The Turkish Currency Crisis -A Balance Sheet Effect Framework-

1. The Turkish Currency Crisis-A Balance Sheet Effect Framework- • Place of the Turkish Crisis within the currency crisis framework • Introduce a third generation model based on balance sheet effects of devaluations • Empirically test the model in Turkey’s case • Learnings for the exchange rate policy in emerging economies

2. Perspective on Currency Crisis Models Literature • First generation models – Irresponsible government policies • Second generation models – multiple equilibria • Third generation models • Excess borrowing • Bank run models • Balance sheet effects

3. First Generation Models • Krugman (1979), Flood&Garber (1984), starting from commodity price fixing models • The crisis is a consequence of the government’s pursuit of leverage leading to foreign reserves depletion • Through backward induction, the timing of the attack is the moment when the shadow price exceeds the peg parity • The crisis is the only outcome possible, given government’s policies

4. Second Generation Models • Obstfeld (1994), as first generation models failed to explain the EMS crisis • The peg is abandoned by a rational government unwilling to sustain it, although it might have been able to keep it • Continuous assessment of the cost of maintaining the peg vs. the cost of removing the peg • Expectations of the peg being abandoned in the future increase the cost of defending the peg, leading to MULTIPLE EQUILIBRIA

5. The Need for a New Generation of Crisis Models • The SE Asia crisis has revealed the need for a new framework for looking at currency crisis • Neither first, nor second generation models provide a rationale for the fall in output after the crisis has occurred • The central role the financial system played in the crisis, leading to the concept of “Twin Crises”

6. Third Generation Models • Excessive lending caused by implicit government guarantees (Krugman 1998, Corsetti, Presenti, Roubini) • The governement assesses the costs of making good/defaulting on its guarantees, a la second generation models • Sachs and Radelet – model of financial fragility • The currency crisis is, in fact, an international banking crisis • Balance Sheet Effects Model by Krugman 1999

7. The Balance Sheet Effect Model of Currency Crisis

8. The Classical Mundell Flemming Framework • (1)   y=d(y,i) + NX(eP*/P,y) • (2)   M/P=L(y,I) • (3) i=i*

9. The Balance Sheet Effect of Domestic Currency Devaluation • Firms have debt denominated in hard currency while their revenues are denominated in local currency • A domestic currency real depreciation will thus deteriorate the firm’s balance sheet • High net worth is essential in obtaining financing because of asymmetrical information • Investment projects are assessed based on their hard currency-returns

10. Effects on Output of a Domestic Currency Depreciation Induced by the Balance Sheet Effect • Contractionary effect in the middle of e ranges • The balance sheet effect fades for extreme e values (both favorable and unfavorable) • The effect on output does not depend on the maturity of the foreign currency denominated debt

11. The Crisis Mechanism • An expected real devaluation translates into an expected fall in output • An expected fall in output makes domestic assets unattractive and leads to a flight of funds • The flight of funds fulfills the expectations of devaluation

12. Mundell Flemming Framework with Balance Sheet Effect • (1’) y = d(y,i,eP*/P)+NX(ep*/P,y) • (2’) M(e)/P=L(y,i) with M decreasing in e –Central Bank’s fear of floating • Where d(y,i,eP*/P) is a decreasing function of eP*/P

13. Macroeconomic Developments in Turkey in the Pre-Crisis Period • External debt of private sector increased more than 10 times since 1987 and more than 3 times vs. the 1994 crisis level, reaching 12% of GDP • M3/M1 ratio tripled vs. 1994 – development of the financial sector • Stock market index drop of 50% between April and September 2000 • A banking crisis in November 2000 • Central Bank foreign reserves increased 12 times vs. 1987 and three times vs. 1994 crisis level • Domestic credit by the central bank eliminated end 1999 (IMF stabilisation agreement) until November 2000 (failing banks bail-out) • Continuous real appreciation of the Lira with the exception of the 1994 crisis

14. Empirical Testing of the Balance Sheet Effect in the Case of Turkey

15. The Variables • Investment – as measured by the gross capital formation • HCPI= (CPIt/CPI0)/(et/e0) - hard currency price index • economic significance = the degree to which domestic firms are able to price-up for the depreciation of their national currency - “Moral Dollarisation” • Q1,Q2,Q3 – quarterly dummies • C - free term

16. Dependent Variable: DINVEST Method: Least Squares Date: 07/02/01 Time: 22:44 Sample(adjusted): 1987:2 2000:4 Included observations: 55 after adjusting endpoints White Heteroskedasticity-Consistent Standard Errors & Covariance Variable Coefficient Std. Error t-Statistic Prob. C -0.476791 0.143641 -3.319324 0.0017 DHCPI 2.950792 0.789090 3.739486 0.0005 Q1 -1.087536 0.225829 -4.815756 0.0000 Q2 1.874560 0.253766 7.386952 0.0000 Q3 1.208776 0.162309 7.447368 0.0000 R-squared 0.831850 Mean dependent var 0.096607 Adjusted R-squared 0.818398 S.D. dependent var 1.228359 S.E. of regression 0.523462 Akaike info criterion 1.629803 Sum squared resid 13.70062 Schwarz criterion 1.812288 Log likelihood -39.81958 F-statistic 61.83852 Durbin-Watson stat 2.022949 Prob(F-statistic) 0.000000 Estimation Output

17. Interpretation Estimation Command: ===================== LS(H) DINVEST C DHCPI Q1 Q2 Q3 Estimation Equation: ===================== DINVEST = C(1) + C(2)*DHCPI + C(3)*Q1 + C(4)*Q2 + C(5)*Q3 Substituted Coefficients: ===================== DINVEST = -0.4767909993 + 2.950791862*DHCPI - 1.087535506*Q1 + 1.874559665*Q2 + 1.208775582*Q3 • The variation in investment is positively correlated with the variation of HCPI • As real e is the inverse if HCPI, real e movement will be negativelly correlated with investment, as suggested by the model

18. Conclusions • The Balance sheet effect is validated empirically in the case of Turkey • We can expect a fall in investment induced by the February devaluation

19. Lessons for other countries • An expansionary policy of real depreciation will work only if the external financing of the private sector is not important