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Brookings Trade Forum 2002 (2002) 121-160

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Banking Sector Fragility and Turkey's 2000-01 Financial Crisis

Fatih Özatay and Güven Sak
Central Bank of Turkey and Ankara University

[Comments and Discussion]

The Turkish economy was hit by two crises in the last decade. The first one, which attracted surprisingly limited international interest, occurred at the beginning of 1994, at which time there was a managed float. 1 The second crisis, preceded by financial turmoil, eruptedin the second half of November 2000 in the midst of a stabilization program based on the exchange rate. In response to the turmoil, a new letter of intent was presented to the International Monetary Fund (IMF) by the government, which calmed market pressure. However, at the end of December average interest rates—both the overnight and secondary market bond rates—were almost four times higher than levels at the beginning of November and more than five times higher than the preannounced (at the outset of the 2000-02 program) year-end depreciation rate of the lira. This unsustainable situation ended on February 19, 2001, when Prime Minister Bülent Ecevit announced that there was a severe political crisis (without naming a specific cause), which had ignited an equally serious economic crisis in the highly sensitivemarkets. The markets were already jittery due to what had happened at the end of the preceding year. On that Februaryday,overnight rates jumped to unprecedented levels of 6,200 [End Page 121] percent in uncompounded terms. Three days later the exchange rate system collapsed, and Turkey declared that it was going to implement a floating exchange rate system.

The crisis of 2000-01, which was more severe than that of 1994, raises a multitude of questions. What were the reasons behind the events of 2000-01? Why did the crisis erupt in the midst of the IMF-supported stabilization program? What are the lessons that can be drawn? By answering these questions, this paper concludes that the root cause of the crisis was the combination of a fragile banking sector and a set of triggering factors that made this fragility crystal clear.

The banking sector's weakness is noted in other studies of the recent Turkish crises. Akyüz and Boratav point to shortcomings in the design of the 2000-02 stabilization program and the inadequacy of crisis management policies. 2 They emphasize the dependence of the banking sector's earnings on high-yielding Treasury bills, thus renderingthis sector highly vulnerable to disinflation. They further argue that since much of the fiscal adjustment was predicated on declines in nominal and real interest rates, the program was not compatible with this feature of the banking system. Alper focuses on the events that occurred at the end of 2000. 3 He argues that three factors were responsible for the crisis: the inability of the Turkish government to maintain the stream of good news and sustain capital inflows; not enough backing for the IMF program; and the "no sterilization" rule of the program, which led to interest rate undershooting in the first phase of the 2000 program. The banking sector's fragility is a major theme of the analysis presented in Alper's work.

Unlike the two studies mentioned above, this paper analyzes the structural characteristics of the Turkish banking system and provides a precise definition for banking sector fragility in the context of Turkey right before the crisis. This paper demonstrates that pressure in the markets increased at the end of 2000. It shows that although the macroeconomic fundamentals were rather weak in 2000, the prerequisites of the first-generation crisis models were absent (see table 1 for descriptions of crisis model features). The role of self-fulfilling prophecies is discussed, and an analysis of the performance of the economy in the aftermath of the crisis is presented.

Was the principal cause of the Turkish crisis a prospective deficit associated with implicit bailout guarantees to a failing banking system? Or was the root cause of the problem financial fragility in the banking sector in the...