A Brief Commentary on the Economic Turmoil of November 2000
***
Turkey entered 2000 with the most ambitious anti-inflationary program in its history. The prevailing mood among businessmen, economists, politicians and especially the man on the street turned more optimistic than ever. For the first time in thirty years, the nation as a whole started to believe that low inflation, healthy economic growth and wider integration with the world economy was achievable in the medium term, even in the short term.
However, the benign picture observed through the first half of 2000 started deteriorating in the second half. The slowdown of the reform pace of the government led to a decline in confidence first among international investors and then among local investors. This decline culminated in an intense liquidity crunch at the end of November.
In order to analyze the November turmoil in detail, it is necessary to review the IMF-backed economic programme and its implementation. The programme had five main aspects: exchange rate regime, fiscal adjustment, monetary policy, structural reform and confidence building measures.
The backbone of the programme was a quasi-fixed exchange rate regime, whereby the rate of depreciation of the Turkish Lira against a 1 U.S. dollar plus 0.77 Euro basket was fixed at declining rates. The Central Bank committed to defend the Turkish Lira against upward or downward movements.
On the fiscal side, in line with all stabilization and anti-inflation programmes ever implemented in the world, the central theme was a significant improvement in the government budget surplus (before interest). This was accomplished through rigorous measures both on the revenue side and the expense side. The additional taxes imposed to finance the recovery after the August 1999 earthquake were continued throughout 2000, and expense management was vigorous with reduced public investments and forward-looking wage adjustments for public sector employees.
The monetary side of the anti-inflationary program in Turkey was based on the Central Bank keeping its Net Domestic Assets (“NDA”) within a very narrow band. Because of this, the money supply fluctuated in parallel to the Net Foreign Assets of the Central Bank. As foreign capital, of long term or short term variety entered the country, the money supply was increased accordingly. Tying monetary supply to foreign capital inflows was a compromise, preventing the increase of the money supply due to the financing of government deficits while refraining from neutralizing the money supply affect of capital inflows. The designers of the programme attempted to allow interest rates to fall in parallel to capital inflows in order to boost the growth rate, allowing a moderate recovery after the steep slowdown in 1999.
On the structural reform front, privatization was accelerated. Projects that had been on the agenda for many years, such as the downstream oil sector, Türk Telekom, Turkish Airlines and the electricity sector were revisited. In addition to privatization, new regulatory frameworks were put in place in the banking, telecoms and energy sectors. Finally, a comprehensive social security reform package aimed at addressing the imbalances created in the early 1990s was designed.
To complement the monetary, fiscal and structural pillars of the programme, confidence building measures were taken both domestically and internationally. On the domestic front, leaders of the coalition parties repeatedly gave strong support to the programme. On the international front, IMF actively took part in the preparation of the programme and publicly supported it. Five weak banks were taken over by Savings Deposits Insurance Fund (“SDIF”) at the beginning of 2000 to indicate the government’s willingness to tackle the difficult problems.
In the first half of 2000, the rapid pace of reform boosted confidence in the international market, leading to net short term inflows. Under the fixed-NDA driven Central Bank policy, these flows pushed short term interest rates from over 80% to 30% as early as January. The fall in short term rates gradually affected the government bond market, in which 6 to 12 month interest rates fell in full correlation with short term rates from over 100% to just under 40%.
Due to the low interest rate environment in early 2000, the rate of GDP growth was quite high, at 5.5% and 6.0% (annualized) in the first two quarters. This acceleration of growth, fueled by a significant increase in aggregate demand, put an upward pressure on the trade deficit on one hand, and delayed the fall of inflation on the other. As inflation fell more slowly than anticipated in the programme, Turkish Lira started to become overvalued, as the rate of depreciation was constant. The overvaluation of the Turkish Lira put further upward pressure on the trade deficit. By the end of the third quarter, the trade deficit was around 5% of GDP and consumer and wholesale price inflation had overshot the depreciation of the Lira by 16% and 10% respectively.
As the Turkish Treasury increased its foreign borrowing in parallel to the programme, and as there was a net short term portfolio inflow to the country in the first half of the year, the widening current account deficit was financed easily.
Starting with the end of the second quarter, the reform pace of the government slowed visibly. The privatization momentum that was achieved in the first half of the year subsided. After the very successful downstream oil sector privatization, the process for Türk Telekom and Turkish Airlines was delayed. The negotiations on the 3rd mobile telephony license award took eight months rather than two months as originally anticipated. The legislative work in the parliament also started to deviate from the laws necessary to support the programme and the government started to appear much less cohesive and focused.
In parallel to the slowdown of the pace of reform, many market participants started to take a closer look at the weakness of the banking system. As more information was revealed about the losses incurred at the banks taken over by the SDIF, the large and ongoing subsidies provided by state banks and the deterioration of the business of the smaller private banks without a clear niche, the health of the banking system as a whole started to be questioned more frequently.
As the pace of reform slowed and the market's confidence receded, the earlier inflows gave way to significant outflows. Coupled with the high current account deficit, these outflows put considerable pressure on the system. Interest rates rose through the third quarter. The rising level of interest rates led market players to question the sustainability of the program, so the outflows turned into panic in late November. Capital outflows for late November and early December was around $7 billion.
Turkish financial markets regularly experience a reduction of liquidity in December due to international market participants reducing their portfolio exposure for year end. This seasonal flow exacerbated the effects of the liquidity crunch in November. Overnight interest rates which were around 50% after late summer climbed first to the 60-70% range, then to over 100%, and finally over 200%. At that point, the Central Bank decided to provide additional liquidity into the system, although it still kept overnight rates high. The NDA guidelines in the programme were suspended due to the exceptional circumstances.
Immediate discussions were held with the IMF to provide additional support to the programme. In the meanwhile, the largest participant in the local government bond market, Demirbank, was taken over by the SDIF on December 6th. After intense negotiations between the IMF and the government, a supplemental support package was agreed on in exchange for new commitments from the government. This package authorized by the IMF board on December 22nd.
The new commitments of the government included:
- New tenders for Türk Telekom and Turkish Airlines
- Enactment of a new Electricity Market Law
- Evaluation and reduction of state guarantees to certain infrastructure projects
- Additional State Economic Enterprises to be transferred to the Privatization Administration
- Follow on legislation on social security reform
- Accelerated sale or closure of the banks taken over by the SDIF
- Recapitalization of state banks to cover their past losses
- Elimination (or inclusion in the budget) of the remaining extra budgetary funds
After the announcement of the supplemental support from the IMF, markets started to return to normal. Interest rates have been higher than their levels in 2000, but much lower than their levels in late November and early December.
With the new year, confidence started to return to the markets and about two thirds of the capital that left Turkey in November and December returned in January. However, it remains to be seen whether Turkey can borrow in 2001 from the international markets an amount close to the $8 billion it borrowed in 2000. The $7 billion domestic government bond redemption in February is expected to test the new found equilibrium in the financial markets.
The events in the second half of 2000 underscored a the main vulnerability of the programme: the fragile state of the banking system. Due to a lack of transparency and the inadequate regulation and supervision prior to 1999, the Turkish banking system had a number of fundamental weaknesses built up over the last fifteen years. The enacting of the new banking law and the creation of the new Baking Regulatory and Supervisory Board was an important step in the right direction. The Board will be instrumental in discovering the extent of the current problem in the banking system and addressing potential problems in the future. However, regulation and supervision has not been sufficient to solve the large problems inherited from the past.
There are two very important parameters governing the risk profile of the Turkish banking system.
1. There is a $15-20 million structural FX short position in the system. This results from $50-55 million of FX liabilities, consisting mainly of $40 million of FX deposits and $10-15 million of international syndications against $35-40 million of FX assets consisting mainly of $25-30 million of FX and FX-indexed loans and $10 million of Turkish eurobonds.
2. There is a very large maturity mismatch in the system, as the average duration of deposits is 15-20 days against an average duration of assets between 9 and 12 months.
3. Close to half of the assets of the system are government liabilities and a very large percentage of the system are explicitly or implicitly guaranteed by the government, making the banking system as a whole dependent on the government.
From these parameters, it is clear that a comprehensive reshaping of the banking system is necessary to restore it to health. Under the current parameters, the banking system is unable to perform its role as the allocator and optimizer of resources in the country. Instead, it is forced to act as a branch of the government raising financing to cover the government deficits. Clearly, the scope of the required banking sector reform is not limited to supervisory and other administrative remedies. A significant reshaping of the resource allocation mechanism of the system is called for.
***
Turkey entered 2000 with the most ambitious anti-inflationary program in its history. The prevailing mood among businessmen, economists, politicians and especially the man on the street turned more optimistic than ever. For the first time in thirty years, the nation as a whole started to believe that low inflation, healthy economic growth and wider integration with the world economy was achievable in the medium term, even in the short term.
However, the benign picture observed through the first half of 2000 started deteriorating in the second half. The slowdown of the reform pace of the government led to a decline in confidence first among international investors and then among local investors. This decline culminated in an intense liquidity crunch at the end of November.
In order to analyze the November turmoil in detail, it is necessary to review the IMF-backed economic programme and its implementation. The programme had five main aspects: exchange rate regime, fiscal adjustment, monetary policy, structural reform and confidence building measures.
The backbone of the programme was a quasi-fixed exchange rate regime, whereby the rate of depreciation of the Turkish Lira against a 1 U.S. dollar plus 0.77 Euro basket was fixed at declining rates. The Central Bank committed to defend the Turkish Lira against upward or downward movements.
On the fiscal side, in line with all stabilization and anti-inflation programmes ever implemented in the world, the central theme was a significant improvement in the government budget surplus (before interest). This was accomplished through rigorous measures both on the revenue side and the expense side. The additional taxes imposed to finance the recovery after the August 1999 earthquake were continued throughout 2000, and expense management was vigorous with reduced public investments and forward-looking wage adjustments for public sector employees.
The monetary side of the anti-inflationary program in Turkey was based on the Central Bank keeping its Net Domestic Assets (“NDA”) within a very narrow band. Because of this, the money supply fluctuated in parallel to the Net Foreign Assets of the Central Bank. As foreign capital, of long term or short term variety entered the country, the money supply was increased accordingly. Tying monetary supply to foreign capital inflows was a compromise, preventing the increase of the money supply due to the financing of government deficits while refraining from neutralizing the money supply affect of capital inflows. The designers of the programme attempted to allow interest rates to fall in parallel to capital inflows in order to boost the growth rate, allowing a moderate recovery after the steep slowdown in 1999.
On the structural reform front, privatization was accelerated. Projects that had been on the agenda for many years, such as the downstream oil sector, Türk Telekom, Turkish Airlines and the electricity sector were revisited. In addition to privatization, new regulatory frameworks were put in place in the banking, telecoms and energy sectors. Finally, a comprehensive social security reform package aimed at addressing the imbalances created in the early 1990s was designed.
To complement the monetary, fiscal and structural pillars of the programme, confidence building measures were taken both domestically and internationally. On the domestic front, leaders of the coalition parties repeatedly gave strong support to the programme. On the international front, IMF actively took part in the preparation of the programme and publicly supported it. Five weak banks were taken over by Savings Deposits Insurance Fund (“SDIF”) at the beginning of 2000 to indicate the government’s willingness to tackle the difficult problems.
In the first half of 2000, the rapid pace of reform boosted confidence in the international market, leading to net short term inflows. Under the fixed-NDA driven Central Bank policy, these flows pushed short term interest rates from over 80% to 30% as early as January. The fall in short term rates gradually affected the government bond market, in which 6 to 12 month interest rates fell in full correlation with short term rates from over 100% to just under 40%.
Due to the low interest rate environment in early 2000, the rate of GDP growth was quite high, at 5.5% and 6.0% (annualized) in the first two quarters. This acceleration of growth, fueled by a significant increase in aggregate demand, put an upward pressure on the trade deficit on one hand, and delayed the fall of inflation on the other. As inflation fell more slowly than anticipated in the programme, Turkish Lira started to become overvalued, as the rate of depreciation was constant. The overvaluation of the Turkish Lira put further upward pressure on the trade deficit. By the end of the third quarter, the trade deficit was around 5% of GDP and consumer and wholesale price inflation had overshot the depreciation of the Lira by 16% and 10% respectively.
As the Turkish Treasury increased its foreign borrowing in parallel to the programme, and as there was a net short term portfolio inflow to the country in the first half of the year, the widening current account deficit was financed easily.
Starting with the end of the second quarter, the reform pace of the government slowed visibly. The privatization momentum that was achieved in the first half of the year subsided. After the very successful downstream oil sector privatization, the process for Türk Telekom and Turkish Airlines was delayed. The negotiations on the 3rd mobile telephony license award took eight months rather than two months as originally anticipated. The legislative work in the parliament also started to deviate from the laws necessary to support the programme and the government started to appear much less cohesive and focused.
In parallel to the slowdown of the pace of reform, many market participants started to take a closer look at the weakness of the banking system. As more information was revealed about the losses incurred at the banks taken over by the SDIF, the large and ongoing subsidies provided by state banks and the deterioration of the business of the smaller private banks without a clear niche, the health of the banking system as a whole started to be questioned more frequently.
As the pace of reform slowed and the market's confidence receded, the earlier inflows gave way to significant outflows. Coupled with the high current account deficit, these outflows put considerable pressure on the system. Interest rates rose through the third quarter. The rising level of interest rates led market players to question the sustainability of the program, so the outflows turned into panic in late November. Capital outflows for late November and early December was around $7 billion.
Turkish financial markets regularly experience a reduction of liquidity in December due to international market participants reducing their portfolio exposure for year end. This seasonal flow exacerbated the effects of the liquidity crunch in November. Overnight interest rates which were around 50% after late summer climbed first to the 60-70% range, then to over 100%, and finally over 200%. At that point, the Central Bank decided to provide additional liquidity into the system, although it still kept overnight rates high. The NDA guidelines in the programme were suspended due to the exceptional circumstances.
Immediate discussions were held with the IMF to provide additional support to the programme. In the meanwhile, the largest participant in the local government bond market, Demirbank, was taken over by the SDIF on December 6th. After intense negotiations between the IMF and the government, a supplemental support package was agreed on in exchange for new commitments from the government. This package authorized by the IMF board on December 22nd.
The new commitments of the government included:
- New tenders for Türk Telekom and Turkish Airlines
- Enactment of a new Electricity Market Law
- Evaluation and reduction of state guarantees to certain infrastructure projects
- Additional State Economic Enterprises to be transferred to the Privatization Administration
- Follow on legislation on social security reform
- Accelerated sale or closure of the banks taken over by the SDIF
- Recapitalization of state banks to cover their past losses
- Elimination (or inclusion in the budget) of the remaining extra budgetary funds
After the announcement of the supplemental support from the IMF, markets started to return to normal. Interest rates have been higher than their levels in 2000, but much lower than their levels in late November and early December.
With the new year, confidence started to return to the markets and about two thirds of the capital that left Turkey in November and December returned in January. However, it remains to be seen whether Turkey can borrow in 2001 from the international markets an amount close to the $8 billion it borrowed in 2000. The $7 billion domestic government bond redemption in February is expected to test the new found equilibrium in the financial markets.
The events in the second half of 2000 underscored a the main vulnerability of the programme: the fragile state of the banking system. Due to a lack of transparency and the inadequate regulation and supervision prior to 1999, the Turkish banking system had a number of fundamental weaknesses built up over the last fifteen years. The enacting of the new banking law and the creation of the new Baking Regulatory and Supervisory Board was an important step in the right direction. The Board will be instrumental in discovering the extent of the current problem in the banking system and addressing potential problems in the future. However, regulation and supervision has not been sufficient to solve the large problems inherited from the past.
There are two very important parameters governing the risk profile of the Turkish banking system.
1. There is a $15-20 million structural FX short position in the system. This results from $50-55 million of FX liabilities, consisting mainly of $40 million of FX deposits and $10-15 million of international syndications against $35-40 million of FX assets consisting mainly of $25-30 million of FX and FX-indexed loans and $10 million of Turkish eurobonds.
2. There is a very large maturity mismatch in the system, as the average duration of deposits is 15-20 days against an average duration of assets between 9 and 12 months.
3. Close to half of the assets of the system are government liabilities and a very large percentage of the system are explicitly or implicitly guaranteed by the government, making the banking system as a whole dependent on the government.
From these parameters, it is clear that a comprehensive reshaping of the banking system is necessary to restore it to health. Under the current parameters, the banking system is unable to perform its role as the allocator and optimizer of resources in the country. Instead, it is forced to act as a branch of the government raising financing to cover the government deficits. Clearly, the scope of the required banking sector reform is not limited to supervisory and other administrative remedies. A significant reshaping of the resource allocation mechanism of the system is called for.
posted by Ümit Kumcuoğlu at 1:43 AM
0 comments
