The Turkish Crisis of 2001 - ieu.edu.tr

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Emerging Markets Finance and Trade, vol. 42, no. 1,January–February 2006, pp. 5–32.© 2006 M.E. Sharpe, Inc. All rights reserved.ISSN 1540–496X/2006 $9.50 + 0.00.

CEM AKYUREK

The Turkish Crisis of 2001A Classic?

Abstract: In February 2001, Turkey became the latest emerging market toexperience a devastating crisis, following the collapse of its soft exchangerate peg. The crisis severely damaged the country’s banking system and ledto an unprecedented contraction in economic activity. The boom that pre-ceded it seemed to be relatively short lived, as the initial rush of capitaloutflow occurred just eleven months after the start of the program, and thefatal exit just three months later. This paper discusses the factors that seemedto play an important role in the collapse of Turkey’s International Mon-etary Fund (IMF)–supported exchange rate–based stabilization plan justthirteen months after its commencement. It is often difficult to attribute suchcrises entirely to a single factor, and not always possible to arrive at a strongverdict by analyzing economic developments in light of, or in the mannerformally suggested by, the alternative models commonly used to analyze cur-rency crises in the literature. In the Turkish case, enumerating the many fac-tors that may have contributed to the collapse is important and very useful—yetthis should not obscure the critical role played by the failure to establish orachieve tangible progress toward a sustainable fiscal regime. Not recogniz-ing this fundamental weakness could easily lead observers to emphasize de-sign flaws as the main culprit or to argue that the collapse could have beenavoided if several other factors had broken more in Turkey’s favor.

Key words: currency crises, exchange rate–based stabilization, fiscal policy.

Cem Akyurek ([email protected]) is chief economist at Global Securities,Istanbul, Turkey.

6 EMERGING MARKETS FINANCE AND TRADE

In February 2001, Turkey became the latest emerging market to experi-ence a devastating crisis following the collapse of its soft peg. The crisisseverely damaged the country’s banking system and led to an unprec-edented contraction in economic activity. Worse yet, it came thirty monthsafter the country was struck by a destructive earthquake, and just oneyear after the start of a comprehensive stabilization program supportedby the International Monetary Fund (IMF). The program was introducedafter several months of exhaustive talks between IMF officials and Turk-ish authorities, and following the completion of reforms (prior actions)in several areas. The buildup of economic imbalances before the crisis,and the manner in which the crisis unfolded, in many ways resembledthe experiences of other emerging market economies that had imple-mented similar exchange rate–based stabilization programs. The boomcycle began with massive short-term capital inflows, leading to real ex-change rate overvaluation and growing current account deficits before asharp turn of events led to the bust. Yet this boom cycle seemed to berelatively short lived: The initial rush of capital outflow occurred justeleven months after the start of the program, and fatally exited threemonths later. Though Turkey’s crisis has the mark of a “classic” case, tomany observers, the collapse appeared to come too soon. Thus, the se-ries of events leading up to the crisis warrants a careful analysis beforepassing judgment and drawing lessons for future economic policy. Tothe author, a classic case is identified as one in which currency collapseis preceded by an underlying inconsistency in economic policy, ratherthan by a shift in market expectations for the worse that is somewhatindependent of fundamentals.1 In domestic circles, a combination of is-sues, ranging from flaws in program design and implementation to exter-nal factors beyond the control of policy makers, were said to have playeda significant role in the failure of the 2000 economic plan. This paperattempts to discern the various factors, including case-specific features,to find the main culprit(s) of the collapse of the Turkish stabilizationplan in February 2001.

Fundamental Features of Macroeconomic Instability:1980–1999

Some of the features of the Turkish economy that may have contributedto the crisis are also long-standing conditions. Turkey has suffered fromhigh and volatile inflation: Average inflation during 1980–99 registered

JANUARY–FEBRUARY 2006 7

Figure 1. Capital Inflow, Bank Credit, and Growth, 1988–2001 (four-quartermoving averages)

Sources: Central Bank of Turkey and State Institute of Statistics.

60%

66%

65%

90%

85%

80%

75%

70%

at 61.5 percent, with a standard deviation of 26 percent. Inflation hashad a strong fiscal effect, and yet several studies of its dynamics in Tur-key indicate that there is a strong inertial component as well, which hasprogressively strengthened over the years.2 Turkey’s gross domestic prod-uct (GDP) growth has also been unstable, averaging 4 percent with astandard deviation of 4.7 percent over 1980–99. Capital inflows andoutflows have been catalysts for booms and busts, as evidenced by acursory look at the correlation between GDP growth and net capitalmovements over the past several years (see Figure 1). Episodic capitalinflows relieved the fundamental foreign exchange bottleneck in theeconomy, allowing imports of essential intermediate goods to increase,and facilitating an expansion of the domestic financial system and bankcredit, which led to periodic bursts in growth.3 Fiscal discipline has beenweak, however. The public-sector borrowing requirement (PSBR) hasaveraged nearly 8 percent over the past twenty years. Moreover, trans-parency in fiscal accounts has been very poor, with a substantial portionof government expenditure remaining outside the central governmentbudget. Protracted deficits have made monetary policy largely subordi-nate to fiscal policy, as the central bank has monetized deficits either


directly, by extending credits to the Treasury, or indirectly, through thecommercial banking system. Particularly as the government debt mar-ket deepened, switching from money finance to bond finance becamevery popular among policy makers, as this strategy often temporarilydampened inflation (which led, from time to time, to a rather tenuousshort-term link between inflation and deficit size). However, the snow-balling securitized debt eventually led to massive monetization, a phe-nomenon that has repeated itself on numerous occasions over the pastseveral years. Moreover, monetary policy has accommodated severalexternal shocks over the past two decades (see Figure 2).4 Finally, andclosely related to broader fiscal problems, concerns regarding thesustainability of public-sector domestic debt progressively increased inthe 1990s, peaking just before the 2000 stabilization plan was intro-duced. The domestic debt (securitized) ratio stood at 17 percent by year-end 1995, increasing to 29 percent by the end of 1999. While this ratioappeared to be relatively low, markets perceived it to be on an unsus-tainable path, given that real interest rates were, on average, well over20 percent. A simple model of debt dynamics indicated that stabilizingthe debt ratio demanded high levels of growth and strict fiscal disciplinefor many years to come.5 Heavy intermediation of domestic debt bybanks had created a captive market for it, arguably helping the treasuryto place more public debt than would otherwise be likely. While thisresulted in a relatively stable demand for government debt, in the pro-cess, the banks took on excessive risks. Their bond portfolios were fi-nanced with mostly overnight repurchase agreements and short-termloans from international banks, creating maturity and currency mis-matches on (and off) their balance sheets.

Chronologically, the twenty years before the 2000 stabilization plancan be divided into three periods. The first, 1980–86, corresponds torecovery from debt crisis and transition to a more liberalized, market-oriented economy under an IMF-led stabilization program. The PSBRwas cut from 10.5 percent of gross national product (GNP) in 1980 to4.3 percent by 1982, and generous foreign inflows from official andmultilateral sources helped to reduce reliance on central bank financ-ing.6 Inflation declined from over 100 percent in 1980 to the range of 25percent in 1981–82. Growth resumed, as a real GDP contraction of 2.4percent in 1980 was followed by positive growth rates above 4 percentfor the remainder of the period. The success with inflation proved tem-porary, however. As reforms were not sufficiently deep to achieve sus-


Figure 2. Annual Change in CPI, Base Money, Exchange Rate, andWages, 1989–2000

Sources: Central Bank of Turkey and State Institute of Statistics.Note: CPI inflation exceeded 150 percent in 1994 following a balance-of-paymentscrisis.

tainable cuts in the PSBR, and as official financing dried up, monetarypolicy loosened, and the annual inflation rate climbed to the 35 to 45percent range during 1983–86.

The year 1987 marked the start of a six-year period of poor policy,the outcomes of which eventually led to the 1994 crisis. The PSBR in-creased progressively; the 1987–93 average of 7.4 percent of GNP wasdouble that of 1981–86. Similarly, annual inflation doubled, fluctuatingin the 60 to 80 percent range. Growth also fluctuated widely: GDP growthin excess of 9 percent in 1987 and 1990 were record rates, but both ofthese bursts were followed by low growth rates of 0.3 and 0.9 percent in1989 and 1991, respectively. High growth in 1987 was largely due toexpansionary domestic policies. The 1989–91 boom–bust period wasTurkey’s first true taste of the sweet and sour experience of short-termcapital inflows, as the capital account was liberalized in 1989. Theperiod saw a substantial rise in short-term capital inflows, leading torecord expansion in the economy and substantial appreciation of the


currency, until foreign investors pulled out in the wake of the Iraq crisis.But this boom–bust episode was just a preview of what would happen inearly 1994.

As the lira appreciated (by 35 percent against a trade basket between1989 and mid-1991) and the trade deficit widened (from an average of$9 billion in 1990–92 to $14 billion in 1993), policy makers overlookedsevere macroeconomic imbalances in key areas and failed to take cor-rective action. The 1993 budget deficit reached twice the planned level.In February 1994, the government announced that it was devaluing theofficial dollar-lira nominal exchange rate by nearly 10 percent, whichundermined the credibility of government policies. Further capital out-flows and accelerated currency substitution led to a further 70 percentslide in the exchange rate over the following two months. The cumula-tive inflation rate in the first four months of 1994 was over 60 percent.This crisis led to the April 1994 stabilization package, supported througha standby arrangement with the IMF, which introduced several mea-sures aimed at controlling public-sector deficits and limiting their fi-nancing by the central bank.7 The deficit was halved through immediateincreases in public-sector prices, one-off tax measures, and limits onpublic-sector wage increases.8 As growth rebounded strongly in 1995,to 7.5 percent, and the inflation rate declined from over 125 percent inApril 1994 to 70 percent by mid-1995, the IMF agreement was termi-nated following the collapse of the coalition government in September.Over the following two years, despite political uncertainty and poor eco-nomic policy, Turkey’s fragile imbalances—consisting of large PSBRs,high inflation and nominal interest rates, and a relatively strong lira—were maintained without leading to another collapse. Sustained capitalinflows provided support, as GDP growth was at 7 percent and 7.5 per-cent in 1996 and 1997, respectively.

The Russian crisis of July 1998 hit Turkey hard, affecting the economymainly through two channels. First, there was strong real contagion, asexports to Russia, nearly 25 percent of total exports, fell sharply.9 Sec-ond, capital outflows led to a severe credit crunch, and interest ratesincreased from around 90 percent to 140 percent within four weeks,raising fears regarding the sustainability of public-sector debt. All ofthis occurred in an environment of fragile domestic politics, leading to asharp deterioration in domestic sentiment.10 Economic conditions wors-ened ahead of the parliamentary elections in April 1999, as GDP con-tracted in the first quarter of the year by 8.4 percent. Following the


elections, contraction slowed: GDP fell by 2.2 percent in the secondquarter, and a sharp pickup in economic activity in the second half of1999 was expected. But in August, a devastating earthquake struckKocaeli, which generates close to 17 percent of the country’s manufac-turing output. A range of industrial sectors were hit hard, causing anoverall supply shock. The economy contracted by 4.9 percent in thefinal quarter of the year, bringing annual GDP contraction to 6.4 per-cent. The decline in inflation was relatively modest.11

By the end of 1999, the greatest concern regarding economic funda-mentals had become the sustainability of public-sector debt. The com-bination of lax fiscal policy, high real interest rates, and GDP contractionled to a sharp increase in the domestic debt ratio, from 22.2 percent atend-1998 to 29.6 percent at end-1999. The primary balance of the cen-tral government swung from a 4.7 percent surplus in 1998 to a nearbalance in 1999, mainly due to contraction and quake-induced tax losses,and a significant rise in noninterest expenditure. The average real inter-est rate (ex post) on domestic debt was approximately 30 percent in1999, and the operational budget balance (of the central government)deteriorated sharply, from –1.1 percent of GNP in 1998 to –6.8 percentin 1999. It became apparent that the ongoing path was unsustainable,which eventually led to the introduction of the 2000 stabilization plan.

The 2000 Stabilization Program: Key Points and Issues

IMF and Turkish officials had been in close contact, holding severalofficial meetings starting in late 1997 to discuss the prospects for adisinflation program. Improved transparency in fiscal operations andthe ensuing adjustment in the primary budget balance led to a staff-monitored agreement with the IMF in June 1998. Despite significantcontagion from the Russian crisis, the program had remained broadlyon track throughout its duration. The IMF granted a few waivers andpublished favorable quarterly reviews for 1998 and the first half of 1999.In July 1999, the agreement was extended with the objective of leadingto a standby agreement and financial assistance from the IMF. From thevery beginning, the IMF’s blueprint set structural reforms as “prior ac-tions.” When the newly formed coalition government took steps towardpension reform, implemented new banking legislation, and made con-stitutional changes to allow international arbitration for the settlementof disputes over the sale of public-sector assets, the preconditions had


largely been met.12 It seemed as though the open-loop bargaining pro-cess between the two sides would conclude before the end of 1999. TheIMF pressed for one remaining government plan of action, a record fis-cal adjustment plan for 2000, along with a commitment from the coali-tion to complete several fiscal reforms to reduce public-sector deficitsin a sustainable way.

With persistently exorbitant rates on government debt in the secondhalf of 1999, a substantial interest burden was shifted to the followingyear’s government budget. Interest expenditures were expected to riseto an unprecedented 18 percent of GNP in 2000. Thus, barring a record-level primary surplus, the budget deficit in 2000 appeared set to reachan all-time high. This raised concerns about credibility ahead of thelaunching of the disinflation program. Thus, the 2000 fiscal plan hadtwo components, with two major objectives in mind. First, one-off mea-sures were planned to achieve a large primary surplus, to be used forcontaining the budget deficit and improving debt dynamics immediately.To this end, various tax measures were introduced, including a onetimetax on banks’ government bond holdings, increases in value-added tax(VAT) rates, and withholding taxes on repurchase agreements and bankdeposits. The one-off component of the tax package was expected toraise tax revenues in 2000 by approximately 2.3 percent of GDP. Sec-ond, several measures were included in the program to make fiscal ac-counts more transparent and ensure durable fiscal discipline. Agriculturalsubsidies and deficits in social security institutions had been two blackholes in the government’s budget for several years.13 These two itemshad been part of populist government policies in the past; reforms inthese areas would help sustainably reduce government expenditures andrelieve fiscal policy from political pressures in the future. The programplanned to replace the existing agricultural support policies with a di-rect income support program.14 As for social security reform, in addi-tion to increasing the retirement age, the necessary legal groundwork tointroduce a private pension scheme would be completed. Moreover, thefiscal program included measures to strengthen tax enforcement by avoid-ing any subsequent amnesties—a common government practice in thepast—and improving the tax monitoring system. The IMF plan also in-cluded measures to reduce quasi-fiscal deficits. Consolidating public-sector accounts to include public institution losses outside the centralgovernment budget, particularly those of public-sector banks, and abol-ishing extra-budgetary funds were deemed crucial to monitor the “true”


position of fiscal policy and increase accountability.15 In fact, this waswhat the IMF had required as a starting point for the proposed fiscaladjustment plan since the very beginning of talks with Turkish authori-ties in 1997. Fiscal reforms were thought to enhance the credibility ofthe program by signaling an enduring improvement in the fiscal regime.

When the coalition government submitted to Parliament a fiscal bud-get for 2000, it included an ambitious turnaround in the primary bal-ance—by 5.4 percent of GNP—toward the end of 1999. It also agreed toall structural reforms relating to fiscal adjustment, which became struc-tural benchmarks for the program.

With the fiscal plan in place, Turkish authorities and the IMF mutu-ally agreed on a “multiple anchor” approach to disinflation in Decem-ber 1999. They aimed to lower wholesale inflation quickly, from 63percent at year-end 1999 to 20 percent by the end of the following year.Together with the nominal exchange rate, increases in public-sector pricesand wages as well as agricultural support prices would be limited totarget inflation during 2000. Instead of being part of a widespread ac-commodation scheme, as it was in previous years (see Figure 3), an-choring these variables was expected to lead private-sector expectationsto help bring down inflation. The monetary program provided tables toprogressively decrease the lira’s monthly nominal depreciation rateagainst a basket consisting of the U.S. dollar and the euro for an eigh-teen-month period.16 Subsequently, an exit strategy was designed in whichthe exchange rate would become increasingly flexible around a centralpath. The program also involved floor values on net international re-serves and ceiling values on net domestic assets of the central bank asperformance criteria. During each quarter, net domestic assets were al-lowed to fluctuate within a 5 percent band of the previous quarter’s basemoney figure, while quarter-end values were fixed. All this, togetherwith a rule preventing the sterilization of capital flows, meant that thesystem would function like a quasi-currency board, determining moneysupply endogenously (Alper 2001).

The success of the approach would clearly depend on the credibilityof the program, as well as the government’s ability to implement andendure it. The measures around which the program was formulated—the degree to which these measures were consistent with the targetedinflation and policy sustainability—were already crucial at the launch-ing of the plan. The markets seemed to be largely convinced by theinternal consistency of the program. Despite all of the well-known dan-


Figure 3. Cumulative Inflation and Depreciation, 2000

Source: Central Bank of Turkey.

gers inherent in this type of disinflation strategy, economic fundamen-tals in Turkey at the time appeared conducive to anchoring the exchangerate. The lira was more or less correctly aligned in real terms, the centralbanks’s foreign exchange reserves were close to its pre-Russia peak,and a large up-front fiscal correction was planned for 2000. There waswidespread belief that the monetary program’s exit strategy was timelyand clever. Moreover, given widespread currency substitution, the ex-change rate peg would help to increase demand for lira balances, therebyraising the seigniorage base to help finance the government’s budgetdeficit.

As for the political environment just before the program commenced,there seemed to be several reasons to believe that the markets would beconvinced and grant credibility to the IMF-endorsed package. When thenew government was formed in June 1999, its legitimacy was in doubtin domestic circles, because it was built on a coalition of parties withvastly different ideological orientations. Public perception held that thethree-party coalition lacked the cohesion it would take to complete sweep-ing structural reforms. Yet, within three months of being formed, the


government delivered reforms that required major legislative and insti-tutional amendments. Suddenly, the government looked like an excep-tion to the rule that multiparty coalition governments in Turkey were arecipe for disaster.

In particular, and quite apart from the scope of the actual reforms(prior actions), the circumstances under which they were completed alsohelped the government gain credibility. The economic liberalization ofthe first half of the 1980s appeared to be the lone period of structuralreform in Turkey in the past twenty years. At the time, the majoritygovernment that had taken office following Turkey’s return to democ-racy in 1983 accomplished far-reaching reforms in a relatively shorttime. The government faced limited opposition from either inside oroutside Parliament, as political parties had been closed and their respec-tive leaders banned from the political arena. Moreover, because the formermilitary government had banned union activities, to a large extent, re-ceiving the blessing of the population was, in effect, not a hurdle toreform. By the time union activities were reconstituted and banned poli-ticians returned to politics in 1987 and 1989, respectively, reform ef-forts had subsided.

From the standpoint of structural reforms, the three-party coalitionassembled in 1999 faced the monumental task of picking up where thepostmilitary majority government of the early 1980s had left off. Yetthis time, gathering public support was crucial, and the government hadto withstand tougher resistance. However, the coalition partners lookedlike they were up to the task. The IMF was convinced that the govern-ment had both the strength and will to uphold a comprehensive stabili-zation plan, which had been missing since the talks with the IMF beganin late 1997 under weaker governments.

But most important, the market consensus was that the governmenthad a strong incentive to uphold disinflation efforts. The economy’s re-silience to less-than-friendly international conditions following the Rus-sian crisis was somewhat encouraging. However, the damage inflictedby contagion was significant, and without a credible shift in economicpolicy and an IMF-supported program, neither inflation nor growth couldbe brought to desirable levels. Given its makeup, the program was likelyto yield windfall short-term political benefits.

Two other events in late 1999 had the potential to be strong sentimentdrivers ahead of the start of the program: namely, improving relationswith the European Union, as Turkey received candidacy status at the


Helsinki Summit in December, and Moody’s change in Turkey’s out-look to positive. All in all, the environment prior to introducing the 2000stabilization plan seemed to be upbeat.

Program Implementation and Results

This section first discusses risky developments observed in macroeco-nomic fundamentals over the course of 2000, with particular emphasison the “usual suspects” in exchange rate programs. This is followed bya discussion of lack of progress in fiscal reforms, which I believe wasthe main culprit behind the collapse of the economic program, throughits negative effect on fiscal sustainability.

After the program started in January 2000, early progress in reducinginflation and interest rates was somewhat surprising, with the formerovershooting and the latter undershooting their targeted and projectedpaths, respectively. As planned, nominal exchange rate depreciation was6.4 percent during the first quarter of 2000. Cumulative inflation mea-sured by the wholesale price index (WPI) rate reached 13.5 percent bythe end of the first quarter, already more than half of the year-end 20percent target. To some extent, high inflation early on was caused by thelagged effect of sharp price adjustments in the public sector and the VATrate increases just before the program started. As such, convergence ofinflation accelerated during the second quarter, although by the end ofthe first half of the year, cumulative inflation and depreciation rates, at19 percent and 12 percent, respectively, remained quite apart comparedwith program projections (see Figure 3). Inflation had already exceededthe year-end target by the end of August, and consensus forecasts showedyear-end inflation at over 30 percent. Moreover, core inflation—in pri-vate manufacturing, which historically had been closely linked to ex-change rate movement—showed occasional spikes on a monthly basis,despite the progressive decline in the rate of depreciation, which dis-tressed the markets.17 Due to these developments, the real exchange rateappreciated by 6 percent by the end of the third quarter.18

Nominal yields on government debt, which stood at 80 percent inNovember 1999, were more than halved within three months (see Fig-ure 4). The exchange rate anchor, together with tight fiscal policy, evapo-rated risk premiums associated with exchange rate depreciation and debtdefault. The ensuing arbitrage opportunity increased capital inflows, andthe resulting rise in liquidity led to a relatively quick and sharp decline


Figure 4. Annual Compounded Rates on Government Bonds inSecondary Market, 1999–2001


in interest rates. As Alper (2001) indicates, the momentum of this pro-cess was augmented by the no-sterilization rule built into the monetaryprogram. The main link between capital inflows and lower bond yieldsoccurred mainly through an all-too-familiar investment strategy pursuedby domestic banks since the capital account was liberalized in 1989–90.Accordingly, Turkish lira–denominated government debt purchases werefinanced by short-term credit lines and syndicated borrowings from for-eign banks. Banks’ stock of short-term foreign debt (on the balance sheet)increased by $4.4 billion during 2000, as some banks accumulated largecurrency mismatches on and off their balance sheets.

Nevertheless, the markets believed that relying solely on the year-to-date inflation outcome, and the ensuing misalignment of the Turkishlira, would lead to undervaluing the stabilization program. Observerswere quite pleased with the results achieved on the interest rate front,along with fiscal tightening. Risky developments in bank balance sheetsdid not seem to be a major concern, though they subsequently played amajor role in the unfolding of the crisis.

On the fiscal side, by midyear, the central government’s primary sur-plus seemed to be headed toward a year-end level larger than budgeted


for, thanks to successful collection of additional taxes introduced for2000 and the sharp economic recovery. This, along with the decline inreal cost of domestic debt, led most observers to believe that fiscal policywas on track. The progress made so far meant a significant improve-ment in debt dynamics, after all, notwithstanding the ambiguity regard-ing fiscal performance as defined in the IMF plan.19

By the end of the first six months of the program, however, the cur-rent account deficit widened to a much higher level than projectionssuggested. The deficit projection in the program stood at 1.8 to 2 per-cent of GNP, but by midyear, it looked as though the figure would reachwell over 4 percent. This was a well-known consequence of exchangerate–based stabilization programs, as recovery in economic growth andstrengthening currency tends to have a significant effect on imports.Indeed, an IMF study indicates a high income elasticity for imports anda high short-run price elasticity of demand for imports in Turkey.20 Similarto what was experienced in 2000, namely, a 37 percent jump in importsby the end of the third quarter, imports had grown rapidly, by 29 percentin 1993, and by 55 percent in 1995, as growth recovered and the cur-rency strengthened both before and after the 1994 balance-of-paymentscrisis. A program-driven effect on imports was also realized through theaforementioned sharp reduction in interest rates, which fueled consump-tion through rising consumer loans.21 It seemed that in Turkey’s case,factors unrelated to the stabilization strategy contributed to the widen-ing current account deficit as well. Accordingly, three exogenous fac-tors added thrust to the rise in imports. First, the rise in oil prices addedan extra burden. Turkey consumed 12 percent less oil in the first half of2000 compared with 1998 (a year of strong growth), and yet, the oilimport bill was twice as high.22 Thus, Turkey faced the load of a rela-tively significant terms-of-trade shock. Second, the start of the programcoincided with significant pent-up demand, which steepened the recov-ery in consumption and imports. Third, the strengthening dollar againstthe euro exacerbated the effect of the initial wealth effect, as importsfrom the EU zone soared.23 Thus, one-off effects played an importantrole in the import boom, and they seemed likely to abate.

Despite its sizable likely transitory component, the widening currentaccount deficit did become a worry, particularly after the markets beganto suspect that Turkey’s fiscal discipline was unsustainable. In the past,current account deficits in Turkey had become worrisome at levels muchbelow that projected by the markets for 2000, basically for two reasons.


First, the savings–investment gap had been largely a result of growinggovernment budget deficits, which were unlikely to be brought downquickly without correcting structural weaknesses in fiscal policy. Onthe other hand, the private sector typically had positive net savings. Thus,a smooth transition to a lower savings–investment gap, rather than anadjustment through external crisis, seemed difficult in the past, giventhe inflexible fiscal policy and lack of commitment to budgetary disci-pline by successive governments. Second, the widening savings gap wasfinanced mainly through short-term borrowing, while longer-term in-flows remained subdued. Markets worried that such inflows could eas-ily become outflows, as they had on several previous occasions, the latestepisode occurring during the 1998 Russian crisis. On the other hand, thedecline in national savings in 2000 largely took place in the private sec-tor. Continuing tight fiscal policy beyond the current year, together withabating the temporary effects that widened the private-sector’s savingsgap, would have allowed a smooth transition to a lower current accountdeficit in the future. However, the future of fiscal discipline looked in-creasingly uncertain toward the end of the year (see below).

Markets were also troubled by the realization that the 2000 currentaccount deficit was likely to be well over the 1993 value of 3.6 per-cent—which preceded the early-1994 collapse of the exchange rate. Inmany respects, the circumstances of 2000 were greatly more favorablethan those of 1993. In 1993, the budget deficit had reached its all-timehigh, domestic debt dynamics had worsened significantly, massive mon-etization had taken place, and there was no IMF plan in place. Develop-ments in these areas seemed to be in a much better state in 2000 comparedwith 1994. But this did not seem to matter. Instead of evaluating a com-posite set of current factors, the markets concentrated on the robustnessof the current account deficit figure, and the future prospects of eco-nomic policy in general and fiscal policy in particular. This contributedto worries regarding the sustainability of the exchange rate peg (seebelow).

Early studies on currency crises, namely first-generation models, em-phasize deteriorating macroeconomic fundamentals as the main deter-minant of eventual collapse. Proponents of this approach emphasize theconflict between the goal of nominal exchange rate stability and thedifficulty in implementing monetary and fiscal policies that are consis-tent with that goal.24 Lax fiscal policy and domestic credit expansionlead to a gradual decline in central bank international reserves. Specula-


tive attacks then massively deplete reserves, and the peg collapses. How-ever, Ozatay and Sak (2002) argue that deteriorating fundamentals werenot the underlying cause of the Turkish crisis, which did not seem to fitthe first-generation framework. Their argument seems particularly con-vincing, given that the budget deficit was not monetized, and that cen-tral bank international reserves were not depleted. But does this meanthat fundamentals, the usual suspects, did not play a major role in theTurkish crisis?

On balance, it can be argued that developments in key areas, such asthe pace of disinflation, real exchange rate appreciation, and current ac-count deficit, were proceeding toward a more vulnerable state as early assix months into the program. Yet markets also seemed hopeful about thesustainability of the program, so long as reform efforts continued. Putdifferently, by the summer, the markets still believed that the programwas internally consistent. And yet, there was a growing perception that itwas too stringent in its reform agenda, leaving very little room for erroror delay in implementation for the coalition government, which had al-ready undertaken politically difficult reforms in several areas. In this re-spect, worries surfaced as early as mid-2000. Thus, going into the secondhalf of the year, the program had become more vulnerable to stress tests.Reform fatigue set in, particularly related to fiscal policy—the keystoneof the stabilization program, as the previous section indicated.

In short, the problem with fiscal adjustment was quality rather thanquantity. “Quality” in fiscal adjustment describes policy changes thathave long-lasting effects. Ter-Minassian and Schwartz (1997) argue thatsuccessful stabilization requires high-quality fiscal adjustment, imply-ing that not only the extent, but also the nature and composition of fiscaladjustment matter. Fiscal disciplines of the same magnitude can differprofoundly in their sustainability, and in the ways that economic agentsperceive them; therefore, they can have very different effects on expec-tations and market behavior. Put differently, fiscal measures that areviewed by economic agents as long lasting are likely to create greatercredibility compared with quick fixes that are less likely to be main-tained over the longer term.25 Cottarelli and Szapary (1998) suggest thatthe key to credible disinflation is to convince the private sector that thestrength of fiscal balances is enduring. Burton and Fischer (1998) arguethat if the private sector perceives that the government’s intertemporalbudget constraint is unlikely to be met, then the credibility of thedisinflation process will be undermined. Cottarelli and Szapary (1998)


also argue that various anchors, such as the exchange rate, could be usedfor disinflation purposes, but they could only help to augment the cred-ibility achieved through establishing a sustainable fiscal position.26 Fi-nally, Burton and Fischer (1998) emphasize the importance of structuralmeasures and reducing quasi-fiscal deficits. All of these arguments seemto be highly relevant to the Turkish case (see below).

In the initial stages of the program, one-off taxation enabled a front-loaded increase in the primary surplus in 2000, which helped to improvedebt dynamics. However, the credibility of fiscal policy began to dete-riorate in the second half of the year as the government’s ability to main-tain fiscal discipline became doubtful, for several reasons. First, thegovernment put no effort into durable fiscal measures; policy makersseemed to be content with the savings on interest expense and their suc-cess in collecting additional taxes. There was virtually no progress inimplementing measures, included in the initial letter of intent, that weresupposed to help widen the tax base, increase tax collection, and reducenoninterest expenditures.27 In this respect, implementation was reminis-cent of the previously unsuccessful IMF plan of 1995, where again, vari-ous one-off tax measures created a sharp turnaround in the primary balance,but long-lasting measures were forgotten. Closing extra-budgetary funds,which was among these measures, proved to be too little too late—thework was partially completed on the eve of the February 21 collapse ofthe exchange rate peg.28 Second, structural measures that were com-pleted or in progress seemed to bear little fruit. The markets realizedthat what had been accomplished in social security and agricultural re-form was insufficient to control the deficits in these areas. Third, asexplained earlier, the fiscal performance criteria of the IMF plan hadbeen set on the greater public sector, which was viewed as an importantstep toward improving transparency and measuring the true state of fis-cal policy.29 However, the government failed to release data on this con-solidated fiscal measure in a timely manner, and eventually stoppedreporting it as early as after the first quarter. Fourth, the lack of transpar-ency increased concern over the size of quasi-fiscal activities, raisingworries about fiscal skeletons in the closet. Finally, the fiscal picturelooked bleaker in the face of bank failures and the accumulation of con-tingent liabilities.30 All of the above eroded confidence in the medium-to long-term fiscal outlook, but developments in privatization shatteredthe prospects for fiscal improvement in the following year as well. Priva-tizing landmark projects, such as Turk Telecom and Turkish Airlines,


became an integral part of intracoalition political troubles and were sub-sequently postponed.31

These developments in Turkey fit all too well into the conceptual andanalytical frameworks used by Kopits (2000) and Burnside et al. (1999)in highlighting the effect of expectations about future deficits on thesustainability of fixed exchange rate regimes. The latter argues that theAsian currency crises were caused by large prospective deficits associ-ated with implicit bailout guarantees to failing banking systems in thosecountries. The expectations that seigniorage revenues would finance atleast a part of those future deficits are shown to have led to a collapse ofthe fixed exchange rate regimes. Accordingly, once agents receive in-formation that future deficits will be larger than they had originally be-lieved, the government’s intertemporal budget constraint implies that aspeculative attack is inevitable. This happens regardless of the govern-ment’s initial level of reserves, or its initial debt position. Thus, the col-lapse occurs due to an underlying inconsistency in economic policy andreflects fundamentals—namely, prospective deficits. Moreover, the au-thors indicate that an analyst looking at the exchange rate crisis wouldnot see large deficits or high growth rates of money prior to the specula-tive attack, and might well conclude that the attack was the result of asudden shift in expectations for the worse, in the style of second-gen-eration models of currency crises.32 In the Turkish case, higher budgetdeficits were expected for several reasons, some of which are differentfrom what Burnside et al. (1999) argue to be the case for East Asianeconomies. First, it was widely known that public-sector banks had ac-cumulated large duty losses over the years, which had to be recognizedas part of the public-sector domestic-debt stock at some point in time.33

Kopits (2000) indicates that in Mexico, the Czech Republic, and Russia,weak financial institutions, which had become vehicles of covert subsi-dization under government control, made the exchange rate regime sig-nificantly more vulnerable to collapse. Second, as indicated earlier, thelarge primary surplus achieved in 2000 was mainly because of addi-tional distortionary taxation, which seemed to be difficult to maintain.Market participants knew this and began to worry about the sustainabilityof these measures as early as mid-2000. Put differently, the 2000 pri-mary surplus was perceived as low-quality fiscal overkill, and marketparticipants realized that the government could not service its futureobligations, perhaps including hidden debt, by introducing new taxes orraising tax rates, as these avenues had already been exhausted. Third,


and as indicated earlier, there was little room to cut noninterest expendi-ture, as completed reforms turned out to be illusory in this respect.

All of these hindered the medium-term orientation of fiscal policy.Thus, more likely than not, the Turkish collapse was indeed a “classic,”as there was an underlying inconsistency in economic policy reflectinga fundamental problem of fiscal unsustainability. Enumerating the manyfactors that contributed to the Turkish crisis, however, should not ob-scure the critical failure of not taking the planned steps toward a moresustainable fiscal regime, which was the main reason for the program’scollapse.

Once market concerns regarding future fiscal discipline arise, Kopits(2000) assesses the scope for policy signaling to turn market sentimenttoward a more favorable outcome, and thus mitigate the economy’s vul-nerability to speculative attack. He focuses on the potential usefulnessof fiscal policy rules to prevent crises, arguing that they can be precipi-tated by unfavorable signaling of a weak government. In the Turkishcase, perhaps strong fiscal signaling on the part of the government couldhave provided some hope following the initial attack on the currency inNovember 2000.34 Instead, the government sent out the worst possiblesignals by launching a search for means to increase budget transfers tothe private sector. Fiscal worries reached their climax, and finally, thanksto the Prime Minister Ecevit–President Sezer duo, the attack on the cur-rency put the last nail in the coffin on February 22 (see below).

Crises and Immediate Aftermath

Given its fundamental weaknesses, the exchange rate peg was doomed tobe tested by the markets. This is when the weak banking system enteredthe picture. The stabilization program included radical measures tostrengthen the banking system. Yet, the foundation of reform in this area,namely, the establishment of an independent banking supervisory board,was completed in August 2000, after considerable delay. This surely playedan important role in the failure to implement the measures suggested tocapture risks associated with on- and off-balance-sheet transactions, whichincreased the risk exposure of the banking industry in general, and cer-tain banks in particular, during 2000.35 Ozatay and Sak (2002) show thatthese risks evolved asymmetrically among banks, creating dichotomiesbetween public- and private-sector banks and within the private bankingsector.36 Public-sector banks became more susceptible to interest rate risk,


and their private-sector counterparts became more vulnerable to exchangerate risk. Among the latter, Demirbank, a medium-sized bank, extendedits exposure in both dimensions well beyond the limits that would havebeen strictly imposed by a strong regulatory framework. Demirbank’s weak-nesses played a major role in the outbreak of the crisis (see below).37

As the experiences of other countries have shown, when fixed ex-change rate currency regimes come under pressure, a weak banking sys-tem places the policy makers between a rock and a hard place. Facedwith pressure on the exchange rate and a shortage of liquidity, the policymaker has basically two choices: to either adhere to the peg, which in-creases the pressures on the banking system, or exit the peg to relievethe pressure on the banks. In November 2000, the stabilization programwas subjected to its first stress test, putting policy makers and the IMFin this difficult position. With confidence deteriorating, August and Sep-tember saw the first signs of capital outflows since the program began,and interest rates began to increase (see Figure 5). Some banks that hadpositioned themselves aggressively in the bond market funded a goodportion of these securities with short-term credit lines from foreign banks,as well as other domestic banks (Alper 2001).38 Rumors of their bank-ruptcy began circulating in domestic as well as international circles. Asinterest rates rose, bond prices, and thus the collateral value of short-term credit lines, declined. Subsequently, lines were shut and margincalls took place, triggering further liquidation of bonds by troubled banks.Demirbank had difficulty finding liquidity from the market, and the cen-tral bank was unable to extend liquidity due to the ceiling imposed on itsnet domestic assets (Alper 2001). This pushed interest rates to over 1,000percent, and yet the central bank adhered to the program, as Demirbankand others’ capital bases were eroded. As the liquidity shortage appearedto take on a systemic scale, the central bank provided liquidity, breach-ing the program’s net domestic asset ceiling. And yet, almost all of theTurkish lira liquidity returned as foreign exchange demand. While for-eign investors were pulling out, domestic banks were also buying re-serves to close their short foreign exchange positions. In the process, thecentral bank lost almost $5.5 billion in reserves in one week, a 23 per-cent fall from $24.4 billion to 18.9 billion (see Figure 5). Finally, theIMF intervened on December 6, providing a three-year supplementalreserve facility in the amount of $7.5 billion to support the currency,while Demirbank was taken over by the Banking Supervisory Board.

The additional IMF support appeared to stabilize the financial mar-


Figure 5. Central Bank Foreign Exchange Reserves, 1999–2001 (weeklybillions of dollars)


kets, as capital outflows subsided. By mid-January, international reserveshad been replenished to precrisis levels, and interest rates had declinedto below 60 percent. However, the genie was out of the bottle. As politi-cians responded lethargically to the crisis and the underlying fundamentalweaknesses, stability appeared transitory, and the probability of subse-quent shocks was on the rise. By mid-February 2001, interest ratesclimbed back to the 70 percent range, and maturities of primary govern-ment debt shortened dramatically.39 Once again, the sustainability ofdomestic public debt became a major concern. The program could notwithstand the spark of political brawl between the prime minister andthe president during the meeting of the National Security Council onFebruary 22, and the financial markets were set ablaze. Again, centralbank reserves declined by $5 billion in one week, as massive flight fromthe Turkish lira occurred and overnight rates exceeded 5,000 percent.This time, the government was obliged to abandon the peg and float thecurrency, which depreciated by 40 percent the next day.

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Following the collapse of the currency, policy makers faced a classicdilemma confronted by many countries that have had to deal with exter-nal and banking crises simultaneously.40 It seemed that the collapse war-ranted a sufficiently large adjustment of the exchange rate, together withtightened monetary and fiscal policy, to facilitate expenditure switch-ing. Yet such policies would have weakened the banking sector furtherin the short term through their potential negative effect on companyearnings, and thus, the volume of nonperforming loans. An additionalproblem with tighter monetary policy, in the Turkish case, was theunsustainability of public-sector domestic debt. This had become an evenlarger problem after the public-sector banks were recapitalized, as it ledto a more than twenty percentage-point jump in the debt ratio followingthe February crisis.

As Kemal Dervis arrived from the World Bank to be the new Ministerof Economy, a new economic program was announced in May 2001.This program emphasized adhering to a floating exchange rate regime,establishing an independent central bank, fiscal discipline, and struc-tural change, particularly in banking reform. This included recapitaliz-ing public-sector banks and rationalizing them through an independentmanagement team with no ties to political parties. The initial resultswere not so good, however: Despite some 30 percent depreciation in thereal exchange rate early on, the adjustment seemed to be inadequate tocalm the markets by the end of the summer of 2001.41 Much of the pres-sure on the exchange rate stemmed from domestic money supply, ascurrency substitution gained pace. The central bank attempted to arrestthe situation by raising the overnight interest rate in August, only to cutit after three weeks as fears regarding debt rollover accelerated exchangerate depreciation. Throughout the summer of 2001, bond yields fluctu-ated in the 80 to 95 percent range.

In the aftermath of September 11, it seemed that the immediate chal-lenge facing policy makers was to lower interest rates to reasonable lev-els, while avoiding the risk of another deadly inflation–devaluation spiral.In this respect, with a new IMF package, the macro-environment im-proved considerably. According to the central bank’s trade-weighted realexchange rate index, the undervaluation in the currency peaked at around15 percent at the end of September 2001, and fears mounted in the mar-ket that a correction could occur mainly through higher inflation. Yettight monetary policy paid off, as the currency appreciated by approxi-mately 30 percent between October 2001 and March 2002. Almost half


of this real appreciation occurred through the appreciation of the lira innominal terms. Thus, another inflation–depreciation spiral was success-fully avoided. Policy makers had hoped that inflation would respondmore to slack and show less inertia in the future, and by early summer,there were strong indications that this was indeed happening. The cen-tral bank reduced overnight rates from 62 percent in September 2001 to47 percent in April 2002, during which 2002 year-end inflation expecta-tions declined from 49 percent to 35 percent. Furthermore, the high vola-tility in the nominal exchange rate throughout 2001 had declinedsignificantly by March 2002. Rather than suppressing volatility in theexchange rate through sale or purchase of reserves, the central bankpatiently awaited policies that eventually lowered volatility by buildingmarket confidence.

Concluding Remarks

This paper discusses the factors that seemed to play an important role inthe collapse of Turkey’s IMF-supported exchange rate–based stabiliza-tion plan in February 2001, just thirteen months after its commence-ment. It is often difficult to attribute such crises entirely to a single factor.Nor is it always possible to arrive at a strong verdict through analyzingeconomic developments in light of, or in the manner formally suggestedby, the alternative models used to examine currency crises in the litera-ture.42 This paper argues that in the Turkish case, enumerating the manydevelopments that may have contributed to the collapse is importantand useful. Indeed, the usual suspects seem to have played a role. Butthis should not obscure the critical role played by the failure to establishor achieve tangible progress toward a more sustainable fiscal regime.This appeared to be a fundamental and growing problem, and not recog-nizing this could easily lead observers to emphasize design flaws as themain culprit, or argue that the collapse could have been avoided if sev-eral other factors had broken more in Turkey’s favor.

While it seemed that the most integral part of the 2000–2003 stabili-zation program was the exchange rate peg and the planned smooth exitfrom it after eighteen months, progress toward a transparent and sus-tainable fiscal regime through a number of reforms and measures overthe three-year duration of the plan had utmost significance. Failure tocomplete fiscal reforms would have rendered the large up-front fiscalcontraction transitory, as it was reached primarily through collecting


one-off taxes. Despite the superior performance in the primary surplusof the central government, worries regarding fiscal performance for thefollowing year erupted as early as the start of the second half of 2000.Markets sensed that it could be difficult to maintain one-off taxes thefollowing year, and the lack of transparency in fiscal accounts of otherpublic entities shook confidence, as hiding fiscal deficits in these enti-ties had been a common practice over the past several years. Moreover,it became clear that public-sector savings from fiscal reforms in socialsecurity and agriculture, on which the government claimed to have madesignificant progress, seemed to be illusory. By the summer, there weregood reasons to believe that progress in one of the building blocks of theeconomic program had been less than satisfactory, and thus the pros-pects of maintaining a strong fiscal position beyond 2000 had dimin-ished. Achieving a lasting reduction in noninterest expenditure seemedvery unlikely, and the likelihood of finding fiscal skeletons in the closetemerged. The fiscal discipline of 2000 increasingly resembled low-quality and unsustainable fiscal overkill. Investors realized that the gov-ernment could not service its future obligations by introducing new taxesagain, or raising existing tax rates, as these avenues had already beenexhausted. Slow progress in institutional reforms raised worries as tohow primary surpluses could be maintained to ensure the sustainabilityof fiscal policy.

The weakness of the banking system certainly played a major role inthe crisis, once the markets tested the program. Yet it is unlikely that astronger banking system could have helped to avert the crisis altogetheronce things had gotten out of hand, as observed in the weeks precedingthe February 22 collapse. On the other hand, it was too optimistic toassume, as the authorities and the IMF seemed to have done, that thebanking system would never be subjected to a stress test throughout theimplementation of this stabilization plan. Adjusting to the rapid changein the macro-environment would be difficult for certain banks, as theyhad to terminate strategies they had followed for several years in thehigh-inflation environment and instead establish real banking relation-ships. With a number of weak banks in the system, this program had ahigh risk, which increased along the way as the authorities failed to takethe proposed measures to make the banking system less vulnerable. Thedelay in establishing the Banking Supervisory Board, and the negligencein implementing measures to capture rising off-balance sheet risks andinterest rate risk exposure, proved to be fatal mistakes.


Notes

1. The section on program implementation and results briefly discusses the rel-evance of alternative approaches used to explain currency crises—namely, first- andsecond-generation models—to the Turkish case.

2. See Kibritcioglu (2001) for a comprehensive literature survey on Turkishinflation.

3. Simple causality tests provide strong evidence of unidirectional causalityfrom capital inflows to growth, consumer spending, and bank credit.

4. Simple causality tests and vector autoregressive (VAR) analysis indicate uni-directional causality from inflation to base money growth. For details, see Akyurek(1999).

5. For example, a combination of 5 percent growth and a primary surplus of 5percent of GNP would stabilize the debt ratio, given an initial ratio of 30 percent andreal interest rates of 20 percent.

6. See Rodrik (1990) for details.7. New legislation allowed the government to finance up to only 15 percent of

budget appropriations through central bank credit, which was scheduled to be re-duced progressively to 3 percent by 1998.

8. Tax measures included a 10 percent surcharge on personal and corporateincome taxes, a net asset tax on businesses, including banks, and increases on realestate and motor vehicle taxes.

9. The shuttle trade—Russian traders traveling to Turkish cities to buy goods—had increased progressively, reaching nearly $6 billion, or 17 percent of total ex-ports, by 1998.

10. A caretaker government took office, as early elections were set to take placein April 1999.

11. A model linking average annual inflation to its past levels and the output gapadequately captures the trend and important turning points in annual inflation. Thissimple statistical exercise suggests that the output gap has a statistically significanteffect on the path of inflation. Still, the estimated coefficient is rather small in magni-tude. A five percentage point increase in the gap, implying a sharp downturn in eco-nomic activity, leads to a relatively moderate seven percent percentage point decline inannual inflation, which averaged 61 percent during the sample period of 1980–99.

12. The increase in the retirement age constituted the first step toward reformingthe pension system.

13. The sum of transfers from the central government budget to farmers andsocial security institutions had reached almost 6 percent of GDP in recent years.

14. The new scheme would start with a pilot program in 2000 and extend nation-wide in 2001. For 2000, the government also committed to limiting price increaseson certain supported products during the year, and to gradually phasing out the creditsubsidy extended to farmers by the State Agricultural Bank. The latter would beobligated to charge a 5 percent spread over the three-month Treasury bill rate onloans to farmers.

15. Performance criteria related to fiscal policy were based on the primary surplusof the consolidated public sector on a quarterly basis. The consolidated definitionincluded the central government, extra-budgetary funds, eight State Economic Enter-prises (SEEs), three social security institutions, and the unemployment insurance fund.


16. Weights of the U.S. dollar and the euro in the basket to which the lira wasaligned were 33 percent and 66 percent, respectively.

17. The price of private-sector manufacturing products corresponds to 52 percentof the overall WPI index.

18. A new series released by the central bank after the February 2001 collapse ofthe peg shows that the real exchange rate was 10 percent higher than its 1995 (baseyear) average at the start of the program in January 2000.

19. See note 16.20. See IMF Country Report on Turkey (October 2000, pp. 55–64; www.imf.org).21. An estimated 47 percent of expenditures on consumer durables was financed

through bank loans in the first half of 2000.22. In the first half of the year alone, the extra burden of higher oil prices was

around $1 billion, as the price of oil per barrel increased from $12 to $26.23. Moreover, imports of intermediate goods are mostly denominated in the U.S.

dollar, while exports to the euro zone are priced in euros.24. See Krugman (1979) for the analytical framework, and Agenor et al. (1992)

for a comprehensive literature review.25. Ter-Minassian and Schwartz (1997) provide broad generalizations of high-

quality fiscal measures and quick fixes. Simplifying the tax system in general, broad-ening the tax base, reducing high marginal tax rates, strengthening procedures formonitoring tax compliance, privatizing public enterprises, reforming the social se-curity systems, strengthening the system of intergovernmental fiscal relations, amongothers, are listed as quality fiscal measures that enhance credibility. On the otherhand, emergency tax measures, including temporary surcharges, suspensions of in-vestment projects underway, reliance on SEEs to place the fiscal deficit outside thegovernment’s budget, and decapitalization of public-sector banks are some of thequick-fix measures listed.

26. Moreover, the same authors emphasize the idea put forward by Suranyi andVincze (1998) that reducing the budget deficit by relying mainly on indirect taxesmay actually undermine the credibility of the disinflation process.

27. For a discussion of these measures, see IMF Letter of Intent (December 1999,pp. 11–12; www.imf.org).

28. The government fell behind the closure schedule of more than sixty budget-ary funds (as indicated in the IMF plan) throughout 2000. Before the collapse of theprogram, however, less than half of these were closed.

29. Tanzi (1990) argues that measuring the extent of the fiscal disequilibrium andselecting the appropriate high-quality fiscal measures are two of the most importantissues that the fiscal component of a stabilization program should address.

30. The authorities took over a total of six banks before the program began. Anadditional two were added to the list in September, at a time of heightened risks, dueto other factors mentioned above. Still more banks, including a couple of medium-sized institutions, whose viability had been questioned by the markets for sometime, remained in operation. For example, a blanket guarantee was offered to allcreditors.

31. Program targets set privatization revenues at $7.5 billion, of which approxi-mately half was realized during 2000.

32. Second-generation models, reviewed in Eichengreen et al. (1996), explainspeculative attacks in terms of the fundamentals identified in first-generation mod-


els, but the fundamentals are themselves sensitive to shifts in private expectationsabout the future.

33. Recognizing these duty losses, which amounted to more than 20 percent ofGDP, was an integral part of the economic program put in place in May 2001 afterthe February 2001 collapse.

34. Stanley Fischer argues that the difficulties in Turkey by the end of 2001related more to the failure to undertake corrective fiscal actions when the currentaccount widened, and to banking sector problems. He adds that IMF and Turkishofficials had agreed to corrective measures in both these areas. In my opinion, thesubsequent letter of intent (LOI) simply reiterated the government’s intention toimplement all of the fiscal measures that were part of the initial LOI at the start ofthe program, and had no positive effect on credibility and market expectations. Forfurther information, see IMF transcript (July 13, 2001; www.imf.org/external/np/tr/2001/tr010713a.htm).

35. Just before the stabilization program was launched, policy makers had low-ered the upper limit of banks’ short foreign exchange position to 20 percent of theirequity base. There was widespread evidence that these measures were not effec-tively implemented. By the summer of 2000, official figures reported the total shortposition of the banking sector at $2.5 billion; the actual number was several timeshigher.

36. The authors posit that the root cause of the 2000–2001 Turkish crisis was thefragility of the banking sector, created by a set of triggering factors. They arguefurther that the banking-sector problem in Turkey was basically a result of the mecha-nism chosen to finance high public-sector deficits (heavy reliance on bank interme-diation of government debt). The markets realized that this mechanism was not aboutto change any time soon because of the failure to implement quality fiscal measures,as the section on program implementation argues. Thus, the argument by Ozatayand Sak (2002) supports the conjecture that fiscal unsustainability was the mainculprit behind the collapse of the Turkish stabilization program.

37. According to Ozatay and Sak (2002), in Demirbank’s balance sheet, the ratioof government debt to total assets was about twice the size of that of other private-sector banks. The maturity mismatch seemed to be higher because Demirbank fundeda greater portion of its debt portfolio by overnight repos and overnight borrowingfrom other banks. Moreover, there was a sharp jump at the beginning of 2000 in thevolume of structured products for Demirbank, for which government debt was usedas collateral for short-term foreign borrowing.

38. As indicated in the above section on fundamental features of macroeconomicinstability, this had been a common strategy for banks over the past decade. Yetpegging the currency had carried the size of such risky positions to unprecedentedlevels, as argued by Ozatay and Sak (2002).

39. The average maturity of primary debt in January–February 2001 was ap-proximately 120 days, as opposed to over 400 days during 2000.

40. See, for example, Goldfajn and Baig (1998).41. By the end of August, cumulative inflation and depreciation since the Febru-

ary crisis reached 55 percent and 106 percent, respectively.42. For example, Garber (1996) indicates that first- and second-generation mod-

els are observationally equivalent if expectations of fundamentals change for “good”reasons not observed by the econometrician.


References

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Akyurek, Cem. 1999. “Post-Liberalization Inflation in Turkey: An Empirical Inves-tigation.” Yapi Kredi Economic Review 10, no. 2: 31–53.

Alper, Emre. 2001. “The Turkish Liquidity Crisis of 2001: What Went Wrong?”Russian and East European Finance and Trade 37, no. 6 (November–Decem-ber): 58–80.

Burnside, C.; M. Eichenbaum; and S. Rebelo. 1999. “Prospective Deficits and theAsian Currency Crisis.” National Bureau of Economic Research Working PaperNo. 6758, Cambridge, MA.

Burton, D., and S. Fischer. 1998. “Ending Moderate Inflations.” In Moderate Inflation:The Experience of Transition Economies, ed. C. Cottarelli and G. Szapary, pp. 15–97. Washington, DC: International Monetary Fund and National Bank of Hungary.

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Garber, P. 1996. “Discussion.” NBER Macroeconomics Annual 11: 403–406.Goldfajn, I., and T. Baig. 1998. “Monetary Policy in the Aftermath of Currency

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Kibritcioglu, A. 2001. “Causes of Inflation in Turkey: A Literature Survey withSpecial Reference to Theories of Inflation.” University of Illinois at Urbana–Champaign, Office of Research Working Paper No. 01–0115.

Kopits, G. 2000. “How Can Fiscal Policy Help Avert Currency Crises?” Interna-tional Monetary Fund Working Paper No. 185, Washington, DC.

Krugman, P. 1979. “A Model of Balance-of-Payments Crises.” Journal of Money,Credit, and Banking 11 (August): 311–325.

Ozatay, F., and G. Sak. 2002. “The 2000–2001 Financial Crisis in Turkey.” Discus-sion paper, Ankara (available at www.tcmb.gov.tr).

Rodrik, D. 1990. “Premature Liberalization, Incomplete Stabilization: The Ozal De-cade in Turkey.” Centre for Economic Policy Research Discussion Paper No.402, London.

Suranyi, G., and J. Vincze. 1998. “Inflation in Hungary, 1990–97.” In ModerateInflation: The Experience of Transition Economies, ed. C. Cottarelli and G.Szapary, pp. 150–171. Washington, DC: International Monetary Fund and Na-tional Bank of Hungary.

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