The Turkish Economy, Post-2001 Crisis - Career

The Turkish Economy, Post-2001 Crisis:

Why Timing, Faith, and Expectations Matter

Megan Chen, Ming Li Chew, Sanya Goyal, Muzoon Matar, and Zeynep Yavuz1

This paper offers a macroeconomic investigation regarding the stabilization of Turkey’s economy following the crises it experienced in the late 20th century when Turkey began to liberalize its economy. In the early 2000s, following decades of chronic inflation, Turkey succeeded in lowering its inflation rate to unprecedented levels. But what caused the crisis, how did the Turkish economy recover so well from it, and how did Turkey manage to combat mounting inflationary pressure? The 2001 crisis was caused by structural problems, namely bad debt management and poorly run public and finance sectors, which were detrimental to consumer confidence. After analyzing key data and conducting surveys of literature on this subject, we conclude that the success of Turkey’s stabilization program is due to a binding and abrupt regime change. This demonstrates the rational expectations model, emphasizing the importance of timing and credibility of a well-implemented program. Finally, we study the relationships between inflation and other macroeconomic variables, and conclude that inflation growth rates remained impressively low despite unanticipated economic shocks. 1 Megan Chen, Ming Li Chew, Sanya Goyal, Muzoon Matar, and Zeynep Yavuz are members of the class of 2015 at the University of Chicago.

UChicago Undergraduate Business Journal

Spring 2014 1

“I think the most important and priority problem in 2002 is going to be

inflation. We are rolling over our debts, there's no problem in current accounts,

we have started a slight recovery, but will we be able to curb inflation to 35

percent? Will we be able to halve inflation, which is 67 percent in 2001?"

- Turkish Economy Minister Kemal Dervis (2001)

Introduction

Research question

Turkey began implementing liberalization models in the 1990s. During this period, Turkey

experienced multiple crises that created and subsequently exacerbated inflationary pressure. This paper seeks

to address and assess the relative effectiveness of policies implemented after the 2001 financial crisis.

Our Project

This research consists of three parts: the first part aims to identify the major causes of the 2001

Turkish Crisis by analyzing key macroeconomic indicators and Turkey’s political environment between 1990

and 2001. The second part focuses on the policies implemented during the post crisis period from 2001-2006

to target inflation and fragilities present within the banking sector. The third part of this paper interprets

economic data from 2004-2010 in order to explore the stabilization of the primary variable inflation/CPI and

its correlation with other macroeconomic indicators.

Methodology

We first compiled data on the Turkish economy by referring to databases such as Federal Reserve

Economic Data (FRED), World Bank, Organization of Economic Co-operation and Development (OECD),

TURKSTAT, International Labor Organization (ILO), Central Bank of Turkey (CBRT), International

Monetary Fund (IMF) and the Turkish Undersecretariat.

We looked at several key variables that included the openness of the economy, the overnight interest

rate, total external debt, current account balance, unemployment rate, real GDP growth, M1 money supply,

consumer confidence index, net government debt, gross external debt, national debt, income share held by

income groups in 20 percentiles, state owned enterprises and total exports.

These variables were trended and graphed in MATLAB prior to being analyzed. This research relies

heavily on literature reviews of previously published research regarding the rise and fall of inflation in Turkey

from 1990-2006. The main sources were ‘Inflation Targeting in Turkey’ (Hasan, Ersel, and Fatih Ozatay),


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‘The Ends of Four Big Inflations’ (Thomas J. Sargent), Strengthening the Turkish Economy (Kemal Dervis),

"Currency and Financial Crises in Turkey 2000 –2001: Bad Fundamentals or Bad Luck?’ (F. Gulcin Ozkan),

among others.

Limitations of this Research

This research has some limitations. Firstly, a number of variables were not available on the

aforementioned databases. These variables include central bank independence measure, real interest rates, the

monetary base and statistics measuring social indicators such as censorship, freedom of speech, participation

of women in politics, and human rights abuses. In light of the above shortcomings, our research may be

relatively limited in its scope. The second limitation was the unavailability of data during certain years. This is

due to the fact that data was comprehensively and reliably recorded after the Turkish crisis of 2001 - the topic

of interest in this paper. A third limitation was the scarcity of literature to corroborate or contradict our

analysis of the data, and our own restricted knowledge on topics such as the foreign exchange market and a

pegged exchange rate regime, which played a significant role in the Turkish crisis of 2001.

Part I: Rise of Crisis, 1990-2001

General Overview of Turkey, Pre-2001 Crisis

Turkey experienced several economic crises during the 1990s. Many critics argue that the instability

of the Turkish economy during the 1990s was due to a lack of implementing necessary legal and institutional

reforms following the liberalization of the Turkish economy in the early 1980’s (see Ozatay and Sak, 2002,

Ozkan 2005, Yeldan, 2002). Turkey was able to handle small crises during the last decade of the 20th century

with relatively minor damages to the economy. Since no measures were taken to safeguard the economy

against potential future crises in the future however, the vulnerability and instability of Turkish economy

continued to grow.


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Figure 1.1: Inflation

Source: Organisation for Economic Co-operation and Development

Throughout the 1990’s, Turkey suffered chronic inflation ranging between 70-90%, as shown in

Figure 1.1 (Ozkan, 2005). To combat such inflationary pressure, Turkey adopted a stabilization program in

1999 with the backing of the IMF. The program adopted was a pegged exchange regime, and the two

essential requirements for the success of the program were tight monetary policy and the liberalization of the

economy.

As shown in Figure 1.1, the stabilization program had a positive impact on Turkey’s economy during

its initial stages. The inflation rate declined, and the interest rates on Treasury Bills fell from 90% to 40%

(Ozkan, 2005). In November of 2000, however, about a year after the stabilization program was adopted, the

Turkish economy experienced a liquidity crisis, which was further worsened by the severe depreciation of the

Turkish Lira in February 2001.

The liquidity squeeze2 in November 2000 was a result of severely increasing interest rates. Despite

the decreasing inflation due to the newly adopted stabilization program, interest rates started to fluctuate well

before the crisis took place. While overnight interest rates fluctuated between 18.9% and 45.9% in April 2000

and between 13.6% and 38.8% in July 2000, interest rates fluctuated between 23.7% and 79.6% in September

and peaked at 315.9% in November and 873.1% in December (Koch and Chaudhary, 2001). A record of the

2 The liquidity crisis Turkey experienced was a result of the reduction in the general availability of loans and credit available for consumers and businesses in the bank reserves.


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overnight increase in the interest rates is also shown in Figure 1.2. The rise in the interest rates made it more

difficult for banks to sell holdings of government bonds and maintain liquidity. Due to the liquidity crisis, the

fall in inflation lessened, and, as a result, Turkey was not able to reach its target level of inflation, causing the

Turkish lira to become further overvalued.

Figure 1.2 Overnight Interest Rates (Ozkan 2005)

On February 21st 2001, also known as “Black Wednesday”, Turkey experienced the most serious

financial and economic crisis in its post-war history. A few days earlier, specifically on February 19th, a heated

argument emerged between the Prime Minister Ecevit and President Sezer, during which Sezer threw the

constitutional book at the Prime Minister and Ecevit warned ominously that “This is a serious crisis.” Many

understood Ecevit’s statement to be admission of defeat by the Turkish government (Ozatay and Sak, 2002).

And two days after this political clash the Turkish Lira collapsed. By the next month, it had lost almost half of

its value. The economy proceeded to contract by 9% in 2001 (Ozkan, 2005).

The aim of this part of this paper is to identify the causes behind the 2001 Turkish crisis. It will be

comprised of two parts: the first will display economic data between 1990-2000, which will show Turkey’s

increasing trade-deficit and disproportional government borrowing; the second will analyze the crisis and

explain how the fragility of the banking sector became the major cause behind the 2001 collapse of the

Turkish Economy.

544 F. GULCIN OZKAN

© Blackwell Publishing Ltd 2005

in the markets. However, the Turkish lira continued to be overvalued as a result

of the slow fall in inflation. Against this background, a public disagreement

between the Prime Minister and the President was followed by a massive attack

on the Turkish lira on 21 February, 2001. The authorities decided to float the

currency the following day with a 28 per cent loss of value against the dollar. In

the subsequent two months, the Turkish lira lost almost half of its value. The

resulting output loss was substantial and the economy contracted by over nine per

cent in 2001, which was the nation’s most severe recession since World War II.

4

The next section aims to identify the sources of these currency and financial

crises and provide alternative explanations. The first, fundamental-based explana-

tion, utilises the first- and second-generation currency crises models for the iden-

tification of a set of potential fundamentals. The second, financial fragility-based

explanation, relies on the third-generation models in specifying fragility measures

that were useful as indicators for a number of other emerging market crises.

We present data over three different spans. First, we look at the evolution of

the likely indicators during the period immediately before the crisis, over the

period 1999–2000. Second, we inspect the change in the potential determinants

throughout the 1990s for medium-term tendencies. Third, for some of the variables

we go as far back as the early 1970s to put the crisis period into some historical

FIGURE 1

Overnight Interest Rates, 1 November–26 December 2000

Source: The Central Bank of the Republic of Turkey.

4

Financial Times (2 April, 2002).


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Liberalization of the Turkish Economy: Historical Background

Turkey has been transforming into a market economy since the 1970s. It is important to note,

however, that a certain degree of government intervention still existed within the economy. This intervention

came in the form of the government’s influence over the Central Bank’s decisions and its ownership of

commercial banks. Starting in the 1980s, the Turkish government began to adopt guidelines that would

minimize government intervention and liberalize their market model, currency and foreign trade (Koch and

Chaudhary, 2001). As a result, foreign direct investment (FDI) in Turkey increased and its external balance of

trade became a significant denominator in Turkish economy. Table 1.1 depicts the increases in exports,

imports and FDI in the late 20th century in Turkey.

Table 1.1 (Koch and Chaudhary, 2001)

In order to measure the significance of external trade, we analyzed the changes in the openness of

Turkish Economy between 1970-2000. The openness of an economy can be measured by taking the total of

exports and imports as a proportion of GDP. Figure 1.3 displays how the openness of the Turkish economy

increased sharply after the government implemented efforts to liberalize the economy in the early 1980s. In

line with this finding, the next section will analyze Turkey’s trade balance during the increase in the openness

of Turkey’s economy.

Koch and Chaudhary

468

power.1 Following ‘January 24 Decisions’ as guidelines for transforming the economy, the government expedited reforms aimed at removal of price controls and subsidies, expansion of private sector, encouragement of private savings and investments, freeing foreign trade by reducing tariffs and other barriers, relaxing controls over money transfers, improving the tax system, and finally encouraging FDI. These reforms attempted to achieve three objectives: minimisation of state intervention in the economy, formation of a free market economy, and, finally, integration of domestic economy into world economy. As a result, trade and FDI increased significantly as depicted in Table 1. However, there is need to carefully examine the measures undertaken to encourage FDI and to liberalise the financial sector of the country and to properly understand the consequences of its crises.

To encourage FDI, the government issued “The Foreign Capital Framework Decree” in 1980. It simplified the administrative procedures of FDI and capital flows and established a separate institution called “The Foreign Investment Directorate”. Although the government issued two other decrees in 1983 and 1984 to relax the constraints on FDI, it enacted more fundamental FDI-related measures in 1985 and 1986, which led to the formation of free trade zones, removal of restrictions on foreign equity participation and discontinuation of minimum export requirements. Consequently, number of foreign equity ventures increased to 2900 and foreign capital inflows to US$7,572 million during 1980 to 1995 [Tatoglu and Glaister (1996)].

However, despite the decrees, administrative obstacles are still pervasive in the country. They cost in various ways. For example, World Business Survey reported that investors in Turkey spend 20 percent of their time in meeting official formalities compared to 8 percent in East and Central Europe. Similarly, Price Waterhouse Coopers argues a number of regulations are not easily understandable and widely applicable. Such a state of affairs creates uncertainty and thus costs the country $1,822 million annually.2

Table 1

Imports, Exports, and Net FDI into Turkey, 1970–1990 (Million Dollars)

1970 1973 1976 1978 1980 1981 1983 1985 1988 1990 Exports 588 1,317 1,960 2,288 2,910 4,703 5,905 8,255 11,929 13,026 Imports 948 2,086 4,872 4,369 7,513 8,567 8,895 11,230 13,706 22,581 FDI 58* – – – 18 141 87 158 387 788 Source: State Planning Organisation, Undersecretariate of Treasury.

* Total capital flow, both inflow and outflow.

1Turgut Ozal worked as a Deputy Counselor in the Prime Minister’s office from December 1979 till the military coup in September 1980, during which he prepared “January 24 Economic Package”. After the military intervention, he first became a State Minister, then Deputy Prime Minister until July 1982. On winning election with the help of self-found Motherland Party in May 1983, he became Prime Minister. He was Premier till November 1989 when he became the President of the country. He died in 1993 of a sudden heart attack while he was still the President.

2http://www.hazine.gov.tr/ (official site of the Treasury).


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Figure 1.3 Openness

Source: The University of Pennsylvania

Worsening of the Trade Balance and Current Account Balance

The trade balance of a country is defined as its exports minus its imports, and it measures the deficit

between revenue from exports and payment for exports. The current account balance is another measure of a

trade deficit, and it is the sum of trade balance, factor income and cash transfers. Figure 1.4 plots the changes

in the current account balance in the last decade of the 20th century. As shown in Figure 1.4, we observe a

decline in Turkey’s current account balance. The OECD’s 2001 Economic Survey of Turkey identifies the

worsening of the current account deficit as one of the main sources behind the collapse of the economy

(Ozkan, 2005). Table 1.2 provides the trade balance and current account balance records during the pre-crisis

period. A sharp decline in both values becomes evident according to these variables. Specifically, the trade

balance experiences a severe decrease in the year 2000. The reason behind the worsening trade-balance is the

weak competitiveness of the Turkish Lira, and this will be explored in more detail in the next section.


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Table 1.2 (Ozkan, 2005)

Figure 1.4 Current Account Balance

Source: International Monetary Fund

Table 1.3 displays Turkey’s imports, exports and FDI between 1990-2000. A reading of the table

shows a continuous rise in the current deficit (Uygur, 2001). In 2000, the trade-deficit to GNP ratio exceeded

its safe limit of 3.5%, correlating the rise in the risk premium of interest rates on foreign debt (Koch and

Chaudhary, 2001). Table 1.4 shows that the ratio of monthly current deficit to foreign currency reserves

jumped from 6% to 50% during 2000, signaling the occurrence of the second crisis in February 2001.

CURRENCY AND FINANCIAL CRISES IN TURKEY 2000–2001 549


To the extent that these balances can be used as warning signals for the

fragility of the peg, there was some cause for concern especially from the second

quarter of 2000 and increasingly so in the lead up to November 2000.

Competitiveness: One of the underlying sources of movements in both the trade

and the current account balances is the competitiveness of the external sector. In

high inflation countries where an exchange rate-based programme is put into

place, the evolution of domestic inflation is a key determinant of competitive-

ness. If domestic inflation is above the foreign one, competitiveness of the home

country will be eroded given that the exchange rate cannot respond to do the

necessary adjustment. This, in turn, damages the credibility of the peg. In the

case of Turkey, a crawling peg against a dollar-euro basket was at the centre of

the stabilisation programme. There was a pre-specified timetable of devaluation

rates until the end of 2002.

Figure 5 plots the inflation performance over the past three decades. Clearly,

the recent stabilisation programme was successful in reducing inflation which

had been on a sharp upward trend since the 1980s. However, it is important to

note that, notwithstanding this reduction, inflation rates for 2000 and 2001 stood

at over 40 per cent, which were still above the target devaluation rates. This, in

turn, resulted in a non-negligible loss of competitiveness of the Turkish economy

over this period.

9,10

TABLE 2

Trade and Current Account Balances, 1996–2000 (in million US dollars)

Year/Quarter Trade Balance Current Account Balance

1996 !10,582 !2,437

1997 !15,358 !2,638

1998 !14,220 1,984

1999 !10,443 !1,360

2000 Q1 !3,794 !2,282

2000 Q2 !5,938 !3,265

2000 Q3 !6,253 !1,194

2000 Q4 !6,311 !3,024

2000 !22,341 !9,765

Source: Central Bank of the Republic of Turkey at www.cbrt.gov.tr

9

This view is also reinforced by the results of a survey conducted by the International Institute for

Management Development (IIMD). The criteria assessed by IIMD have wider coverage and in-

corporate government efficiency, business efficiency and infrastructure in addition to economic

performance. The resulting World Competitiveness Index ranks Turkey as the 46th among the

50 surveyed in 2000 (The Economist, 5 May, 2001, p. 124).

10

Akyuz and Boratav (2001) observe that exchange rate-based stabilisation programmes adopted

by other high inflation countries were considerably more successful in reducing inflation. For


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So, overall, not only was Turkey experiencing a worsening trade-deficit, it was also facing an

increasing risk premium on interest rates for its foreign debt. According to Koch and Chaudhary (2001), the

rise in the risk premium on interest rates was a result of the political instability Turkey experienced during the

1990s. During the last decade of the 20th century, Turkey had two presidential elections and four local

elections that caused government expenditure to rise. Furthermore, Turkey had ten different governments in

power between 1989 and 2000. Each shift in government interrupted previously adopted economic

development and stabilization programs that inhibited steady improvements in the Turkish economy. As a

result of political instability and uncontrolled public expenditure, both domestic and foreign debt increased

(Koch and Chaudhary, 2001).

Table 2

Foreign Trade and FDI, 1991 to 2000 (Million Dollars)

Year 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Export 13,593 14,715 15,345 18,106 21,637 23,224 26,261 26,974 26,587 27,485

Import 21,047 22,871 29,428 23,270 35,709 43,627 48,559 45,921 40,687 54,150

FDI 910 912 797 937 935 937 873 982 823 1307*

FDI Outflow 127 133 175 78 163 325 319 409 685 718* Source: Central Bank, State Planning Organization, and Undersecretariate of Treasury. *January-October

February 2001 Crisis in Turkey

473

Table 3

Selected Financial Indicators for 1999 and 2000

Date, Months

Monthly Current Deficit/Foreign

Currency Reserves (%)

Treasury Compound Interest,

Average (%)

Consumer Price Increase, 12

Month (%)

Wholesale Price Increases, 12

Month (%)

1999 10 109.3 64.7 55.2 11 96.4 64.6 56.3 12 5.9 – (*) 68.8 62.9

2000 1 10.2 38.3 68.9 66.4 2 15.2 42.1 69.7 67.5

3 21.5 39.9 67.9 66.1 4 22.9 34.5 63.8 61.5

5 26.7 39.4 62.7 59.2 6 27.7 41.9 58.6 56.8 7 28.6 34.5 56.2 52.3

8 33.5 33.2 53.2 48.9 9 33.6 33.6 49.0 43.9

10 39.2 38.0 44.4 41.4 11 46.7 41.0 43.8 39.1 12 49.7 39.0 32.7

Source: Uygur (2001) “Krizden Krize Turkiye: 2000 Kasim ve 2001 Subat Krizleri”. * No bid in December 1999.

Indeed, this crisis had diverse effects on the nation. For example, 4,146 firms were closed in the first three months of the crisis7 and there were large-scale demonstrations against government in many cities disturbing production, commerce, trade, communication, and law and order in the country. To control the situation, the Premier of Turkey invited Kemal Dervish, Vice-Director of the World Bank to control and manage the economy.8 He was appointed a State Minister to look after the whole economy. He quickly embarked upon the preparation of a new programme of actions regarding legal and structural reforms, which did not receive proper focus in the previous programme. However, one question frequently asked is: Had the outcome been different, if a different disinflation policy had been followed in Turkey? The answer is, possibly not, because the crisis had resulted not from one but from several adverse factors discussed ahead.

7The Radikal, April 29, 2001. 8It is alleged that the Premier had invited Kemal Dervish on behest of IMF, World Bank and the

USA to administer the committed foreign aid to Turkey. It is, however, believed that it was not the administration of foreign aid alone. The strategic position of Turkey in the world geography was a more important consideration, which prompted the appointment of a person of their confidence. How important Turkey is strategically may be ascertained from what Stanley Fischer of IMF said: “Turkey is not an ordinary country, it is a member of NATO as well as has a big economy”(The Economist, May 19, 2001, pp. 54.) Although they admitted the strategic importance of Turkey, they had reservations about its officials’ honesty in using foreign aid.


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Weak Competitiveness of Lira

As mentioned in the previous section, Turkey experienced a trade-deficit due to the weak

competitiveness of the Lira, as a weak competitiveness of a currency translates into weak competitiveness of

exports. Since Turkey adopted the pegged exchange rate program, domestic inflation measures became a

major determinant of the competitiveness of the Turkish economy. If domestic inflation increased at a faster

rate than the foreign inflation rate, this would erode the competitiveness of the Turkish economy. This is

because the fixed exchange rate cannot respond to necessary adjustments. As a result, the credibility of the

peg declines (Ozkan, 2005).

If we look back to Figure 1.1, we see that, although the stabilization program has been successful in

quickly decreasing the inflation rate from 90% to 40%, inflation still remained above the targeted inflation

rate of the program. This became the major reason for the weakening of the competitiveness of the Lira.

Increase in the Debt Balances and Decrease in the Ability to Pay Debt

Figure 1.5 plots the total external debt balances of Turkey between 1990-1999, and it reveals an

increase in Turkey’s external borrowing. Specifically, the total gross debt of Turkey rose from $4.5 billion in

1990 to $9.5 billion in 1999. What is disconcerting is the fact that Turkey’s short term borrowing increased

drastically, not only foreshadowing problems within the banking sector but also on how Turkey’s ability to

pay back its debt was fragile and unsustainable.


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Figure 1.5 Total External Debt (US dollars in millions)

Source: Central Bank of Turkey

This can be shown by comparing Turkey’s short and long term borrowings, as presented by Table

1.5. Although both values seem to display an overall increase in 1997, there is evidence of a sharp increase in

short term borrowings. Figure 1.6 plots the distribution of short-term debt between the recipients of the debt.

The graph shows that most short-term debt was taken on by commercial banks. This evidence signals the

fragility of the banking system in the 1990s, which will be discussed in the second part of this research.


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Figure 1.6 Distribution of Short-term Borrowing (Ozkan, 2005)

Turkey’s ability to service its debts can be measured by taking the ratio between debt balance and

GDP, and the ratio between debt balance and exports. The first ratio measures the current capacity to pay

back debt in absolute amounts and the second ratio measures the capacity of the Turkish economy to

generate revenue to pay back its debts (Ozkan, 2005). Table 1.6 provides us with the aforementioned ratios

and shows alarming declines in both ratios, implying that Turkey’s capacity to service its debt was steadily

weakening. Furthermore, the table shows that the ratio between interest rates on borrowing and exports was

also increasing. This measure once again shows the heavy burden placed on foreign currency earnings,

especially in 1999 and 2000 (Ozkan, 2005).

552 F. GULCIN OZKAN


FIGURE 7

Real Exchange Rates (Unit Labour Cost-based), 1987–2001

Note:

A rise in the index denotes appreciation of the Turkish lira.

Source: OECD.

TABLE 3

Annual Percentage Change in Total Outstanding Debt

Year Change in Short-term Debt Change in Long-term Debt

1997 4.05 7.28

1998 17.56 13.27

1999 10.63 5.65

2000 23.18 11.21

2001 Q1 !7.87 !1.13

2001 Q2 2.01 0.25

Source: The Undersecretariat of Treasury at www.treasury.gov.tr

regime itself. Therefore, in what follows we present a profile of the external

borrowing structure in Turkey during the 1990s.

Table 3 presents data on the annual percentage change in the total outstand-

ing external debt by maturity since 1997, which highlights the sharp rise in

short-term borrowing over this period. Figure 9 provides information on the



FIGURE 8

Total External Debt, 1971–2001 (US dollars, in millions)

Source: World Bank (1971–1995); The Undersecretariat of Treasury (1996–2001).

FIGURE 9

The Composition of Short-term External Debt, 1990–2001 (US dollars, in millions)

Source: Datastream.


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Fragility of the Banking Sector

Turkey, as many other emerging economies, has underdeveloped bond and equity markets. Thus,

capital transactions, inflows, and outflows are mediated by the banking sector. Despite the liberalization of

Turkey’s economy, the banking system remained integral to the Turkish economy in the 1990s. Many argue

that the weakness of the banking sector was the main contributor to Turkey’s macroeconomic instability

during 1990-2000 and the stock market crash in 2001 (Ozatay and Sak, 2002, Ozkan 2005, Yeldan, 2002).

Lack of proper regulation and institutional frameworks in the banking sector was an evident problem within

the Turkish economy. (Ozkan, 2005) The lack of independence of the banking sector from the government

became the major problem of the banking sector’s framework.

Corruption and Political Favoritism

The weakness of the banking sector was largely due to the corruption endemic within state run banks.

The Turkish government used the state banks to distribute policies of preferential credits to favored groups.

As a result, banks accumulated big losses that were paid by the Treasury in the form of government securities,

thereby damaging the liquidity of these banks. An additional problem was the morally conflicting role of the

Council of Ministers. The Council of Ministers had the right to decide on the entry and exit of banks. As a

result, bank licenses were granted to politically favored individuals. And, since the political authority was

acting under the pressure of banks, it was not able to take any regulatory actions (Ozkan, 2005). It is also

important to recall the unstable political scene during the 1990s when the Turkish government was

overwhelmingly composed of coalition parties. The political authorities had high incentives to use their power

for political favoritism but no intention to apply corrective regulatory action, as it spelled short-term

disadvantages for them. These problems highlight the necessity of an autonomous regulatory body for the

banking sector.



TABLE 4

Some Fragility Measures of the External Sector

Years Debt Service/GDP Debt Service/Exports Interest on External Debt/Exports

1996 6.22 49.16 18.08

1997 6.46 47.29 17.47

1998 7.99 61.22 17.88

1999 9.89 68.89 20.50

2000 10.90 78.98 22.68

Source: The Undersecretariat of Treasury at www.treasury.gov.tr

TABLE 5

Debt Service as a Ratio of Exports, Experience

of East Asian Countries, 1996

Country Debt Service/Exports

Korea 8.80

Indonesia 36.80

Malaysia 8.20

Philippines 13.70

Thailand 11.50

Source: Corsetti et al. (1998a).

For comparative purposes, Table 5 provides the ratio of debt service to exports of

a number of East Asian countries prior to the Asian crisis. A glance at these two

tables suggests that the worsening of the external balance and the debt-servicing

ability in the pre-crisis period was much worse in Turkey than any of the troubled

Asian countries prior to their respective crises.

The above discussion of the vulnerability of the external account focused on

an evaluation of a number of separate indicators. A more appropriate way of

analysing external sustainability would be through the use of a unified measure

combining indicators of external debt burden and the health of trade balances.

One such measure has been proposed by Chalk and Hemming (2000) which is

based on the notion that external sustainability is only possible when the path of

the trade balance leads to non-increasing foreign liabilities over time.

Now consider the following relationship between net foreign liabilities and

trade balances:

(1 + q

t

)(1 + n

t

)f

t+1

= R*

t

f

t

! tb

t

(1)

where q is the real appreciation of the currency, n is the growth rate of real output, f

is the net foreign liabilities – defined as external debt minus foreign assets including


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Maturity Mismatches Between the Assets and Liabilities of the Banking Sector

Banks are defined as financial intermediaries that have mostly short-term deposits as liabilities and

loans to businesses and consumers as assets (Koch and Chaudhary, 2001). When a bank’s liabilities exceed its

assets, the bank becomes insolvent, and this was precisely the case during the 1990s in Turkey.

One key factor contributing to the insolvency of the banks was their practice of giving out short-

term credit that was funded by foreign loans. The increase in short-term borrowings by banks has already

been addressed earlier in this paper. Banks increased their consumer lending because the profitability of

holding government securities declined due to the lower interest rates offered on government securities in

2000 (Ozkan, 2005). This increase is visible in Figure 1.7 that graphs the bank lending to private sector

between 1990-2000.

Figure 1.7 Bank Lending to Private Sector (Ozkan 2005)

During the 2001 crisis, foreign creditors called their loans back due to the instability being

experienced by the Turkish economy. As a result, domestic banks increased their purchases of foreign

currency, thereby causing domestic currency reserves of Turkish banks to decrease and increasing the

pressure on exchange rates. Although the government should have closed public sector banks that were in the

red, these banks stayed open due to political reasons. Once again, the lack of an independent regulatory

authority of the banking sector caused the budget deficit by increasing the debt stock. Furthermore, increased

government borrowing from private banks also distorted the performance of private banks, since private

bank reserves failed to finance the budget deficit caused by state-run banks (Koch and Chaudhary, 2001).

566 F. GULCIN OZKAN


Such increases in foreign borrowing which was mostly short-term – as docu-

mented above – also introduced significant maturity mismatches between the

assets and the liabilities of the banking sector. In addition, banks increasingly

turned to consumer lending as the profitability of holding government securities

greatly decreased as a result of lower interest rates offered by them in 2000. This

is clearly visible from Figure 15, which plots bank lending to the private sector in

Turkey during the 1990s. This lending boom worsened the maturity mismatch

that was already growing. It is argued that banks had not developed the expertise

to deal with the resulting interest rate and exchange rate risks (see, for example,

OECD, 2001).

23

Such maturity mismatches have not prevented the already risky

banks from offering even higher deposit rates to remain in business. The overall

result was ever-decreasing profitability over 1999–2000. This can be seen from

Table 9 that presents data on loans quality and the profitability of the Turkish

banking system. It is evident that both the shares of non-performing loans in total

loans and the profitability deteriorated during 2000.

The above discussion of the increase in the banks’ foreign borrowing suggests

that there were substantial capital inflows into Turkey in the wake of the adoption

FIGURE 15

Bank Lending to Private Sector, January 1986–December 2001 (TL, in trillions)

23

In general, such exposure to exchange rate risk creates reluctance on the part of policy makers

to adjust the exchange rate since that would then destabilise the banking system as a whole. This

is a clear example for the state-dependency of preferability of a fixed exchange rate regime over

its alternatives.

Source: The Central Bank of the Republic of Turkey.


Spring 2014 14

After the liberalization of the Turkish economy in the early 1980s, Turkey has experienced several

economic crises and downturns. February 2001 was the most severe of these crises. A good understanding of

the causes behind the 2001 crisis lays out the major fractures that were present in the Turkish economy. This

crisis not only exposed the pervasive corruption present within the Turkish economy to the people of Turkey

but also to the world. Thus, we have shown that the 2001 crisis was an outcome of the combined effects of

unsound fiscal policy, corruption, government intervention in the economy, excessive debt, loss of

competitiveness of the Turkish Lira and record levels of interest payments on borrowing. Structural reform

of the financial sector was necessary not only to solve the 2001 crisis but also to put the Turkish economy on

a successful path to prevent similar crises from occurring in the future.

Part II: Inflation Stabilization Programs and the Rational Expectations Model, 2001-2006

Strengthening the Turkish Economy

The vast number of crises experienced in Turkey pre-2001 are strongly tied to poor regulation and

structuring of the public and financial sector, which were also necessarily entangled in a volatile political

undercurrent. Attempts to reconcile these crises consistently took on a neoliberal approach, which often lead

to more instability since these efforts were never properly regulated. This only served to hurt the credibility of

the Turkish government’s economic programs (Ozatay, 2002). These premature and poorly executed

implementations reveal the importance of timing in the propagation mechanism of rational expectations in

the context of rising inflation rates.

The 2001 financial crisis was no different in that it was largely a result of political uncertainty and

volatility. Six days after Black Wednesday, the government decided to float the Turkish Lira, which again shot

up the overnight inflation rate to 4024.7% (Dervis, 2003). This uncertainty created a worsening situation for

the banking system, leaving the Turkish economy in shambles. Due to the negative perception of the Turkish

economy in the global financial markets, a buffer period was necessary before a formal inflation-targeting

program could be implemented. The reforms following the 2001 financial crisis from 2002-2005 acted as this

buffer period, formally known as Strengthening the Turkish Economy (Central Bank of Turkey). The aims of this

program were to provide a strong backbone for the formal inflation-targeting program that would be

introduced in 2005. The implicit approach, introduced in 2001, emphasized balancing the budget, increasing

competitiveness and restoring faith in the market and the credibility of the Turkish economy. To do this, the

program aimed to increase transparency and accountability in resource allocation within the public sector,

strengthening and formalizing good governances to fight corruption, restructuring the banking sector and

balancing public finances by instilling macroeconomic discipline (Ozatay, 2008). These lofty goals required

frontloading structural reforms, that is, effectively implementing an abrupt regime overthrow in a timely

manner to boost confidence.


Spring 2014 15

Figure 2.1 : Annual Inflation Rate Changes, 1980-2010

As seen in the figure above, inflation peaked during the 1994 crisis and began to subside consistently

in conjunction with the liberalization of the Turkish economy, experiencing a sharp decline after the

implementation of the 2001 crisis programs, before finally stabilizing in 2005. This section attempts to explain

the necessity of an implicit inflation targeting approach before a formal targeting approach could be

introduced in 2005.

Restructuring the Public and Finance Sectors

The legal amendments necessitated a restructuring of the public sector, including state-owned

enterprises, as well as reforming the banking sector. This included the privatization of previously state owned

industries in Turkey’s economy that included civil aviation, Turk Telecom, sugar, tobacco, and natural gas

(Central Bank of Turkey). Moving forward, these industries were no longer controlled by the state, increasing

competitiveness and efficiency by relying on market prices in order to reduce waste. Lastly, there was a

complete restructuring of the banking sector, which affected the state owned Saving Deposit Insurance Fund

(SDIF) and private banks. This included consolidating and shutting down many low performing banks as well

as letting go of employees who performed repetitive jobs.


Spring 2014 16

The Banking Sector Restructuring Program was introduced in May 2001 and focused on heavily

reforming state owned banks and increasing competition. The state-owned banks needed restructuring due to

treasury debt they had accumulated, which was securitized by using government issued bonds. The state

owned banks were merged into two main banks, retrenching a lot of employees with similar responsibilities

and laying off inefficient labor in the hopes of allocating resources more efficiently (See Figure 2.2). Also, the

management of these banks was transferred to a newly appointed autonomous Board of Directors to oversee

prudence with sub-prime loans and to ensure transparency and accountability. SDIF banks underwent similar

changes that included merging banks and cutting labor, both of which that had aided the private banking

sector. This was paired with prudent capital requirements, including a strengthening of the banks’ capital base

in order to ensure their ability to pay back liabilities (Ozatay, 2008).

Figure 2.2: The decline of state-owned enterprise 1984-2010

As seen in this figure, both reforms to the private and public sector significantly reduced state-owned

enterprises and public sector employees, a trend that continued into the new millennium. This was a measure

to ensure that public and private sectors were running efficiently while aiding competition within industries

by reducing state-owned enterprises. By merging banks and cutting employees, the state increased reserves

while sacrificing employment rates.


Spring 2014 17

Balancing the Budget

Figure 2.3: Gross Government debt

Unsustainable public debt obligations skyrocketed during the 2001 financial crisis. In turn the hike in public

debt led to a higher perceived risk of default which increased the real interest rate, placed upward pressure on

the cost of borrowing and caused debt sustainability to go down (Ozatay, 2008). Thus legal reparations were

necessary in order to balance the budget. During this time, 15 budgetary funds were closed and the central

bank became completely independent in order to divorce itself from politics. To safeguard the economy from

corruption, regulatory economic and social councils oversaw the implementation of reforms in order to

increase transparency and accountability while managing public debt. During this time, exports significantly

increased, in addition to the public sector reforms mentioned earlier, which reduced the number of

government employees. This helped balance the budget by late 2006, as shown by the steady drop in gross

public debt, as shown in Figure 2.3.


Spring 2014 18

Figure 2.4: Total Exports, 1986-2006

This figure shows the steep rise in exports in conjunction with the new liberalization model of Turkey,

increasing openness to foreign trade and helping balance the budget deficit.

Formal Inflation Targeting in 2005

The buffer period directly following the 2001 financial crisis was necessary in order to restore

confidence in the market and to boost expectations by creating more transparency and accountability in

Turkish economic programs. Effectively, the implicit inflation targeting approach fully liberalized the Turkish

economy by privatizing and optimizing the public sector. In 2005, following growth in consumer confidence,

a formal inflation-targeting program was introduced. The new program acted as a more aggressive

continuation of earlier reforms

The central bank increased reserves by reforming the tax structure, i.e. collecting more taxes,

reforming agriculture programs, and social security. In 2006, the Turkish Lira was redenominated by

dropping the zeros in hopes of re-establishing credibility and improving consumer’s inflationary expectations

by making the currency more comprehensible to consumers. This practice effectively improves consumer

perceptions about future prices, which aids inflationary expectations, thereby helping stabilize price increases

(Mosley, 2005). This was done concurrently with setting new inflation targets and setting up more regulatory


Spring 2014 19

boards, including the Monetary Policy Committee, in order to increase the quality of both monetary and fiscal

discipline, transparency, and accountability.

The Role of Expectations in the Economy

The economy was stabilized after the introduction of the formal inflation-targeting program

introduced in 2005. This was only possible due to the frontloading structural reforms implemented in the

public and financial sector while simultaneously balancing the budget as Turkey fully transitioned into a

neoliberal model of monetary and fiscal policy in 2001. The introduction of neoliberal policies however

coincided with the first major crisis of 1994, and disinflation programs were rarely sustainable, leading to

more poorly implemented neoliberal policies, which perpetuated instability in the economy. Hence, after the

2001 crisis, the Turkish government first implemented an implicit inflation-targeting program that included a

strict and thorough regime change that segwayed into a formal inflation reduction program in 2005, which

truly stabilized the Turkey’s inflation rate. This implicit targeting was necessary due to the impaired credibility

of the government’s economic programs from previous crises paired with low accountability and

transparency. These structural reforms effectively depoliticized Turkey’s economy, which was often the main

source of volatility in consumer confidence due to corruption, poor regulation, and inefficient allocation of

resources in important sectors of the economy. The reforms accomplished this de-politicization by privatizing

industry, setting stricter borrowing laws, and reforming the banking sector. The reforms also coincided with a

restoration of sustainable confidence in the market, proving the effectiveness of rational expectations model.

This explains how the reform program after the 2001 crisis was a necessary buffer in order to restore

credibility and faith in the market before a strict inflation-targeting program, which finally served to stabilize

inflation. In contrast to earlier reforms, a successful stabilization program in developing countries, given

Turkey as a case study, necessarily combines a binding and abrupt regime reformation with the expectation that

is widely believed to be successful. This emphasizes both the importance of timing and credibility of a well-

implemented program.

The Rational Expectations model explains the inherent momentum of current-day inflation. That is,

consumers expect high inflation due to the government’s current and prospective monetary and fiscal policy.

It states that inflation responds slowly to isolated policy, and rather the momentum is a result of long-term

government policy of large deficits financed by printing money at a high rate. Therefore, inflation can be

stopped much more quickly than the momentum view allows as long as there exists a change in policy

regime. This needs to be an abrupt change in government policy or strategy for setting deficits now and in the

future that is sufficiently binding so that it may be widely believed (Sargent, 1981). This explains how the

stabilization in Turkey occurred so rapidly. Since the frontloading of structural reforms in Turkey included

the de-politicization of the economy, consumer confidence was positively affected by increasing the

perception of accountability and transparency. The actual effectiveness of the accountability protocol is not as


Spring 2014 20

important as the consumer perception surrounding these policies. Expectations matter so much because they

are tied to future growth; they are, however, derived from past and current perceptions.

Part III: Inflation Relation to Other Macroeconomic Variables, 2004-2010

The following section will be concerned with analyzing the relationship between inflation and other

macro-economic variables. This section provided many interesting and fresh insights into the Turkish

economy - specifically underscoring the Turkish government’s commitment to controlling inflation in the

face of both positive and adverse shocks.

Firstly, the fact that inflation remained stabilized since 2005 signaled progress in the Turkish

economy. This is important because stable price levels do not only boost consumer and investor confidence,

accelerating the success of any governmental programs to push Turkey forward. They are also an indicator

that the Turkish government had become better equipped at predicting people’s rational expectations. As

such, consumer and investor confidence along with the concept of rational expectations play a significant role

in explaining the discrepancies between our observations of the Turkish economy and those of theoretical

predictions.

Figure 3.1: Inflation/CPI and Unemployment Rate

Intuitively, inflation/CPI growth and the unemployment rate have no relation to one other.

Although higher inflation levels may correspond to lower unemployment levels in the short-run because

monetary growth does indeed have a positive effect on the economy, this does not continue in the long-run,

because by virtue of being in the long-run, variables adjust in response to the economy-wide rise in prices and

unemployment returns back to pre-inflationary levels. This theory is more commonly known as the Phillips

Curve3.

In the context of the Turkish economy, we plotted both variables on the same graph to identify if

this correlation holds from the years 1980 to 2010.

3 The Phillips Curve theory states that there is an inverse relationship between inflation and unemployment in the short run (assuming that consumers do not have rational expectations),


Spring 2014 21

Figure 3.1

As seen in Figure 3.1, there appears to be no particular correlation between inflation and the

unemployment rate from the year 2000 to 2010. Specifically, unemployment increases drastically while

inflation rate is stable around 2008, and inflation falls from 2002 to 2004 while unemployment rate is

relatively stable.

Analysis:

As per our predictions and the Phillips Curve theory, inflation/CPI growth appears to have no

correlation with the unemployment rate in the Turkish economy from 2000 to 2010 (Karahan, Colak,

Bolukbasi, 2012). Economists Ozcan Karahan, Olcay, Colak, and Omer Faruk Bolukbasi, who focused on the

Turkish Explicit Inflation Targeting Regime from 2006 to 2011 in their paper ‘Tradeoff between Inflation

and Unemployment in Turkey,’ verify this through sophisticated mathematical computations and empirical

evidence (Karahan, Colak, Bolukbasi, 2012).

For the majority of the past decade, the unemployment rate ranged from 10 to 15% of the total

Turkish labor force, as shown in Figure 3.1. This is attributed to the large-scale privatization and

consolidation of the banking and public sector, where public workers were laid off in an attempt to achieve

greater efficiency in the economy, as discussed in the previous sections. Other factors contributing to high

unemployment rates include burdensome labor regulations, such as very high tax wedges, high minimum


Spring 2014 22

wages relative to productivity and the necessity to comply with additional regulations such as quotas for

hiring disabled people, ex-convicts etc. (OECD, 2006).

Figure 3.2: Inflation/CPI and Real GDP Growth

Inflation/CPI and real GDP growth are positively correlated but not causally related. As is the

relationship between unemployment and inflation, there is a trade off between inflation and GDP growth in

the short run, as inflation spurs the economy if it is unanticipated, thereby increasing GDP. However, in the

long run, prices adjust, and GDP returns to pre-inflationary levels. Effectively, there is no causal relationship

between GDP and inflation growth.

Figure 3.2

As shown in Figure 3.2, there appears to be no particular correlation between inflation growth and

real GDP growth from 2000 to 2010. Specifically, real GDP growth declines from 2004 to 2008 while

inflation remains relatively stable.

Analysis:

In 2006, the GDP dropped drastically in response to adverse financial developments in the economy.

In fact, Turkey was one of the most adversely affected countries (Ersel, Ozatay, 2008) because foreigners


Spring 2014 23

maintained large positions in relations to the size of the local market (IMF, 2006). From May to June 2006,

there was a rise in risk aversion among investors due to a fear that “increasing commodity prices, growing

capacity utilization, and tightening labor markets” would accelerate inflation in mature markets (IMF, 2006).

Under the assumption of a closed economy without exports and imports, we would theoretically

expect an increase in inflation during a decline in real GDP growth. This is because a decline in investment

leads to a lower demand for the Turkish Lira, resulting in its depreciation, and thereby making Turkey more

vulnerable to inflation. In fact, the new Turkish Lira in particular weakened by 22% against the US dollar in

the last three weeks of May 2006 (IMF, 2006) because imports became relatively more expensive.

Nevertheless, there was no rise in inflation in 2006. This occurred because the Turkish Central Bank

responded to the sharp depreciation of the Lira and added threat to inflation by raising interesting rates,

which encouraged foreign investors to increase their savings in Turkish banks. As a result, the demand for the

Lira increased, causing its value to appreciate while successfully reigning in the inflation rate. This act

highlights “Turkey’s commitment to achieving its inflation aims” (IMF, 2006). It is also important to note,

however, that Turkey launched its full-fledged inflation-targeting program in 2006, which had further

diminished the threat of inflation.

Figure 3.3: Inflation/CPI and M1: Money Supply

Theoretically, inflation/CPI and money supply are expected to be positively correlated. This is due to

the phenomenon where there exists “too much money chasing after too few goods” (OECD, 2006).


Spring 2014 24

Figure 3.3

Comparing these two variables on the same graph between the years 1990 and 2010, there appears to

be a particularly sharp increase in M1 growth followed by a sharper decrease of it during the time period of

interest, i.e. from 2004 to 2010. On the other hand, inflation experienced small changes and remained

relatively stable.

Analysis:

The sharp rise in the growth of M1 money supply is owed to the replacement of the Turkish Lira

(The Lira) with the New Turkish Lira (YTL) in January 2005.

This change involved converting every million of the Lira to one YTL. Such a redenomination of

currency helps to restore public confidence through a purely psychological effect (Mosley,2005). This is

because the changes are nominal and hence do not have any real effects on the economy. As discussed in Part

II of the paper, low consumer confidence induces economic agents to use foreign currency, thereby

depreciating the value of the Turkish currency. In light of this and the 2001 crisis, the Turkish Central Bank

(TCB) sought to reduce Turkey’s vulnerability to potential inflationary pressures and threats by removing six

zeroes in the Turkish Lira, reassuring citizens of the Lira’s worth and restoring consumer confidence.

This new currency led to an increase in the printing of money in an attempt to replace the old Lira

bills in the economy. Interestingly, however, although money supply growth spiked in 2005 and reached its


Spring 2014 25

peak at nearly 85%, inflation growth rate remained very stable throughout these years. The success of this

redenomination lies in its timing. With the right timing, “redenomination caps off high levels of inflation”

(Mosley, 2005). The timing of the redenomination was rather appropriate in the case of Turkey, as the

consumer confidence index had been dwindling until the beginning of 2005. This is revealed by the

Consumer Confidence Graph that will be discussed next.

As for the sharp decline in M1 during 2006, we hypothesize that this was a result of measures taken

by the TCB to ensure price stability. This is because the TCB may have feared that the previous year’s

increase in money supply might have had severe inflationary implications, which could potentially be further

aggravated by the strong depreciation of Lira and the adverse global economic conditions at that point of

time. In fact, the TCB “acknowledged that the 2006 year-end inflation target of 5% (with an uncertainty band

of +/-2%) would not be achieved (OECD, 2006). Hence, the large decline in money growth may have been

in reaction to this expectation or could be seen as a measure that would contain this deviation. One of the

ways in which the TCB went about to reduce the rate of M1 growth was “by abandoning its previous course

of interest rate cuts and raising the short-term policy rate in three consecutive rounds by a total of 425 basis

points, pushing the short-term interest rate up to 17.50%” (OECD, 2006). Higher interest rates correlate with

lower M1 growth rate because higher interest rates encourage savings. This in turn leads to a reduction in the

money multiplier effect4.

Figure 3.4: Inflation/CPI and Consumer Confidence Index

Theoretically, inflation/CPI and consumer confidence are expected to be positively correlated with a

time lag. This suggests that higher GDP, characterized by high inflation, also boosts consumer confidence.

4 According to Investopedia, the money multiplier effect is the expansion of a country's money supply that results from banks being able to lend.


Spring 2014 26

Figure 3.4

Juxtaposing both variables on the same graph between the years 2004 and 2012, however, reveals a

negative correlation between inflation and consumer confidence in the context of the Turkish economy. This

could be due to Turkey’s history of consistently high inflation that undermined the political credibility that the

Turkish government and the TCB tried to build.

Analysis:

Figure 4 demonstrates significant fluctuations in consumer confidence between the years of 2004 and

2010: From 2005 to 2007, consumer confidence was rising; from 2007 onwards, consumer confidence fell

sharply.

The reason consumer confidence rose from 2005 to 2007 was the redenomination of the Turkish

Lira in January 2005. As explained in the M1 analysis, this rise in consumer confidence was a manifestation of

consumers’ psychological expectations.

From 2007 to 2008, the large decline in consumer confidence could be attributed to the Turkish

government’s announcement that it had missed its inflation target of 5% (OECD, 2006). This corresponds to

the increase in inflation. While the concept of rational expectations is one of the main factors behind

consumer confidence, other factors such as political instability and terrorism adversely affect consumer

confidence too. In the context of Turkey, these factors include concerns regarding national elections and a

bomb blast in Ankara that claimed 6 lives (BBC, 2012).

Interestingly, during the 2008 global financial crisis, Turkish consumer confidence rose tremendously

until year 2010, exhibiting positive indices throughout. This restoration of consumer confidence stands as


Spring 2014 27

measure and witness of the 2001 implicit and 2005 full-fledged disinflationary programs’ successes. While

much of the world struggled to adjust and combat the economic crisis, Turkey coped relatively better. The

principal reason was due to policies and initiatives that Turkey implemented, which managed to restore

consumer confidence and eventually curb inflation.

It is also important to note that, recently, consumer confidence has recently declined. As of the end

of 2012, it was at approximately 0.1. There is a lesson to be gained from this: Striving to increase consumer

confidence is insufficient. Concerted efforts are also needed to further cushion the economy from unforeseen

shocks.

As shown by the analysis above, it is challenging to determine a conclusive correlation between

consumer confidence and inflation. This is because consumer confidence is significantly shaped by other

exogenous factors such as political developments.

Figure 3.5: Inflation/CPI and Net Government Debt (% of GDP) & Figure 3.6: Gross External Debt

and National Debt

Theoretically, inflation and debt are positively correlated because debt is usually financed by the

printing of money. Hence, higher debt corresponds to higher money growth and, by extension, higher

inflation growth rates.

Figure 3.5


Spring 2014 28

This hypothesis is confirmed in the context of the Turkish economy between the years of 2001 and

2010: A steep decline in net government debt (from 75% of GDP in 2001 to approximately 35% in 2010)

corresponds to a large decline in inflation growth.

Figure 3.6

Upon further examination of Turkey’s local and external debt, we find that they are negatively

correlated, particularly so between 2008 and 2012. There are various possible reasons behind these trends,

which we explain and analyze in the Discussion section.

Analysis:

With regards to Figure 5, the positive correlation between net government debt and inflation reflects

the fiscal restraint that the TCB exercised as a part of the structural reforms it pursued in the wake of the

2001 crisis. These reforms involve strictly refraining from printing money in order to enhance the

effectiveness of its disinflationary program.

The negative correlation between Turkey’s local and external debt in Figure 6 suggests that Turkey

may have been financing its debt by borrowing from international agencies such as the IMF. The decline in

local debt further underscores Turkey’s fiscal restraint and commitment to the structural reforms proposed by

Dervis. Moreover, while growing international debt may have its adverse implications, analysis of these

implications on the Turkish economy is beyond the scope of this research. In spite of the increase in

international debt, it is important to note that, in May 2013, Turkey paid its last loan installment to the

International Monetary Fund (Bloomberg, 2013).


Spring 2014 29

Is Everything As Good As It Seems?

While Turkey has been successful in combating inflation, restoring consumer confidence and

simultaneously ensuring economic growth, is everything as good as it seems?

Upon studying the above graph of income share held by different income groups, categorized in 20

percentiles, it seems that there is a wide disparity in Turkish society. The majority of the income share is

captured by the top 20% group, while the second 20% holds merely around 12% of the income share. The

last 20% has minimal access to income share in the Turkish economy at approximately only 6%. Although

over the years the share of income held by the top 20% has been declining and that held by the other 20%

groups has been rising, the move has been slow.

With regard to other socio-economic indicators, it appears as though one of the most pressing issues

faced by Turkey is the treatment of women and their participation in both politics and the labor force. This

can be owed to patriarchal and cultural factors inherent within the Turkish society (Kasapoglu and Ozerkmen,

2011). Domestic violence in particular seems to be a dominant issue in Turkish society, where police and

courts regularly fail to protect women who have applied for protection orders under the Family Protection

Law (Human Rights Watch, 2012) Another equally pressing issue is the restricted degree of political and

economic freedom in Turkey, and this has manifested itself in the recent protests that have rocked Turkey’s

capital, Istanbul, and the government’s aggressive response to these protests. Now that Turkey has


Spring 2014 30

successfully subdued the threat of high inflation rates and dwindling consumer confidence, it should focus on

other parameters of welfare in order to fit the bill of a truly robust economy.

Conclusion

After the liberalization of the Turkish economy in early 1980s, Turkey has experienced several

economic crises, the most severe crisis occurring in February 2001. We have shown that the 2001 crisis was

an outcome of the combined effects of economic factors, unsound fiscal policies and structural problems in

the banking industry. This led to a lack of confidence in Turkish economic programs and thus structural

reforms were necessary in an attempt to restore faith in the market. The period directly following the 2001

crisis from 2001-2005 saw the advent of a targeted approach to inflation by heavily reforming the

infrastructure of monetary policy with a focus on restructuring public and financial sectors and balancing the

budget. Implicit in these reforms were measures to increase transparency and accountability of the

government while increasing competition, thus restoring consumer confidence. After this buffer period, the

formal inflation targeting approach was implemented in 2006, which was a continuation of the programs

from 2001, finally stabilizing the inflation rate. This shows the mechanism of the rational expectations model

and how consumer confidence propagates inflation. The success of inflation stabilization can also be owed to

the government’s opportune implementation of its policies and, more importantly, the government’s and

Central Bank’s fiscal discipline and exemplary commitment to its policies in the face of many adversities.

However, now that inflationary pressure has been successfully managed, the Turkish economy should address

other pertinent issues such as high unemployment and other socio-economic factors such as human rights.

Addendum: The Way Forward for Turkey

Turkey’s ability to remain relevant in the future depends considerably on the perception of

sustainability of economic programs, emphasizing the rational expectations model. There are, however,

sufficient reasons to be optimistic about this issue. Having successfully stabilized the inflation rate in Turkey,

future strategies of the Turkish government should place more emphasis on maintaining consumer

confidence, not merely increasing it.

As seen from the graph below, future inflation targets appear stable at approximately 5%. This

suggests that Turkey’s inflation-stabilizing program has been successful in the past and it will continue to

strengthen in the future.


Spring 2014 31


Spring 2014 32

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