A “made-in-IMF” origin mark on crisis in Turkey?
The financial turmoil in Turkey has proved much deeper than recent emerging-market crises due mainly to the flawed design of the country’s IMF-supported stabilization programme and mismanaged crisis intervention by the international financial institution, according to two leading economists.
by Chakravarthi Raghavan
GENEVA: After coming under the tutelage and supervision of the International Monetary Fund in 1998, and two consecutive standstill and stabilization programmes (in 2000 and 2001) launched with strong IMF support and bailout packages, Turkey is in an unprecedented crisis, with employment and economic activity depressed.
The crisis in Turkey is similar in many respects to that in Argentina and several other countries that followed the advice of the Bretton Woods institutions. However, while Argentina has been left to sink - since not many other economies, except perhaps for Uruguay, have had an adverse effect - Turkey, as a frontline state vital to the US “war on terrorism” and the campaign to overthrow Iraq’s Saddam Hussein, has been getting trade and other benefits. (Some of these trade benefits, like textiles and clothing quotas, are in violation of WTO obligations, but the US and Turkey have been resisting even to disclose and notify them, despite rulings by the WTO’s Textiles Monitoring Body.)
Still, Turkey has so far been unable to overcome the crisis and turn its economy around, and is now worse off than when the IMF stabilization programme was instituted in December 1999.
In a United Nations Conference on Trade and Development (UNCTAD) discussion paper (April 2002), “The Making of the Turkish Financial Crisis”, Yilmaz Akyüz and Korkut Boratav suggest that the failure of the stabilization programme, though formulated and launched with strong IMF support, “is in large part because of serious shortcomings in design as well as in crisis intervention which appears to have drawn no useful lessons from the recent bouts of crises in emerging markets.”
Akyüz and Boratav are well-known economists from Turkey. Akyüz is Director of the UNCTAD Division on Globalization and Development Strategies. Boratav is Professor of Economics at the University of Ankara.
The paper analyzes the two stabilization programmes of 2000 and 2001, though there are references to earlier problems and programmes. Turkey had a major crisis in 1994, and had IMF stabilization programmes for two years, and then managed without external aid for two more years. In 1998, the IMF took over the supervision of Turkey; and in December 1999, the government launched an exchange-rate-based stabilization programme with the support of the Bretton Woods institutions (BWIs) to bring down inflation and check what looked like “an unsustainable process of public debt accumulation.”
The programme seemed to be on course in the subsequent nine months, enjoying wide public confidence and support as well as gaining praise from IMF officials, but started running into problems in the autumn of 2000, necessitating a large IMF bailout to keep it on course. After a few months of muddling through, it became clear that the programme was not viable, and in the face of massive attacks on the currency and rapid exit of capital, the currency peg had to be abandoned in February 2001, replaced with a regime of free floating, “again on advice of the IMF.”
As in most other episodes of financial crisis, the currency overshot, interest rates rose sharply and the economy contracted at an unprecedented rate. After another IMF bailout package, the financial and currency markets stabilized towards the end of 2001, “but employment and economic activity remain depressed.”
What went wrong?
Akyüz and Boratav point out that the Turkish crisis has a number of features common to crises in emerging markets that implemented exchange-rate-based stabilization programmes - that typically use the exchange rate as a credible anchor for inflationary expectations, often leading to currency appreciation and relying on capital inflows attracted by arbitrage opportunities to finance growing external deficits.
The consequent buildup of external financial vulnerability eventually gives rise to expectations of sharp currency depreciations and a rapid exit of capital, resulting in overshooting of the exchange rate in the opposite direction and hikes in interest rates. Through such a boom-bust financial cycle, some countries (e.g., Mexico, Brazil and Russia) have succeeded in overcoming their chronic price instability and avoiding a return of rapid inflation, despite the collapse of their currencies and the external adjustment necessitated by the crisis.
The Turkish programme initially followed a similar path, but ran into difficulties at a much earlier stage of the disinflation process, forcing policymakers to abandon the peg and setting off a sharp economic downturn in the context of high inflation.
The difficulties arose largely because the programme was launched in the face of structural problems and fragilities on many fronts, notably in public finances and the banking sector, which was heavily dependent for its earnings on high-yielding Treasury bills associated with rapid inflation, and was thus highly vulnerable to disinflation.
As a result, there was an inconsistency in policy since much of the fiscal adjustment was predicated on declines in the very nominal and real interest rates on which many banks depended for their viability. While the programme incorporated a pre-announced exit from the crawling peg after 18 months, it failed to meet inflation targets despite full implementation of monetary and fiscal policy targets. Thus, what initially looked like a strength of the programme backfired, as persistently high inflation, together with widening current-account deficits, fed into expectations of a sharp depreciation of the currency.
The IMF, post facto, has been blaming widespread corruption and bad implementation by the Turkish government for the failure. However, say Akyüz and Boratav, the shortcomings in the design of the programme, rather than a failure to implement it, are the main reason why the boom in capital inflows was much shorter in Turkey than in most other experiments with exchange-rate-based stabilization, and why the crisis broke out before inflation was brought under control.
“The recent bouts of liquidity crises in emerging markets have significantly eroded the confidence of international investors in the sustainability of such soft pegs, so that rapid exits tend to be triggered at the first signs of trouble. The Turkish experience also suggests that the chances of successful disinflation by means of an exchange-rate anchor may now be significantly lower.” Also, the behaviour of private capital flows to emerging markets in the current downturn in the world economy shows that, unlike in the first half of the 1990s, international investors have become much more nervous in raising their exposure to emerging markets despite falling investment opportunities in the major industrial countries.
That the Turkish crisis has proved much deeper than most crises in emerging markets is not only due to problems in the design of the stabilization programme. Equally important is mismanagement in crisis intervention (by the BWIs), which had been premised, as in most other emerging markets, on restoring confidence, maintaining capital-account convertibility, and meeting the demands of creditors through fiscal and monetary tightening.
“While the implementation of the programme had created a trade-off between public and private finances, abandoning the peg and moving to free floating under full capital-account convertibility and extensive dollarization aggravated the difficulties of both public and private sectors,” say Akyüz and Boratav.
The collapse of the currency hit hard those sectors with high exposure to exchange rate risks that the earlier peg had encouraged. Public finances were squeezed from rising external and domestic debt servicing obligations due to the collapse of the currency and the hike in interest rates. Fiscal austerity and monetary tightening have served to deepen recession, and even growth in exports has remained relatively modest despite the sharp depreciation of the currency because of disruptions in the credit and supply systems, in very much the same way as in the earlier phase of the crisis in East Asia.
Various packages of legislation passed in order to initiate structural reforms in the public and private sectors have failed to restore confidence, while their initial impact was to add to stagflationary pressures. Furthermore, the external economic environment deteriorated further with the downturn in the major industrial countries and the events of 11 September.
Add Akyüz and Boratav: “However, these events have also helped Turkey in mobilizing unprecedented amounts of external support from the IMF due to the strategic position that the country occupies in the United States ‘war against terrorism’. Despite four IMF bailout packages in two years, however, the economy has shrunk at an unprecedented rate of some 9.5 per cent in 2001, and prospects for a strong recovery are highly uncertain.”
As in other recent crises in emerging markets, the IMF has come up with a number of ex post facto explanations for why the crisis broke out and why it has proved so deep. These explanations have put the blame on “slippages in implementation” of the policies agreed as well as on some adverse external developments, “rather than on the design of the stabilization programme or misguided intervention in the crisis.”
The paper cites some examples of such explanations (from senior IMF staff): the speculative attack on the Turkish lira took place against the background of increased political uncertainty, policy slippages and a weakening of economic fundamentals; the Turkish authorities were initially very effective in implementing the IMF-supported programme but were less successful in coping with unexpected events such the tripling of oil prices, the strong dollar, rising international interest rates and an overheating economy; and the recent difficulties in Turkey relate more to banking sector problems and the failure to undertake corrective fiscal actions when the current account widened, than to the design of the exchange rate arrangement.
However, point out Akyüz and Boratav, these explanations have been challenged by many Turkish economists, including some former senior economists of the BWIs, on grounds that “the policies advocated were based on a poor diagnosis of economic conditions in the country and the Fund was experimenting with programmes that lacked sound theoretical underpinnings.”
It is particularly notable that the programme was so designed that there was little policy space left for corrective macroeconomic action in the face of widening current-account deficits. By the time the difficulties became apparent, the 2000 budget had already been finalized according to the deficit targets set in the programme, and there was effectively little room either on the spending side or on the revenue side to act rapidly to slow demand expansion. This role could have been achieved by monetary policy, in the absence of the quasi-currency board and non-sterilization rules incorporated in the stabilization programme. There can be little doubt that, given the extent of fiscal profligacy and financial fragility, there was no easy way to stabilize the Turkish economy.
“However,” say Akyüz and Boratav, “in many respects the Turkish economy today is in a worse shape than it was on the eve of the December 1999 stabilization programme.” The programme has failed and the crisis has deepened in large part because of serious shortcomings in its design and implementation as well as in crisis management.
Anyone familiar with the Turkish banking system and the dynamics of the exchange-rate-based stabilization programmes could have anticipated the risks entailed by a rapid decline in interest rates as well as the vulnerability of the economy to boom-bust cycles in capital flows. Certainly countries such as Brazil have been successful in exchange-rate-based stabilization despite large fiscal imbalances, but in such cases the banking system had undergone an extensive restructuring and strict supervisory and regulatory provisions had been introduced well in advance.
Again, one of the lessons from the East Asian crisis was that the worst time to “reform” a financial system is in the middle of a crisis. Overhauling the banking system before launching the stabilization programme would have helped greatly to avoid many of these difficulties. However, these lessons appear to have been overlooked both in the design of the stabilization programme and in crisis intervention.
Even more, a careful examination of recent experiences with soft pegs and exchange-rate-based stabilization programmes shows that many of the weaknesses in economic fundamentals, including currency appreciation, deterioration of the current account, and increased exposure to exchange-rate risk, often result from the effects of capital inflows themselves rather than from policy slippages. Such episodes are often characterized by an upturn in economic activity and a surge in imports, financed by inflows of arbitrage capital. In Turkey both the Fund and the government were quite happy to see that the economy was making a strong upturn in 2000 after a deep recession in 1999, and they were not willing to discourage capital inflows underlying the process.
After the recent bouts of financial crises, the IMF has willy-nilly admitted that market-based restrictions over arbitrage flows (including Chilean-type reserve requirements) could be useful. However, the Fund has never actually encouraged developing countries to check such flows even when it was clear these could not be sustained over the longer term.
Experience also shows that even countries with strict financial discipline have not always been able to pursue counter-cyclical policies at times of massive capital inflows to prevent overheating and currency appreciation. The room for such policies was much limited in Turkey, owing to the size of the initial fiscal imbalances and extent of retrenchment already incorporated in the stabilization programme. On the other hand, monetary policy was excluded from playing this role by currency-board and non-sterilization rules.
Analyzing the policy response in Turkey to the speculative attacks on the currency, and comparing it with the responses to the East Asia crisis, Akyüz and Boratav point out that “much of the IMF funding (to Turkey) has been used to pay foreign private liabilities, notably of banks, and to cover the withdrawals of foreign portfolio investors.” In effect, this has allowed the Turkish government to translate part of its domestic debt into external liabilities to the IMF.
Referring to UNCTAD proposals to involve the private sector in crisis resolution, combined with temporary debt standstills and strict limits on access to IMF resources, and restrictions on capital-account transactions of both residents and non-residents, Akyüz and Boratav note that the IMF board has now recognized that countries as a last resort might impose a unilateral debt standstill, but has been unable to provide statutory protection to debtors in the form of a stay on litigation because of strong opposition from some of the major economic powers and market participants.
More recently, IMF Deputy Managing Director Anne Krueger has voiced the IMF’s new approach to managing crises, though the proposals are different from that of UNCTAD in that a standstill could be activated only by the Fund. However, the proposals amount to a recognition that the approach so far adopted in official intervention in emerging-market crises, built on the principle of maintenance of open capital accounts and convertibility and guaranteed repayment to creditors, may not always be successful in stabilizing the markets and avoiding costly crises.
This has certainly been the case in Turkey. But, even if orderly debt workouts become part of the international financial architecture, present difficulties in Turkey have to be resolved under existing rules. Only, unlike in Argentina, Turkey may not be allowed to sink for US geopolitical reasons. (SUNS5127)
From TWE No. 281 (16-31 May 2002)