International Journal of Emerging Markets

Emerald Article: Anatomy of a currency crisis: Turkey 2000-2001 Animesh Ghoshal

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To cite this document: Animesh Ghoshal, (2006),"Anatomy of a currency crisis: Turkey 2000-2001", International Journal of Emerging Markets, Vol. 1 Iss: 2 pp. 176 - 189 Permanent link to this document: http://dx.doi.org/10.1108/17468800610658334 Downloaded on: 02-04-2012 References: This document contains references to 25 other documents To copy this document: permissions@emeraldinsight.com This document has been downloaded 1649 times.

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CASE STUDY

Anatomy of a currency crisis: Turkey 2000-2001

Animesh Ghoshal
Department of Economics, DePaul University, Chicago, Illinois, USA
Abstract
Purpose To examine in depth one of the currency crises proliferating in emerging markets during the last decade. Design/methodology/approach Three generations of currency crisis models are used to identify vulnerabilities facing the Turkish economy in the period 1999-2000, leading up to the crisis. The IMF-backed stabilization program, which attempted to use an active crawling peg as an ination anchor, is reviewed critically. The specic events triggering the onset of the two crises in 2000 and 2001 are analyzed. Findings The crisis is seen to be a consequence of capital inows, real currency appreciation, increasing external vulnerability, and the rapid exit of capital. Research limitations/implications It is concluded that it is a mistake for emerging economies to liberalize the nancial system before implementing adequate supervisory measures, and to adopt a crawling peg which is not supported by scal reform. Originality/value The paper adds to the extensive examination of currency crises, and integrates macroeconomic and microeconomic approaches. The Turkish crisis can be viewed as a learning experience that policy makers in other developing nations could avoid by following the guidelines and conclusions given. Keywords Currency accounting, Emerging markets, Macroeconomics, Microeconomics, Turkey Paper type Case study

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International Journal of Emerging Markets Vol. 1 No. 2, 2006 pp. 176-189 q Emerald Group Publishing Limited 1746-8809 DOI 10.1108/17468800610658334

1. Introduction A number of currency crises have erupted in emerging markets in the last decade[1]. They have usually been accompanied by nancial crises and often followed by economic crises. The experience has triggered extensive examination of both the microeconomic and macroeconomic causes. Some studies have taken a global approach and tried to nd commonalities among the countries involved. While there were indeed some common features-all of them had a currency regime featuring some form of peg, formal or informal, all experienced massive outows of capital during the crisis, and all eventually abandoned the peg-the circumstances of the individual were very different. In this paper, we focus on the Turkish crisis of 2000-2001, in the context of three generations of currency crisis models, attempt to identify the specic vulnerabilities, and provide suggestions for preventing future crises. Section 2 of this paper provides some background information on Turkeys economic situation. Section 3 reviews briey the major models of currency crises.
An earlier version of this paper was presented at the annual meeting of the Academy of International Business in July 2004. The author would like to thank Mark Sessoms and Kendra Hudson for excellent research and computational assistance.

Section 4 shows the increasing vulnerability of the Turkish nancial system in 1999-2000. Section 5 discusses the onset and aftermath of the two crises in November 2000 and February 2001, and Section 6 attempts to draw some general conclusions regarding stabilization programs applicable beyond Turkey. 2. Turkeys efforts to attain macroeconomic stability Like many developing countries, Turkey has undertaken various programs, often as part of IMF loan packages, to bring about macroeconomic stability. These programs included trade liberalization, nancial liberalization, and reducing capital account restrictions, and while there was much progress in these areas, success in reducing persistently high ination was much more limited. In spite of a number of economic stabilization plans, ination averaged around 40 percent a year in the early 1980s, 60 percent in the late 1980s, and 80 percent in the 1990s[2]. Turkey experienced a severe economic crisis in 1994, when the lira fell from TRL15,000 per dollar to TRL35,000 per dollar between January and April. An IMF-supported stabilization program was agreed on, but abandoned the following year, and there was little serious effort to bring about macroeconomic stabilization until July 1998, by which time the lira had fallen to TRL266,000 per dollar. This disination program appeared to work for a while, and the currency was relatively stable for about three months, but the severe earthquakes of October (and contagion from the Russian crisis) weakened it considerably. The government resumed its stabilization program in 1999, by which time the exchange rate was TRL500,000 per dollar, once again with some apparent success, until the onset of a nancial crisis in November 2000, followed by a second crisis three months later. Table I shows Turkeys basic macroeconomic data. Figure 1 shows the chronic ination and currency depreciation during the period 1994-1998. In late 1999, Turkeys economic situation appeared better than it had for quite some time. In November, it was given a positive outlook by Moodys. In December the IMF and Turkey signed a letter of intent regarding stabilization and disination, and the European Union announced that Turkey was to be considered for membership at a future enlargement. Finally, the foreign exchange regime was changed to provide more stability and increase investor condence. As part of the stabilization program, it was agreed to use the exchange rate as an ination anchor, as had been done successfully in Argentina in 1991 and Brazil in 1994. Specically, the Central Bank of Turkey would adopt an active crawling peg (with regular pre-announced devaluations) for 18 months, followed by a gradually widening band until full exibility was reached in 2003. The objective of ultimate exibility was to avoid the straightjacket of a xed exchange rate regime which had already caused severe problems in Argentina. Within the constraints of the crawling peg, the central bank was to act like a quasi currency board, and refrain from operations to adjust the liquidity of the nancial system. Unfortunately, the economic circumstances of Turkey, combined with specications of the IMF agreement, led to a capital account crisis, as in so many other countries with soft pegs or what Corden (2002) has very appropriately called xed-but-adjustable regimes. 3. Models of currency crisis Under the Bretton Woods system, there were a large number of currency crises, but little in the way of rigorous models to explain them[3]. The system was one of

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178

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1994 23.9

1995 24.1

1996 28.4

1997 28.5

1998 28.4

1999 213.0

2000 211.4

2001 219.2

Table I. Macroeconomic data for Turkey, 1994-2001

Current account Millions As percentage of US$ of GDP Consumer price index (1995 100) Annual Quarterly Exchange rate (lira/US$) Ination rate (percent change in CPI) 21,133 1,408 2,014 342 428 2443 26 22,349 2429 21,430 470 21,048 21,260 21,057 944 21,306 21,069 2227 1,440 1,840 1,276 21,379 128 21,385 22,269 23,264 21,360 22,926 2473 1,255 1,976 638 23.50 5.41 5.19 0.97 1.28 21.09 0.05 25.25 21.27 23.72 0.83 22.19 23.61 22.53 1.60 22.68 22.87 20.53 2.31 3.61 3.66 23.35 0.22 22.96 26.09 27.29 22.21 25.39 21.48 3.86 4.73 1.79 36 51 56 69 81 93 104 122 145 169 187 220 256 300 352 432 511 575 641 747 840 941 1,057 1,241 1,417 1,522 1,613 1,766 1,923 2,317 2,559 2,957 70.36 113.80 109.52 120.64 125.00 82.35 85.71 76.81 79.01 81.72 79.81 80.33 76.55 77.51 88.24 96.36 99.61 91.67 82.10 72.92 64.38 63.65 64.90 66.13 68.69 61.74 52.60 42.30 35.71 52.23 58.65 67.44 15.41 41.67 9.80 23.21 17.39 14.81 11.83 17.31 18.85 16.55 10.65 17.65 16.36 17.19 17.33 22.73 18.29 12.52 11.48 16.54 12.45 12.02 12.33 17.41 14.18 7.41 5.98 9.49 8.89 20.49 10.44 15.55 19,251 33,105 32,396 36,370 41,158 43,029 46,533 53,258 64,713 76,768 85,986 99,541 119,224 138,344 163,155 189,494 224,915 254,258 273,714 295,086 343,931 397,114 440,646 499,142 563,392 609,417 645,821 679,721 785,030 1,193,877 1,412,496 1,560,306

Budget decit/surplus Trillions As percentage of lira of GDP

2150.84

2316.62

21,238.13

2244.09

24,387.04

210,075.8

214,263

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

234,963

350000 Exchange Rate (Lira/US$) 300000 250000 200000 150000 100000 50000 0 Jan-94 Oct-94 Jul-95 Apr-96 Jan-97 Oct-97 Jul-98 Exchange Rate (Lira/US$) Consumer Price Index

1000 900 800 700 600 500 400 300 200 100 0

Anatomy of a currency crisis

Consumer Price Index

179
Figure 1. Turkey ination and exchange rate January 1994-December 1998

xed-but-adjustable rates, with the exchange rate determined by policy and maintained by the central bank buying and selling foreign exchange reserves at this rate. The rate could be changed, in response to either a sharp actual or impending fall in reserves, or a change in ofcial perceptions of fundamentals, but changes were not eagerly embraced, and in most cases put off until the onset of a crisis. The rst comprehensive modern analysis of currency crises under an adjustable peg regime was not published until the Bretton Woods system had broken down, and most developed countries adopted some form of oating rates. However, many developing countries still followed that regime, and the analysis by Krugman (1979) is particularly applicable to such countries. Krugmans rst generation model combines the theory of exhaustible resources (with foreign exchange reserves as the exhaustible resource) with scal decits being nanced by central bank credit. The result is a growth in the money supply and ination. With the nominal exchange rate pegged, the real exchange rate appreciates[4], leading to a current account decit. To maintain the peg, the central bank sells foreign exchange reserves, which gradually decline. Once the market becomes aware of this decline, there is sudden speculative attack as investors, who have a choice of holding assets in domestic or foreign money, anticipate an abandonment of the xed exchange rate and try to avert a capital loss by converting domestic money into foreign money[5]. The central banks reserves are thus depleted, before they would have been in the absence of speculation (Krugman, 1979, p. 319). The government may be able to draw on secondary reserves, such as a loan from the IMF, and reafrm its commitment to the xed exchange rate. This can restore investor condence, with a corresponding reversal in the capital outow. But the reprieve will be only temporary, unless the scal decit is reduced. If it is not, expectations of monetization would again bring about apprehensions of devaluation, and as investor condence wanes, there will be another crisis. There may be series of such crises before the xed rate is abandoned. A second generation model can be attributed to Obstfeld (1994, 1995). Once again, the crisis is driven by market expectations of a devaluation, but here the critical factor is not the adequacy of foreign exchange reserves, but a decision by the government that the cost of maintaining the peg is too high. Developed countries, in particular, have several options which can be used to defend the peg, such as borrowing in world capital markets, increasing domestic interest rates, or pursuing contractionary scal

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policy. All of these options, however, have an economic and social cost, specially in times of high unemployment. Alternatively, the government may seek a realignment of the exchange rate to offset shocks to competitiveness and employment. In either case, a perception that the government might abandon the peg will cause a speculative attack on the currency. A nal set of models, often referred to as third generation, was developed in a number of papers by Chang and Velasco (2000a, b, 2001). Focusing on emerging markets, Chang and Velasco posit that currency crises are based primarily on international illiquidity. If (potential) short-term obligations of the domestic banking system exceed assets denominated in hard currency, holders of these obligations may lose condence and attempt to liquidate them, leading to a sudden outow of international capital. As in the classic article on bank runs (Diamond and Dybvig, 1983), the problem arises because of a mismatch between assets and liabilities; in this case, the maturity mismatch inherent in the role of banks in capital markets is augmented by the role of foreign creditors, and a run will occur if these creditors, fearful of inadequate liquidity, refuse to roll over debt. Larger capital inows increase the vulnerability of the domestic banking system to runs if these inows are primarily short term rather than long term. 4. Vulnerability of nancial system As mentioned in the introduction, Turkeys economic outlook seemed bright in late 1999. After ten governments in ten years, a three party coalition offered the prospect of a stable government, and the upgrade by Moodys, the prospect of eventual acceptance into the European Union, and the IMF program bolstered investor optimism. The ISE stockmarket index rose from 5,000 to almost 20,000 in the second half of the year. As will be seen, the large capital inows caused by this optimism increased the vulnerability of the banking system. A major plank of the stabilization program was the use of the exchange rate as an anchor to rein in inationary expectations; this was to be accompanied by attempts to check the scal decit, which had risen from 8.4 percent of GDP to what appeared to be an unsustainable 13 percent in 1999. The central bank would announce the daily exchange rate for 18 months, with the lira depreciating slowly according to a set schedule. The logic of this kind of active crawling peg is that a country nancing large scal decits by monetary expansion faces price and wage increases which get built into expectations (as in Krugmans model), and the ination may continue because of further decits or because of the inationary expectations. One way to break the inationary cycle is to peg the exchange rate to a currency with a history of low ination. A crawling peg is particularly appropriate for countries which start with much higher ination than the currencies they are being pegged to. The pre-announced rate of depreciation declines steadily. If successful, there is a steady decline in price and wage ination, following the exchange rate. However, success requires both credibility that monetary expansion will be controlled, and discipline in scal policy. The agreement to emulate a currency board and limit discretionary monetary policy was viewed as providing such credibility and discipline[6]. In the case of Turkey, the pre-announced exchange rate appeared to reduce exchange rate risk on Turkish securities to zero, making both government securities and bank debt more appealing to foreigners, and there was a surge in short-term

capital inow (Alper, 2001). As the central bank did not engage in any sterilization efforts, money market liquidity increased and interest rates fell. Among other things, this eased the debt burden of the government, and caused the default risk to decrease, encouraging even more capital inows. At the same time, the disination program seemed to going well, with monthly ination down to 2-3 percent in mid 2000 from the 6 percent rate of December 1999. Figure 2 shows the apparent success of the stabilization program in the period 1999-2000. Domestic banks, too, found government securities very attractive, and nanced these purchases through short-term borrowings (Euromoney, 2001). As Gopinath (2001) put it, the banks were:
. . . gambling on the success of the countrys disination program, borrowing short in both local and international markets and investing long in Turkish government securities, setting up currency and maturity mismatches[7].

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181

The overall effect of investor optimism was surging capital inows, increased foreign credit to the government and to the banking system, increased foreign currency liabilities, and increased risk exposure due to maturity and currency mismatches in the balance sheet of domestic banks. Moreover, by the third quarter of 2000, the total short-term external debt was approximately equal to the total foreign exchange reserves of the central bank (Table II). As postulated by Chang and Velasco (2000a), international illiquidity arises when the potential short-term hard currency obligations of a nancial system (exceed) the liquidation value of its assets. Beim and Calomiris (2001) have a similar observation: at the national level, liquidity implies the existence of sufcient reserves of foreign exchange at the central bank and
1400000 Exchange Rate (Lira/US$) 1200000 1000000 800000 600000 400000 200000 0
Jan-99 May-99Sep-99 Jan-00 May-00Sep-00 Jan-01 May-01 4000 3000 2500 2000 1500 1000 500 0 Consumer Price Index

Exchange Rate (Lira/US$) Consumer Price Index

3500

Figure 2. Turkey ination and exchange rate January 1999-June 2001

Period 2000 2000 2000 2000 2001 2001 Q1 Q2 Q3 Q4 Q1 Q2

Total debt 39.2 42.3 43.5 47.3 43.6 38.3

Debt/GDP 1.05 0.94 0.71 0.87 1.36 1.18

Short-term debt 23.2 25.2 26.7 29.3 27.4 22.3

Short-term debt/GDP 0.62 0.56 0.43 0.54 0.86 0.69

Foreign exchange reserves 22.9 24.5 24.5 25.1 18.8 16.4

Short-term debt/FX reserves 1.01 1.03 1.09 1.17 1.46 1.36 Table II. Short-term international debt and foreign exchange reserves (billions of dollars)

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aggregate foreign exchange earnings relative to the foreign exchange payment requirements and the government . . . wants to avoid any suggestion that the country as a whole cannot meet its foreign exchange obligations as they fall due. Given the maturity mismatch and the fact that central bank reserves did not meet the Beim and Calomiris criterion, Turkey had become vulnerable to what Chang and Velasco would call a run equilibrium. 5. The two crises The onset of the initial crisis of November 2000 can be attributed to three separate factors a rising current account decit, a loss of credibility regarding government policies, and a criminal probe into ten failed banks. The crawling peg had slowed down the depreciation of the lira (Figure 2), but ination, while reduced, remained higher than the rate of depreciation. The consequent real appreciation of the lira, together with the sharp reduction in interest rates referred to earlier (which increased overall domestic expenditure), led to a sharp jump in imports. The weakening of the current account caused investors to doubt that:
. . . foreign capital inows would be sufcient to fund both spendthrift consumers and the perennially penurious government (The Economist, 2001b).

182

At the same time, the government appeared to slow down in its economic reforms. Owing to internal opposition to privatization plans for a number of state owned enterprises, these were put on hold. At the same time, proposed regulatory reforms of the banking sector were postponed. These delays increased the suspicion in the market that the program was about to end (Ertrugul and Selcuk, 2001). The case of the failed banks obviously did not strengthen condence (The Economist, 2001a). As Corden has emphasized, one of the keys to a successful stabilization program is credibility that the government will follow through on its commitments. In the case of Turkey, which had liberalized its capital account[8], credibility entailed attracting and maintaining foreign capital inows. Given Turkeys history of ination and currency depreciation and numerous failed stabilization attempts, it was to be expected that a perception of lack of commitment would cause investors to lose condence. As indicated in the third generation models, foreign creditors began to shut down lines of credit to domestic banks, and interest rates began to increase. Banks which had acquired huge holdings of government securities now found themselves at risk of signicant capital loss. Demirbank, in need of liquidity, began a massive sale of government bonds on November 20 (Alper). Since Demirbank was a major holder, other participants in the government bond market dumped their holdings too.
A combination of portfolio losses and liquidity problems in a few banks . . . sparked a loss of condence in the entire banking system (Bibbee, 2001).

Banks whose foreign credit lines were still intact soon found it difcult to obtain liquidity in the market, since higher interest rates reduced the value of their security holdings and hence the value of the collateral they could offer foreign lenders. Faced with this liquidity crisis, at this point the central bank reversed its policy of refraining from injecting reserves into the nancial system, and made heavy purchases of government securities. As might have been expected, this further damaged the credibility of the stabilization program. The additional liras were quickly converted to

foreign currency, and during the month of November the central bank lost $6 billion in foreign exchange reserves (Keyder, 2001). The capital outow ended only when the government negotiated an emergency loan of $7.5 billion from the IMF on December 6, to be used only to fend off speculative attacks. Table III illustrates the weekly changes in central bank reserves during the period November 3-January 12. As postulated by Chang and Velasco, foreign creditors, noting the vulnerability as shown in Table II, withdrew capital rapidly. The capital outow is also consistent with Krugmans model where a speculative attack is prompted by investors realizing that a countrys reserves are declining. Krugman also held that governments commitment to defend the currency, if re-established, would be met with returned inows of capital. In the light of Turkeys experience, it is worth quoting him at some length:
It sometimes happens, however, that a government is able to weather the crisis by (negotiating) an emergency loan. At this point there is a dramatic reversal the capital that has just owed out returns, and the governments reserves recover. The reprieve may only be temporary, though. Another crisis may occur, which will oblige the government to call on still further reserves. There will be a whole sequence of temporary speculative attacks and recoveries of condence before the attempt to maintain the exchange rate is nally abandoned (Krugman, 1979, p. 312).

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Turkey did experience fears of an unsustainable currency peg, particularly when the central bank conducted open market operations to inject liquidity. Reserves owed out rapidly in the last two weeks of November, and the process was reversed when the government obtained an emergency loan from the IMF (Table III). The reversals impact on the exchange rate is seen in Figure 3, with the lira recovering from TRL690,000 to TRL670,000 per dollar during the month of December. The government reafrmed its commitment to the stabilization and disination program, and to its bank reform and privatization efforts. But, as Bibbee indicates,
Date November 3, 2000 November 10, 2000 November 17, 2000 November 24, 2000 December 1, 2000 December 8, 2000 December 15, 2000 December 22, 2000 December 29, 2000 January 5, 2001 January 12, 2001 January 19, 2001 January 26, 2001 February 2, 2001 February 9, 2001 February 16, 2001 February 23, 2001 March 2, 2001 Level of reserves 24,256 23,583 24,433 21,583 18,942 19,624 19,823 19,934 19,635 25,097 26,593 26,143 25,693 25,928 26,565 27,943 22,581 21,521 Difference (673) 850 (2,850) (2,641) 682 199 111 (299) 5,462 1,496 (450) (452) 237 637 1,375 (5,362) (1,060)

Table III. Gross foreign exchange reserves of central bank, November 2000-January 2001 (billions of dollars)

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investor condence was still weak and the countrys increased risk premium was reected in the demand for higher interest rates. The banking system remained weak, and vulnerable to a second shock. This was not long in coming. A fresh panic occurred in mid February 2001,with the collapse of Ilhas Finans, a nance house[9] charged with mismanagement and abuse of depositors funds, and the stock market index fell to below 10,000, its lowest level of the year. This was made much worse when on February 19 a political feud erupted very publicly between the prime minister and the president[10]. The future of the ruling coalition was now in doubt, and so was the future of the stabilization program. Jittery investors pulled $5 billion out of Turkey (Table III), and the stock market fell by 18 percent on February 19 alone (The Economist, 2001b). This time, the central bank refrained from injecting liquidity, and interest rates soared. The rate on one-month treasury bills jumped to 144 percent on February 20, while the overnight interest rate climbed to more than 4,000 percent as banks desperately sought liquidity (Table IV). At these rates the currency peg became too painful to maintain, as suggested in the Obstfeld model, and on February 28 the lira was oated[11]. The exchange rate plunged from TRL700,000 per dollar to TRL1,000,000 per dollar immediately. 6. Lessons and policy implications The aftermath of the two crises was severe. As shown in Figure 2, the currency continued to sink and ination resumed its upward march, as the economy had to

Exchange Rate (Lira/US$)

695000 690000 685000 680000 675000 670000 665000

01-Nov-00 11-Nov-00 21-Nov-00 01-Dec-00 11-Dec-00 21-Dec-00 31-Dec-00

Figure 3. Turkey exchange rate (lira/US$) November 1-December 31, 2000

Date February February February February February February February February February March 1 March 2 16 19 20 21 22 23 26 27 28

Average overnight interest rates (percent) 40.3 43.7 2,057.7 4,018.6 1,195.3 568.0 102.1 100.2 100.1 96.6 86.1

Table IV. Overnight interest rates, February-March 2001

adjust to a oating lira after a period of pre-announced exchange rates under the crawling peg. Perhaps the most painful feature was the effect of the high interest rates accompanying the nancial collapse on the real economy, which contracted drastically with the GDP falling by 10.4 percent in the year 2001. As in many emerging markets, the nancial and currency crisis led to an economic crisis. In May 2001, Turkey entered into another agreement with the IMF, which provided $14.3 billion to assist with recovery and a new stabilization program. While the nancial and currency markets did indeed stabilize toward the end of 2001, employment and economic activity remain(ed) depressed (Akyuz and Boratav, 2002). To understand what went wrong in Turkey, and to draw lessons for other developing countries, we can start by looking at the question of pegged vs exible exchange rates, and then the narrower issue of exchange rate based stabilization. Developing countries are generally more seriously affected by exchange rate volatility, since there is a greater pass-through of exchange rate changes, and consequently a greater threat to price stability (Ho and McCauley, 2003)[12]. Moreover, underdeveloped nancial systems are particularly vulnerable to exchange rate uctuations. If the currency depreciates, local rms and banks with debt denominated in foreign currency face a large increase in their liabilities, and can default. Thus, to reduce such volatility, some exchange rate stabilization may be called for, specially if the central bank engages in sterilized intervention to prevent changes in foreign exchange reserves from destabilizing the domestic money supply. However, the non-sterilization aspect of Turkeys agreement with the IMF did not permit this. Turning to exchange rate based stabilization, a stable exchange rate may be an effective ination anchor, at least for a while. An active crawling peg with pre-announced devaluations plays the same role, providing monetary discipline and credibility, and can bring down ination (as in Brazil and Mexico in the early 1990s). It was not very effective in Turkey because the public nances remained in disarray, the crawling peg was not supported by scal reform, and failure to meet ination targets strengthened expectations of devaluation beyond the targeted amount. As Corden has shown, a timely exit from a crawling peg is necessary to avoid a crisis, specially in a high speculation environment. As mentioned earlier, Turkey had an exit plan, with full exibility set for 2003, but the nancial market was not convinced that necessary scal reforms would take place in this time frame, and forced an early abandonment of the plan. Moreover, the banking system remained weak and heavily dependent on holdings of Treasury bills, often nanced with foreign borrowing. It now seems clear that it was a mistake to liberalize the nancial system before strengthening the banking sector and subjecting it to adequate supervisory measures, which could have better monitored excessive foreign exchange and interest rate risk. In this respect, the situation in Turkey was similar to that of Thailand, Indonesia, Malaysia, and South Korea, which, despite having much better economic fundamentals, suffered from a wave of capital outows in 1997 partly due to premature opening of the capital account, as well documented in Bhagwati (2001) and Desai (2003). The problem was compounded by the central banks policy of not serving as a lender of last resort in the initial phases of both crises, leaving the liquidity of the nancial system highly dependent on international capital ows. When the central bank reversed itself, it lost credibility,

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and the additional liquidity was quickly transformed into demand for foreign currency, causing a run on its external reserves. Some general conclusions to be drawn from the Turkish debacle of 2001-2002 are that soft exchange rate pegs are undesirable for developing countries, and premature capital account convertibility compounds the risks. A speculative attack on the peg will cause the government (or central bank) to lose funds in an unsuccessful attempt to defend the exchange rate; a spike in interest rates will devastate private sector borrowers and the government if it has a large debt; unhedged borrowers in foreign currency will incur substantial losses with a sharp devaluation; and perhaps most important, the credibility of economic policy makers is lost. Finally, if citizens and foreign investors can expect good scal and monetary policy and strong nancial institutions, the choice of exchange rate regime is less important (Calvo and Mishkin, 2003). However, while there will undoubtedly be IMF supported stabilization plans in the future, the Turkish experience suggests that it may be the last one based on the exchange rate as an anchor.

Notes 1. Major crises have occurred in Mexico (1994-1995), East Asia (1997), Russia (1998), Brazil (1999), and Argentina (2001-2002). 2. As of May 2005, Turkeys ination rate continues to be high; at 8.2 percent, it was among the highest in the major emerging markets listed in The Economist. 3. Explanations typically took the form of mutterings about the gnomes of Zurich attacking a particular currency. 4. The real exchange rate R is dened as (P/(P *)e), where P is the domestic price level, P * is the price level in the trading partner, and e is the nominal exchange rate expressed as the price of domestic currency in units of foreign currency. A nominal appreciation of the domestic currency, denoted by an increase in e, makes a countrys products less competitive than those of its trading partners. A real appreciation, denoted by an increase in R, has the same effect. 5. This is similar to buffer stocks of a commodity held for price stabilization being depleted by speculation. 6. Keynes (1923) considered strapping down Ministers of Finance the strongest argument for pegged exchange rates. 7. Demirbank, a major commercial bank ultimately taken over by the Savings Deposit Insurance Fund, acquired $7.5 billion of government securities, nearly 15 percent of the total domestic debt. This huge portfolio was nanced through short-term borrowing from the money market (Ertugul and Selcuk, p. 25). 8. As of August 1989, foreign investors were permitted to freely trade domestically listed securities, and the rst ADR was introduced in July 1990 (Bekaert et al., 2003). 9. Finance houses were established in 1983 to cater to those who disapproved of the role of interest in the banking system. These agencies were not covered by deposit insurance. 10. The dispute had little to do with economic policy. According to The Economist (2001b), President Sezer chided Prime Minister Ecevit for not pursuing corrupt politicians vigorously enough, leading the latter to storm out of the meeting. 11. A formal analysis, using the IS-LM-BOP framework, is shown in the Appendix.

12. Ho and McCauley found that in Indonesia 48 percent of annual changes in the consumer price index was accounted for by exchange rate uctuations, in contrast to 2 percent for the USA. References Akyuz, Y. and Boratav, K. (2002), The making of the Turkish nancial crisis, UNCTAD discussion paper, April. Alper, C.E. (2001), The Turkish liquidity crisis of 2000: what went wrong, Russian and East European Finance and Trade, Vol. 37 No. 6. Beim, D.O. and Calomiris, C.W. (2001), Emerging Financial Markets, McGraw-Hill, New York, NY. Bekaert, G., Harvey, C.R. and Lundblad, C.T. (2003), Equity market liberalization in emerging markets, Federal Reserve Bank of St Louis Review, Vol. 85 No. 4. Bhagwati, J. (2001), The Wind of the Thousand Days: How Washington. Mismanaged Globalization, MIT Press, Cambridge, MA. Bibbee, A. (2001), Turkeys crisis, The OECD Observer, Vol. 225. Calvo, G. and Mishkin, F. (2003), The mirage of exchange rate regimes for emerging market economies, NBER Working Paper No. 9808, June. Chang, R. and Velasco, A. (2000a), Exchange rate policy for developing countries, American Economic Review, Vol. 90 No. 2. Chang, R. and Velasco, A. (2000b), Banks, debt maturity and nancial crises, Journal of International Economics, Vol. 51. Chang, R. and Velasco, A. (2001), A model of nancial crises in emerging markets, The Quarterly Journal of Economics, May. Corden, W.M. (2002), Too Sensational: On the Choice of Exchange Rate Regimes, MIT Press, Cambridge, MA. Desai, P. (2003), Financial Crisis, Contagion and Containment, Princeton University Press, Princeton, NJ. Diamond, D.W. and Dybvig, P.H. (1983), Bank runs, deposit insurance, and liquidity, Journal of Political Economy, Vol. 91. Ertrugul, A. and Selcuk, F. (2001), A brief account of the Turkish economy, 1980-2000, Russian and East European Finance and Trade, Vol. 37 No. 6. Euromoney (2001), The Turkish economy, Euromoney, August. Gopinath, D. (2001), Turkeys troubles, Institutional Investor, Vol. 35 No. 1. Ho, C. and McCauley, R. (2003), Living with exible exchange rates: issues and recent experience in ination targeting emerging market economies, Working Paper No. 130, Bank for International Settlements, February. Keyder, N. (2001), The aftermath of exchange-rate based program and the November 2000 nancial crisis in Turkey, Russian and East European Finance and Trade, Vol. 37 No. 5. Keynes, J.M. (1923), A Tract on Monetary Reform, MacMillan, Basingstoke. Krugman, P. (1979), A model of balance-of payments crises, Journal of Money, Credit and Banking, Vol. 11 No. 3, pp. 311-25. Obstfeld, M. (1994), The logic of currency crises, Working Paper No. 4640, NBER, February. Obstfeld, M. (1995), Models of currency crises with self-fullling features, Working Paper No. 5825, NBER, October.

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The Economist (2001a), Full of interest, The Economist, 17 February, p. 77. The Economist (2001b), Turkeys future: on the brink again, The Economist, 24 February. Further reading Raghavan, C. (2002), A made-in-IMF origin mark on crisis in Turkey?, Third World Network, 16-31 May. Appendix The situation facing Turkey can be analyzed formally with a standard IS-LM-BOP model, with high but imperfect capital mobility, i.e. a shallow BOP curve. The initial condition is one of a current account decit balanced by autonomous capital inows, leading to an equilibrium in the balance of payments. This is shown at point A in Figures A1 and A2, with the BOP curve passing through the intersection of the IS and LM curves, depicting internal as well as external equilibrium. A disturbance occurs when the BOP line shifts up, creating a decit at the initial equilibrium point A. The shift can be due to two sets of reasons. There can be an increase in the current account decit, which, in the case of Turkey, is attributable to the real exchange rate appreciation. There can also be a decrease in the capital account surplus, due to a change in expectations. The increasing current account decit, the postponement of promised economic reforms and the political crisis would lead to a weakening of credibility and reduce capital inows. In either case, a given level of income requires a higher interest rate for the balance of payments to be in equilibrium;, i.e. the BOP shifts up to BOP0 . To restore external equilibrium, there must be a reduction in the current account decit, an increase in the capital account surplus, or some combination of the two. With exible exchange rates (Figure A1), the adjustment takes place through currency depreciation. The IS curve shifts out to IS0 , as expenditure in the domestic economy increases, and the BOP curve shifts down to BOP00 , as net exports increase, leading to a new equilibrium at C. With pegged rates (Figure A2), the adjustment takes place through the central bank selling foreign exchange. As the money supply is reduced, the LM curve shifts up to LM0 , until external equilibrium is attained at B. However, the loss in reserves may cause the market to anticipate a devaluation, shifting the BOP curve further up. A continuing contractionary monetary policy may be seen as too painful, particularly in the context of a weak banking system and/or high unemployment. In that case, the peg will be abandoned.

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i LM BOP BOP BOP C A IS

B +

Figure A1. Decit in exible exchange rate regime

IS 0 Y

i LM LM BOP

Anatomy of a currency crisis

B + A

BOP

189

IS 0 Y

Figure A2. Decit in pegged exchange rate regime

Corresponding author Animesh Ghoshal can be contacted at: aghoshal@depaul.edu

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