall more

quickly than the interest rate, pushing up the real interest rate on Turkish debt, and thus making it temporarily

harder for Turkey to service its debts (Akyüz and Boratav, 2002). Privatization of state-run firms – already

part of the program – was seen as the solution to harder-to-service debts. As Turkey sold off parts of firms

such as Turk Telecom and Turkish Airlines (“The Crisis in Turkey,” 2000), the proceeds were to go towards

servicing debt at its temporarily higher rate.

The final component was a fixed exchange rate policy. The lira would be pegged to a basket

comprised of dollars and euros. The lira would then depreciate 20% with respect to this basket over the

course of the year 2000, with a monthly rate of depreciation starting at 2.1% and gradually decreasing to 1%

over the course of the year – as to avoid any sudden exchange rate risks. After 18 months of this, the lira

would be allowed to stay in a slowly-widening band around the basket (IMF, 1999). To enforce this exchange

rate regime, the CBRT had to give up its control of monetary policy and become, in the words of Akyüz and

Boratav, “a quasi-currency board” (2002.)

There were several channels through which these three pillars of the IMF program were supposed to

decrease inflation. The first was that by anchoring the value of the lira to the value of more trusted currencies

– the dollar and the euro – the supply of lira would be limited, ideally lowering inflation (Kayıkçı, 2013). The

second was that as the lira depreciated against the dollar-and-euro-basket, more foreign (mostly American and

European) goods would be allowed into Turkey, increasing competition (Akyüz and Boratav, 2002). As long

as relatively cheap foreign goods were flowing into Turkey, Turkish firms would have to control their prices

and wages, lest they be out-competed by foreign firms. The fiscal conditions on Turkey would also help to

control inflation. Pension payments and civil servant raises were to be indexed to Turkey’s inflation targets,

and agricultural handouts were to be “rationalized” (Kayıkçı, 2013) in order to implant expectations of

disinflation in the minds of the Turkish people.

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2.1. Fragility in the Banking System

As several authors and have noted, this program ignored the fragility of Turkey’s banking system.

First of all, when Turkey’s financial system was deregulated in the 1980s, it had been given deposit insurance.

However, this insurance came with relatively few new regulations (Akyüz and Boratav, 2002), leading to a

problem of moral hazard, where banks were free to take risks, with Turkish taxpayers on the line should the

banks fail. Second, Turkish banks (both state- and privately-owned ones) had become major source of

government financing. Interest rates on Turkish government paper were very high – in the double digits even

after inflation (Brinke, 2013), so banks, seeking safe, high returns, bought them up; and by the beginning of

2000, over half of Turkish bank assets were government securities (Özatay and Sak, 2002.) This exposed

banks to a large degree of interest rate risk. Any drop in the interest that the government was paying on its

debt – a major goal of the IMF program – would cut into banks’ profits.

At first, most of this paper-buying was done with domestic deposits. However, the banks, seeking

still-higher returns, began to leverage their buying of government securities by borrowing from abroad and

using this borrowed money to buy more government debt. On the eve of the crisis that was to come, almost

two thirds of Turkish bank liabilities were denominated in currencies other than the lira (Akyüz and Boratav,

2002.) This exposed the banks to two additional types of risk. First of all, by borrowing in foreign currencies,

Turkish banks exposed themselves to exchange rate risk. If the lira were to depreciate sharply, the banks

could very well become unable to pay their foreign creditors. Secondly, this system made the banks vulnerable

to capital reversals. Even a Turkish bank facing a favorable exchange rate might find itself in trouble should a

foreign creditor refuse to roll over debt and ask for their money back. As we shall see in the next section, this

is exactly what happened.

3. Crisis

3.1. Round One

Over the course of the year 2000, Turkey met its exchange rate and deficit reduction targets.

However, inflation remained stubborn, staying at around 55% instead of the targeted 25% (Akyüz and

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Boratav, 2002.) As deficit reduction pulled down the nominal interest rate on Turkish government debt, but

inflation remained relatively steady, the real interest rate that debt became negative, cutting into the profits of

banks with large portfolios of government debt. Meanwhile, foreign capital continued to flow into Turkey,

helping to finance a large current account deficit (Akyüz and Boratav, 2002.)

Despite failure to meet inflation targets, the program went essentially as planned until November

2000, when capital suddenly began to flow out of Turkey. There is no one single trigger for this outflow.

Instead, it was due to a confluence of factors, including disappointing inflation figures for October, higher

trade deficits largely due to rising oil prices, political instability over the pace of privatization, contagion from

Argentina’s economic difficulties, and a corruption probe into the banks which had been taken over by the

government in the wake of the 1999 recession (Akyüz and Boratav, 2002.) As this bad news began to filter in,

creditors started selling Turkish securities and refusing to roll over Turkish debts. Turkish banks began selling

lira and assets to pay their creditors, creating a liquidity crisis. The CBRT could be of no help to domestic

banks because of their commitment to upholding the fixed exchange rate, forcing the banks to relay on the

interbank market to stay afloat. As all the banks tried to borrow at once, the overnight interbank rate

skyrocketed, going from 50-60% to 873% over the course of a few days (see fig. 3.)

Fig. 3

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As everyone tried to sell lira and lira-denominated assets, pressure was put on the lira to depreciate,

and the foreign reserves of the CBRT began to fall rapidly. Then, as banks started to fail, the CBRT was faced

with the decision to either protect the exchange rate or the banks. They decided to help the banks by

providing liquidity. While this policy may have saved the banks, it put further pressure on the lira and

accelerated the outflow of capital and CBRT reserves (Akyüz and Boratav, 2002.) This did not last very long –

after a few days, the CBRT ceased providing liquidity to the banks and the IMF came in with a rescue

package of USD 10.5 billion (Brinke, 2013) to both provide liquidity to the banks and replenish the CBRT’s

foreign reserves. The IMF also loosened the restrictions on the CBRT, raising the ceiling on printing money

against domestic assets, while simultaneously demanding further concessions from the government, including

yet more tax increases paired with spending cuts, especially in agricultural support; and liberalization of goods,

services, and financial markets (Akyüz and Boratav, 2002.)

Fig. 4

The IMF rescue package, additional conditions, and a pledge by the CBRT to guarantee foreigners’

investments and deposits were able to calm the panic and restore confidence in Turkey’s banking system. The

CBRT’s reserves stopped falling (see fig. 4) and the overnight interbank rate dropped back to its pre-

November level (see fig. 3).

0 ₺ 2,000,000 ₺ 4,000,000 ₺ 6,000,000 ₺ 8,000,000 ₺

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CBRT Foreign Reserves, 2000


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3.2. Round Two

After the IMF rescue package restored confidence in Turkey, its economy got, to some extent,

quickly back on track. Not only did Turkey’s foreign reserves stop falling, but the CBRT began to accumulate

reserves, soon passing the level of reserves held on the eve of the November crisis. Overnight interest rates

remained stable. The current account began to push towards a surplus. Inflation also began falling, albeit still

at a lower rate than had been hoped for (Akyüz and Boratav, 2002.)

Because Turkey could not bring inflation down to a level consistent with the controlled nominal

depreciation of the lira, the lira began to appreciate in real terms (see fig. 5). Additionally, government debt

had begun to increase after the first phase of the crisis, pushing interest rates back up. These three factors –

stubborn inflation, real currency appreciation, and growing debt – fermented doubt about the sustainability of

the IMF program in the minds of investors and Turks.

Fig. 5

This time, there was one single event that set off a crisis. On 19 February, 2001, Prime Minister

Bülent Ecevit publically announced that he and President Ahmet Sezer were in disagreement, although he

refused to elaborate on what exactly they were in disagreement about, saying only that it “amounted to a very

important political crisis” (Özatay and Sak, 2002.) That announcement set off a more severe version of

November 2000. Investors rushed to sell Turkish assets, causing the Istanbul Stock Exchange to lose 14% of

its value very quickly (see fig. 6). Liquidity dried up in the Turkish banking system as capital flowed out of

0 ₺

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a

Real Lira Exchange Rate 1998-2001


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Turkey, and the overnight interbank lending rate jumped to 4,019% over the next two days (see fig. 7.) The

severity of this new crisis cast doubt on Turkey’s resolve to uphold their exchange rate regime, and a massive

speculative attack on the lira began. In the face of this attack, the Turkish government, with support from the

IMF (Akyüz and Boratav, 2002), let the lira float on February 22. It immediately lost about one-third of its

value vis-à-vis the dollar (see fig. 8.)

Fig. 6

Fig. 7

02,0004,0006,0008,00010,00012,00014,00016,00018,00020,000

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Fig. 8

4. Aftermath

4.1 Economic Effects

The most immediate economic effect was its impact on government debt. The liquidity crisis caused

by capital outflows and subsequent devaluation of the lira was punishing for banks – most of which had large

foreign-denominated liabilities. The Turkish government had to recapitalize both state and private banks

through the Savings Deposit Insurance Fund (SDIF). The costs of doing so pushed the Turkish debt-GDP

ratio up to 74% from a pre-crisis low of 38% (Brinke, 2013,) reversing one of the main points of progress

made by Turkey under the IMF program. The float also endangered Turkey’s (admittedly less-than-stellar)

progress in curbing inflation. With the lira floating again, there was nothing to anchor Turkish prices, so there

was a very real prospect of inflation shooting back up to pre-program levels (Özatay and Sak, 2002.)

The post-float loss of confidence had the medium-term effect of setting off a recession in Turkey.

Turkish real GDP stagnated between the 2000 and 2001 phases of the crisis, and contracted rapidly after the

float, only beginning to truly recover in mid-2002, just before the next round of elections (see fig. 9.) This

contraction translated to a 6.5% drop in per capita GDP from the float to the trough of the subsequent

recession (Brinke, 2013.) Unemployment also climbed steadily after the 2000 crisis, but it did not return to its

pre-crisis levels (see fig. 10.)

0 ₺

200,000 ₺

400,000 ₺

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800,000 ₺

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Lira-Dollar Exchange Rate, 2000-01


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Fig. 9

Fig. 10

The crisis also prompted a series of economic reforms, along with a new IMF-backed stabilization

program: creatively dubbed the “Transition to Strong Economy Program” (TSEP.) Banks that had come

under the purview of the SDIF were barred from participating in the banking system as they were

restructured, recapitalized, merged, and sold. State banks were slimmed down, given new regulations and new

governors. The government also bought up all of its own debt from these banks in an attempt to stabilize

them. The CBRT was given a mandate for price stability, forcing them to deal more with the domestic

66,000 ₺

67,000 ₺

68,000 ₺

69,000 ₺

70,000 ₺

71,000 ₺

72,000 ₺

73,000 ₺

Milo

ns

of

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10

Lir

a

Turkish Real GDP 2000-02


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% U

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Turkish Unemployment, 2000-06


Cooper 13

economy than with the exchange rate. The austerity and privatization conditions remained in place (Özatay

and Sak, 2002.)

Despite these reforms, it took some time for the Turkish economy to return to full strength. There

are a variety of reasons for this delay. The crisis fractured the already less-than-stable coalition, creating

uncertainty over the credibility of government policies, at a time when the economy hinged on government

promises (Özatay and Sak, 2002; Cizre and Yeldan, 2005.) Turkey had already abandoned one program in the

face of a major crisis: what was stopping that from happening again?

In addition to government instability, there were a number of exogenous factors that dampened

Turkey’s recovery. The .com crash and 9/11 attacks in the United States created uncertainty over economic

prospects in the developed world, on which Turkey depended for trade. The Argentine economic crisis of the

early 2000s also had the prospect of spreading financial contagion to other emerging markets, especially one

as fragile as post-crisis Turkey.

Finally, the nature of Turkey’s pre-crisis economy and of the IMF program itself has been blamed for

the slow recovery. Large duty losses by state banks and large numbers of non-performing loans in the years

leading up to the crisis (Özatay and Sak, 2002) seem to hint that the banking sector was not making efficient

use of its funds, and that much of the lending done during that period went toward inefficient, unproductive

investments that would not create economic growth. With this in mind, Erinç Yeldan argues that the IMF

program was not helpful for the Turkish economy, and that it served the interests of Turkish banks and their

foreign creditors, rather than those of the Turkish people and domestic economy.

4.2. Political Effects

As mentioned before, the crisis was a major blow to Turkey’s ruling coalition. Its economic policy

had failed spectacularly, and the coalition’s constituent parties, only ever united on an economic platform,

were only keeping together in a desperate bid to project confidence and stability to investors (Cizre and

Yeldan, 2005.) Even if their economic policy had just amounted to implementing IMF directives, the Turkish

electorate was ready to take it out on the parties in power.

Cooper 14

The general elections of 2002 saw the conservative, somewhat-Islamist Justice and Development

Party (AKP) under now-president Recep Tayyip Erdoğan campaign on a “pro-EU, pro-reform, and pro-

stability platform” (Cizre and Yeldan, 2005.) Their message was exactly what the Turkish people wanted, and

they attracted huge numbers of protest voters. November 2002 saw all of the parties elected in 1999 swept

out of office, and the AKP win two thirds of the seats in parliament with only 34.3% of the vote (Election

Resources, 2002.) The only other party in parliament was the social-democratic Republican People’s Party,

who gathered most of the remaining third of seats (see fig. 11 – despite the presence of the pro-Kurdish

DEHAP on the 2002 map, they failed to meet the 10% threshold to enter parliament.)

Fig. 11

While AKP government saw major economic improvements, without a counterfactual, it is

impossible to tell how much of this is due to their policies, and how much is due to other factors. Not only is

it likely that a change in government – especially to a more stable, non-coalition one – would have been a

major factor in boosting confidence in Turkey, but the AKP’s policies were very much in line with the IMF’s

demands, which called for fiscal austerity, disinflation through CBRT policy, and a slew of privatizations and

structural reforms (Ugur, 2008.)

While it may be that Turkey’s economic recovery owes more to the AKP’s adherence to IMF

conditions than to any AKP-specific policies, they were certainly in a position to take credit for the recovery.

During the first term of AKP government, national income grew at an average of 7% a year, inflation fell to

7.7% within two years, and the government was able to deliver a primary budget surplus and bring the debt-

Cooper 15

GDP ratio down 38 percentage points over three years (Ugur, 2008.) This apparent economic success has

been a major component in keeping the AKP in power.

5. Conclusion

Turkey was thrown into a two-part financial crisis after the introduction of an IMF stabilization

program in 1999. While the proximal causes and immediate effects are relatively clear, there is little

agreement on the ultimate causes. The orthodox, IMF opinion blames Turkey for the crisis. This view goes

that it was up to Turkey to meet inflation targets, lower its debts, become more market-friendly, and quash

corruption, all at once; and that since they could not (or, possibly, would not) do that, the blame for the

subsequent crisis lies solely on Turkey (Cizre and Yeldan, 2005.) Many Turkish scholars reject this view,

claiming that pegged exchange rates are a flawed stabilization mechanism, as they are near-impossible to

implement correctly, are vulnerable to shocks, and require central banks to give up autonomy (Akyüz and

Boratav, 2002.) Some have also charged that asking emerging countries such as Turkey to fix their exchange

rates and give up monetary autonomy is asking for trouble, and that a much better compromise would be to

implement capital controls while stabilizing the economy (Yeldan, 2002.) Still others claim that the fault lies

neither with the IMF nor with Turkey, but rather that Turkey was doing the best it could do to meet

reasonable expectations in the face of weak banks, a wide array of external shocks, and reversals of

confidence (Özatay and Sak, 2002.)

Despite the confusion over where to lay blame for the crisis, the different theories on it may yet give

us some insight into the peculiarities of emerging markets and financial crises. And perhaps allow us to find

policies that work in the former while avoiding the latter.

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the turkish financial crisis of 2000-01 -- logan cooper

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