Question

TURKISH ECONOMY

Explain the significance of the 2001 crisis according to Öniş.

Answer 1

INTRODUCTION OF BANKING CRISIS

In November 2000, banks start to close their interbank credit lines to vulnerable Turkish banks, after concerns about the health of the banking sector have increased sharply. The concerns also prompt foreign investors to withdraw funds by selling off treasury bills and equities. Consequently, on 20 November 2000, Demirbank, a private mid-size bank, is not able to borrow anymore in the interbank market (Akyüz and Boratov, 2003). Therefore, it has to sell part of its government securities portfolio, causing a further fall in the value of government securities and an increase in secondary market interest rates, raising doubts about the sustainability of public debt and the crawling peg exchange rate regime that had been in place since December 1999 (Özatak & Sak, 2003). The situation further worsens and causes a hefty sell-off of securities in the debt market by banks to meet margin calls, accompanied by a massive capital outflow, turning the situation into a systemic banking crisis. On November 30, the Turkish central bank (CBRT) stops providing emergency lines of credit to banks, to keep its level of domestic assets constant. Consequently, the interbank rate jumps to 873%. As the interbank credit market dries up, an acute liquidity crisis occurs. On December 6th, Demirbank fails and is taken over by the Savings Deposit Insurance Fund (SDIF), a government body which is responsible for insuring savings deposits and strengthening and restructuring banks if necessary. The IMF assists Turkey with a financial package of USD 10.5bn, which helps to calm the markets and stops the decline in reserves. This allows the CBRT to successfully defend the peg of the Turkish lira to the US dollar, but it had already lost almost 25 percent of its foreign exchange reserves between 20 November and 6 December (see Figure 1).

The turmoil in November is followed by a political crisis in early 2001. On February 21, the prime minister and president have a dispute about fighting corruption in the banking sector (Özatay and Sak, 2002). Again, trust in the sustainability of the stability program disappears and a currency crisis occurs, as both foreign and domestic investors initiate a speculative attack against the Turkish lira (BRSA, 2010). The Istanbul Stock Exchange falls by 14% and interbank rates skyrocket, rising from 50% to 8,000%. Meanwhile, foreign exchange reserves again decline rapidly (see Figure 1). On February 22th, the government allows the lira to float freely. As a result, the Turkish lira loses about one-third of its value against the dollar.

Aftermath

After the abolition of the currency peg, the lira moves in a free float with occasional heavy interventions by the CBRT. The IMF provides more funds in 2001 to stabilize the exchange rate and to bring down interest rates by restoring confidence, bringing the total IMF financing since December 1999 to almost USD 30bn (Özatay and Sak, 2002). Nevertheless, the economy shrinks by 5.3% in 2001. GDP per capita even declines by 6.5% that year. Due to huge losses of state banks and banks taken over by the SDIF, public debt rises from 38% in 2000 to 74% of GDP in 2001. However, confidence returns relatively quickly. The economy starts to recover and GDP grows by 5.7% in 2002. Nevertheless, unemployment rises from 6.5% in 1999 to 10.4% in 2002.

SHORT ECONOMIC HISTORY

Prior to the crisis, the Turkish economy was very unstable. Throughout the 1980s and 1990s, Turkey became heavily dependent on short-term capital inflows and experienced multiple boom-bust cycles. During the 1990s, economic growth fluctuated between -5.5% and 9.3%. Financial markets, interest rates and the exchange rate were also very volatile. While Turkey’s current account deficits were relatively small (around 1% of GDP during 1995-1997), it was mainly financed by short-term capital inflows. Inflation rates often exceeded 80%, caused by heavy reliance on monetary financing until 1997. Meanwhile, Turkey’s government ran large budget deficits, up to 7% of GDP in 1997. Interest rates on government debt exceeded the inflation rate, on average, by more than 30 percentage points (see Figure 2). Several economic sectors, such as the telecom sector, were dominated by state enterprises, and were generally operating at low levels of efficiency and representing a burden on the government budget (EC, 2009). The macroeconomic volatility and instability resulted in a very poor business climate.

1997-1999: WORSENING CONDITION

The Asian and Russian crises in 1997 and 1998 negatively affected the confidence of foreign investors in Turkey (IHS, 2000). As a result, capital inflows into Turkey went down sharply and economic growth slowed down from 7.5% in 1997 to 2.5% in 1998. The slowdown in growth further undermined the confidence of foreign investors. In August 1999, a devastating earthquake hit the industrial heartland of Turkey, further deteriorating Turkey’s economic performance. The strong fall in capital inflows and the devastating earthquake pushed the economy into a deep recession. In 1999, the economy shrank by 3.6%. The budget deficit reached 12% of GDP and public debt rose to 40% of GDP.

THE DAMAGE IN THE BANKING SECTOR

The Turkish banking sector faced significant losses during the crisis. The sharp fall in prices of Turkish lira (TL) treasury bills in November 2000 negatively affected the banks’ balance sheets (Özatay and Sak, 2002). As meanwhile interbank rates increased sharply, this mainly affected banks under SDIF control and state banks with excessive interbank funding requirements (BRSA, 2010). The funding loss for private and foreign banks remained limited. In February 2001, particularly private banks made large losses following the devaluation of the Turkish lira, due to their un-hedged foreign currency position. The contraction in economic activity resulted in a sharp deterioration in loan quality, as the ratio of NPLs reached 19% in 2001.

These losses had large consequences. During 1999-2001, the SDIF had to rescue 18 banks in total, together holding 12% of total assets in the banking sector. The banking sector asset size decreased by 12.6% in real terms during the crisis, while the contraction in loans was even 29%. Also, the number of banks, branches and personnel decreased considerably.

CONCLUSION

Prior to the crisis, the Turkish economy faced serious macroeconomic imbalances and a fragile banking sector. Concerns over the weak banking sector and slow reforms, together with a decline in capital inflows, triggered the banking crisis, followed by a currency crisis. Interest rates skyrocketed, several banks had to be rescued and the IMF assisted Turkey with almost USD 30bn in total. After three months of turmoil, exchange rate controls were abandoned. A successful debt-swap in June 2001 prevented a sovereign default. Partially thanks to far-reaching structural reforms the economy quickly recovered. Bank regulation and supervision were strongly improved. The reforms contributed to persistent banking sector stability during recent crisis years. Afterwards, the economy vigorously recovered from the crisis.