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The Structure of a Financial Crisis

The year 2001 had been unlucky for Turkey. Apart from the crisis in 1994 and November 2000, the country had to face another financial crisis, causing problems in the management of its economy. Why does a country delve deep into financial crisis? What are the possible immediate triggers for both the current and potential new crises? What precautions should be taken for the key issues like the fragility of the financial and banking system, belated reforms and privatisation, rampant corruption, exchange rate policy? And how can the governments satisfy the markets and people to undertake these reforms?

The current crisis has not hit the country overnight. This article figures out the weakness of the system, years of neglect and mismanagement, possible solutions for other developing countries. One has to bear in my mind that even evaluating the aftermath of the 1994 crisis, Turkey was a rising star, with aspirations towards full membership to the European Union. Among the potential applicants of EU membership, – mostly the Transition Economies of Eastern Europe- Turkey was the mere applicant with a functioning Customs Union with the EU back in 1995.

With a relatively large and dynamic market, having high hopes for rapid economic and social progress, Turkey seemed a valuable candidate for the European Integration. Now after the 2000 November and 2001 February crises, the shrinking of the economy suggests that Turkey can only catch up with the figures of year 2000, as far as the year 2004, let alone the EU membership and further growth. To indicate why such a failure has been suffered, we have to go back to the roots of mismanagement. And that begins with the problems of Privatisation practices.

Privatisation has proved to be a successful method for improving institutions and maintaining corporate efficiency all around the world. But under certain conditions either privatised firms can get into serious difficulties or delaying the privatisation programs could trigger economic crises, together with the impact caused by years of mismanagement, not undertaking the progressive reforms and corruption – as experienced in some of the transition economies of Eastern Europe, Central Asia, Far East, and as is the case in this article, in Turkey

The past decade forced the public sector to its knees, all around the world. Though Turkey was not a transition economy, the winds of change has affected the public sector like in all other developed and developing economies. However, unlike the Transition Economies, Turkey embarked on a prospective plan to privatise a major part of the public sector in the mid 80’s and laws enacting and enabling the privatisation of the State Owned Enterprises (SOE) in late 1985, was an important breakthrough.

In the 1990’s privatisation went ahead but caused disappointment in many sectors. Most privatised firms could not improve their performance and some that succeeded, had been profitable already as SOEs. But that was not the only problem the country had to face. Turkey had already begun to face significant problems regarding the Privatisation Policy in the 1990’s. These mentioned problems not only aroused from the aggregate demand concerning the SOE, and the negative effect of investment but the ongoing debate carried by the opposing political parties in the Parliament.

The governments have overcome several difficulties and successfully resumed privatisation in the beginning of the second decade. Though the outcome was promising, the program proceeded more slowly than the original plan. In 1993 for example, a net revenue of US$ 543 millions was raised through several privatised firms including two electric companies, two communications equipment manufacturers, a supermarket chain and four cement factories.

In 1994 a total of approximately US$ 412 million was raised through the sale of an automobile manufacturer, remaining cement factories by international offering resulted in US$ 330 Million. In 1995, a total of US$ 573 million was raised. Sales during this year included entities in the sugar, cement and magnesium industries, as well as a state bank. In 1996, a total of approximately US$ 300 million resulting from disposal of entities in the cement, zinc, forestry and textile industries had been realised.

A major problem of the Turkish economy — shared with many of the transition and developing economies — is the high inflation rate. In a low inflation rate economy, the income redistribution effect of privatisation is substantial, thus can gain large public support. In many developed economies, including the most obvious example in Britain, unlike the developing economies, privatisation had clearly improved both the overall economic performance and corporate efficiency. In the developed countries, even the privatised large firms have marginal consequences in terms of the whole economy.

Government interference had been minimised thanks to the relatively transparency of the process. Most economies with high inflation rates also suffer from rampant corruption, so neither efficiency nor transparency can be maintained in these countries. Corrupt management practices prevent a radical reform of corporate management. And the slowdown of economic growth affects the public negatively. Following the Turk Telecom failure, in 1999, the negotiations for the privatisation of several large SOEs was still going on.

Yet the major reason for the economic crisis that occurred in 2001 – and is still continuing with several impacts – was proved to be the banking sector. The Turkish private banking sector went awry rapidly; and many banks – some of them privatised in the last decade- were gutted of their funds; illegal loans were thought to be granted; while the bank owners were accused of transferring money to their own companies – some of which were again privatised in the last decade- and capital was completely wasted due to the loans not being repaid.

A number of bank owners were taken into custody for questioning and even formally arrested and charged; and banks went into state receivership overnight. These momentous operations resulted in new regulations for the banking & financial sector. Nineteen private banks, which were thought to have been robbed and whose capital structures were found out to be fragile, were turned over to the Savings Deposits Insurance Fund (SDIF). A new Institution called as BBR (Board of Banking Regulations) was installed to inspect and audit the operations of SDIF.

The government’s aim was to strengthen the capital structures of these banks and sell the appropriate ones immediately. During the process various banks merged under the same roof and the government succeeded in selling some of these banks. The net gains from these selling operations helped to net approximately $20 billion for SDIF. But the need for deeper reforms in the financial sector has assumed much greater urgency since the dramatic crises of November 2000 and February 2001.

The economic crisis created by the somewhat poor state of governance in the financial sector, has brought to a boil the long simmering potential of the sector to undermine macroeconomic stability. Inasmuch as the gradual balance sheet strengthening of the large state banks, prior to their privatisation dominated concerns until recently, the need to analyse and solve the crisis in private banking seems to impose very large fiscal costs on the budget. The impact of the crisis on inflation control proved to be grave.

Turkey experienced another failure of an exchange rate-based stabilisation, originally a three year program announced approximately 14 months prior to the February 2001 crisis. The principal aim of the government was to end high inflation dominating the economy for two decades. The government was forced in February 2001 to abandon the currency peg at once, which had been based the anchor of the fiscal strategy, thus sparking an immediate devaluation of the national currency, the lira, by around 32% in the following week.

The program had started out with unprecedented political backing, managed to achieve some highly impressive initial results and the public opinion widely held provided a far better chance of prosperity than several previous internationally supported programs. Yet the outcome was the worst failure in the history of the country. Considering past events, it’s clearly figured out that the weakened banking system and tendency to over-reliance on inflows of hot money left the country defenceless and highly vulnerable to potential crises of confidence.

This has resulted in the currency peg’s failure to hold position when the inevitable tensions of such a rapid adjustment emerged. The unpredicted devaluation delayed the government’s plan and promise to achieve single-digit inflation. The simultaneous interest rate increase and the banks’ liquidity preference indicted large bank balance sheet losses and severe fiscal stress.

The tensions climaxed in a crisis first in late November 2000. This first crisis was also deeply rooted in the country’s lacking economic system, but the primary cause of the stress was a mixture of the banks’ portfolio losses and liquidity problems in a few banks, which addressed a loss of confidence in the entire banking system both in the markets and public eye, as well as the foreign investors.

The Central Bank then acted to inject massive liquidity into the system, violating its own quasi-currency board rules effective for several decades, it created fears that the program and currency peg were no longer sustainable, and the extra liquidity merely flowed out through the capital account and drained reserves. This first panic was arrested only with a $7. 5 billion IMF emergency funding package which is over and above the original and standard $4 billion stand-by loan.

Then the coalition government backed and reaffirmed the commitment to the previous inflation package expectations, promised to speed up privatisation efforts and financial sector reforms, eventually took over a major bank assumed to be the origin of the current liquidity problems, and announced a new and unpredicted guarantee for all liabilities of the banking sector, either private or state owned. The grave situation experienced seemed to stabilise by January 2001, while the government claimed nearly all of the $6 billion that had assumed to exit the domestic markets in the crisis flowed back and national reserves were again reconstituted.

Nonetheless, the investors were now demanding incredibly higher interest rates as compared with these before the crisis, while indicating an upward shift in the current country risk premium. What’s more, virtually the recent capital inflow was fixed on short-terms, mostly overnight basis, deprived of suggestions towards a possible residual devaluation fear. The investors’ confidence in the ongoing programme was not positively restored, despite several government pronouncements and IMF support.

In this defined critical financial environment, a public row between President and Prime Minister occurred on February 19 2001, seemingly centred on the President’s anti-corruption campaign, at once guided the way to the perception that the governing coalition and consequently the programme was threatened and found deciphered. Renewed crisis followed. Nevertheless, the Central Bank stuck well to its quasi-currency board rules, seemed reluctant to act as lender of last chance, and assumed that banks would be eager to expend their foreign exchange reserves for the purpose of obtaining national currency.

However this misadministration resulted in record overnight interest rates, peaking at approximately 5000% on February 21. The banking system, already intensely depressed by the first crisis, faced a terrible breakdown as the markets experienced the interbank payments system’s ceasing to function altogether. The following day the distressed coalition government concluded a floating for lira, and publicly announced the official end of the exchange rate-based stabilisation programme.

Free floating of the currency was presumably the only convenient solution. The market confidence that would have been required to sustain the crawling peg strategy was not present. Acknowledging this certainty as soon as possible has allowed the government to initiate such floating regime with most of the intact possible reserves, instead of depleting them in a futile attempt to defend the peg. The authorities were forced to initiate anew to plan the outlines of a programme in light of the new currency framework.

Consequential quasi-fiscal programs mandating the large state banks to provide subsidies and preferential credit highly influenced by short term domestic politics, led to significant accumulation of government obligations to the state banks which has shown to increase from 2. 2 percent of GNP in 1995 to 13 percent of GNP by 1999. The so – called problem of “duty losses” is being addressed through measures taken to solely securitize the existing stock of duty losses and to merely phase out substantial credit subsidies and fully budget for any duty losses in 2002.

With the cost of money increasing, the real sector could not produce properly due to the lacking bank loans and some other negative events in the economy. When all circles accepted that economic stability could not be provided in an environment in which there was no production, the real sector and the government held long meetings and tried to find solutions for the problems of the real sector and regulations to increase production. Nonetheless, the quasi-fiscal operation had a high cost repugnant impact on the state banks and thus on the budget.

The lack of liquidity experienced in these two huge state banks resulted in increasing costs and delayed remuneration for the huge amount of duty losses which were imposed as part of the governmental quasi-fiscal policy contributed to distortions in the financial market. These mentioned two state banks concluded to borrow liquidity in the overnight market and from the Central Bank, and this was a very risky step, merely increasing the costs especially in the aftermath of the financial crises of November 2000 and February 2001.

It has to be noted that between the crucial years 1995 and 1999, these two banks received only 10 percent of their total duty loss amount due from government. However the inconsistency continued after February and in May 2001, both banks were first estimated and then judged to be unable to pay their outstanding debts. The settlement of the outstanding government liabilities to the two banks and the relatively costs of injecting new capital in order to reach 8 percent capital adequacy imposed a consequential burden on the new budget.

But back in early December 2000, the government had introduced a new legislation to privatise the three main state banks Ziraat Bank, Halkbank and Emlakbank ( the Housing Credit Bank which was amalgamated later into Ziraat Bank)The Parliament eagerly approved the legislation, but concluded in enabling the restructuring of the banks prior to privatisation. A critical article of this legislation obliged the state banks not to undertake ‘duties’ not having the suitable compensation included in the new budget.

The privatisation of Ziraat and Halk banks would arouse new hopes to remove the vicious cycle of the quasi- fiscal policy, but these dreams have turned sour. The apparent lesson from this experience is that the non-transparency inherent in such a deep rooted quasi-fiscal policy would result in frustrating and costly consequences both for the financial sector and the budget.

By the summer of 2001 total budgetary outlays for re-capitalising all three state banks had reached to approximately 25 Billion US$. As the handicapped quasi-fiscal relationship between government and state banks carried significant risks, the government was also denounced to risks from the rest of the banking and financial sector mostly from the private banks as a result of an extensive environment mismanagement, and accountability.

Subsequent to the 1994-95 banking crisis, the government had initiated a very risky100 percent deposit insurance scheme for household deposits, and thus caused a moral hazard. Implicitly large contingent liabilities were then tied to the fluctuating health of the financial sector. The threatening result was the rapid growth of the banking system with assets of US$58 billion in late 1994 rising to US$156 billion in late 2000. Nonetheless, judicious regulations were insufficient and enforcement was significantly weak.

This resulted in various banking practices which caused an increase in the liability of the banking system to the interest rates and more important exchange rate behaviours. Incautious banking practices like, deficiency in diversification and disproportionate exposure to foreign currency risk, non-performing loans going unchecked, and the insider lending and criminal frauds committed added new risks. Then government attempted to rehabilitate the public banking sector.

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