Another exchange rate-based stabilisation has been tried and failed in Turkey. Just 14 months into a three-year programme to end decades of high inflation, the government was forced in February to abandon the currency peg that had been the anchor of its strategy, sparking an immediate devaluation of its currency, the lira, by around 30%. The programme had started out with unprecedented political backing, achieved impressive initial results and was widely believed to have a far better chance of success than many previous internationally supported programmes for Turkey. So what went wrong?
In retrospect, a weak banking system and an over-reliance on inflows of hot money made the country highly vulnerable to crises of confidence, so that when the inevitable tensions of a rapid adjustment emerged, the currency peg could not hold. The devaluation shock will delay the achievement of single-digit inflation, and with a simultaneous interest rate shock, implies large bank balance sheet losses and severe fiscal stress.
The authorities now have no choice but to try to limit the damage with judicious macro-economic policies, find a solution for banking system problems, and re-establish market confidence by continued implementation of the structural reform and privatisation programmes.
But the main challenge will be to contain the domestic fallout from the collapse of monetary credibility and to ensure that the adjustment process is equitable. As has been the case elsewhere, the push to join the European Union could perhaps serve as a focal point for new social cohesion and a renewed political commitment to reform.
The tensions that culminated in a crisis in late November 2000 were deeply rooted in Turkey’s economic system, but the immediate cause was a combination of portfolio losses and liquidity problems in a few banks, which sparked a loss of confidence in the entire banking system. When the central bank decided to inject massive liquidity into the system in violation of its own quasi-currency board rules, it created fears that the programme and currency peg were no longer sustainable, and the extra liquidity merely flowed out via the capital account and drained reserves. The panic was arrested only with a $7.5 billion IMF emergency funding package (over and above an original $4 billion stand-by loan). The government then reaffirmed its commitment to the previous inflation targets, pledged to speed up privatisation and banking reforms, took over a major bank that had been at the origin of the liquidity problems, and announced a guarantee of all bank liabilities.
The situation seemed to stabilise in early 2001, as virtually all of the $6 billion in capital that had exited in the crisis flowed back and reserves were reconstituted. However, investors were demanding much higher interest rates than before, indicating an upward shift in the country risk premium. Also, virtually all of the new capital inflow was on a very short-term (overnight) basis, suggesting residual devaluation fears. Confidence in the programme was not really restored, despite government pronouncements and the support of the IMF.
In such an atmosphere, a public row on February 19 between President Ahmet Necdet Sezer and Prime Minister Bulent Ecevit (apparently centred on the former’s anti-corruption campaign) immediately translated into the perception that the ruling coalition, and hence the programme, could be unravelling. Renewed crisis followed. However, this time around the central bank stuck to the quasi-currency board rules and refused to act as lender of last resort, hoping that banks would turn in their dollars in order to obtain lira. The result was record overnight interest rates, which peaked at close to 5000% on February 21. The banking system, already greatly weakened by the first crisis, faced breakdown as the interbank payments system ceased to function altogether. The next day the government decided to float the lira, spelling the end of the exchange rate-based stabilisation programme.
Under the circumstances, floating the currency was probably the only solution available. The market confidence that would have been required to sustain the crawling peg strategy was not present.
Acknowledging this fact sooner rather than later has at least allowed the government to enter the floating regime with most of its reserves intact, rather than finding them depleted in a vain attempt to defend the peg. The authorities have had to start anew to design a programme in light of the new currency framework.
Whatever the strength of the new strategy, they will face higher costs and greater risks because of the credibility that has been lost. The major risk is prolonged weakness of the currency coupled with a high country risk premium due to an inability to re-establish confidence quickly. If the risk materialises it would be unequivocally negative for Turkey. It would imply large terms of trade and real income losses for consumers, real balance sheet losses in the bank and corporate sectors, a growing public debt as such losses are nationalised, and a renewed debt-deficit spiral due to growing interest costs on the public debt.
In such an environment, rising political and social tensions could weaken the will to reform. Also, the temporary inflation spike following the currency devaluation could easily become entrenched via renewed inflation-linked wage rises, especially if the fiscal situation were perceived to be out of control. The task of the authorities will be to avoid such a scenario – essentially a repeat of the 1994 crisis – at all costs. There is little room for policy mistakes.
Once the dust has settled and a more stable market rate for the lira has been established, the monetary authorities will need to identify a feasible disinflation path and gear monetary policy to achieving it, implying a shift to a tighter stance. But this poses an acute dilemma, as banks are likely to need low interest rates and ample liquidity before they can be returned to health. Resolving this problem will require strict adherence to privatisation goals and the structural reform programme, notably in the banking and state enterprise sectors, which would help to drive down the country risk premium and eventually attract more stable forms of foreign finance such as direct investment. Fiscal discipline must be imposed, in particular by exercising tight control over public spending.
A major challenge will be to rebuild a social consensus for adjustment given that so much hard-won monetary credibility has been squandered. Depositors, banks and businesses can claim with some justification that they are suffering precisely because they put so much faith in the programme. An equitable income policy must be worked out with the social partners, but this was never fully accepted even when the programme was credible. It will thus be hard to ask for further sacrifices, such as further real wage cuts due to devaluation or more lay-offs due to structural reforms.
However, without some kind of social pact, it might be very difficult to find a new anchor for inflation. The drive to join the EU might serve as a catalyst for rallying public sentiment to the cause of reform. The need for economic stabilisation and institutional modernisation is inherent in the quest for convergence toward Europe, and remains essential for finding a solution to Turkey’s problems.
• OECD, Economic Survey: Turkey, 2000/2001.
©OECD Observer No 225, March 2001