On The Structural Weaknesses Of The Post-1999

ABSTRACT

Turkey initiated an extensive dis-inflation program in December 1999 backed and supervised by The International Monetary Fund (IMF). The Program aimed at decreasing the inflation rate to a single digit by the end of 2002. It exclusively relied on a nominally pegged (anchored) exchange rate system for dis-inflation and on fiscal prudence. In November 2000, however, just after one year from its introduction, Turkey experienced a very severe financial crisis which deepened and continued to-date. In this paper we highlight the structural weakness of the exchange rate backed dis-inflation program as manifested in its liquidity creation mechanism in a small and fragile financial system such as Turkey. We document the fragility indicators of the Turkish banking system, and show that the disinflation program led to an increase of the vulnerability of the banking system throughout 2000/2001. Given the structural characteristics of the Turkish banking system, we argue that the orthodox policy of fully connecting the monetary expansion and liquidity requirements of the domestic economy exclusively to the speculative short term capital flows was clearly a design flaw, overseen by the IMF's technical expertise.

I. Introduction

Turkey initiated an extensive dis-inflation program in December 1999 backed and supervised by The International Monetary Fund (IMF). The Program aimed at decreasing the inflation rate to a single digit by the end of 2002. It exclusively relied on a nominally pegged (anchored) exchange rate system for dis-inflation which has been a major concern for the Turkish policy makers for over three decades. In November 2000, however, just after one year from its introduction, the country experienced a very severe financial crisis. More than US$ 6 billions of short term capital fled the country, creating a severe liquidity shortage and skyrocketing interest rates.

In Early December 2000, The government requested access to the Supplemental Reserve Facility of the IMF. The request was granted with US$7.5 billions of additional support in December 22, and the technical targets of the monetary program have been revised. Only then continued implementation of the program could have been secured as the markets seemed to have calmed down. However, shortly after this rearrangement with the IMF, the public disclosure of a political dispute between the Prime Minister and the President of the Republic on February 19, 2001 badly hit the uneasy markets. The Central Bank was forced to sell a large portion of its foreign reserves in an attempt to support the Lira as the short-term interest rates rocketed to above 5,000 percent. In what follows, the government could not endure the pressures of the markets any further, and declared the surrender of the pegged exchange rate system on February 22, thereby letting the exchange rates to free float.

Following the demise of the exchange rate based disinflation program, the newly appointed minister, Mr. Kemal Dervis (former Vice President of the World Bank), submitted a new letter of intent to the IMF. Finally in May 15, Mr. Dervis announced the invigoration of a new stabilization effort under the guidance of the “Transition to the Strong Economic Program”. As it was mentioned in its introduction, the new program would be the continuation of the previous disinflation program, and would be backed by a series of “structural reforms” aimed at strengthening the banking system and at transforming the “old ways of economic policy making”.

The September 11 terrorist attack undermined the implementation of the program, affecting investors’ perceptions adversely. The Turkish government requested, in turn, a new threeyear stand-by arrangement for offsetting the detrimental effects of the external shock. The Fund accepted the new letter of intent dated January 18, 2002 with a considerable amount of financial support.