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Turkey's troubles

In the past, a number of Turkey,s economic reform programs didn,t work out because of a failure to fix the banking problems," says Bill Rhodes, who ought to know.

In the past, a number of Turkey,s economic reform programs didn,t work out because of a failure to fix the banking problems," says Bill Rhodes, who ought to know.

By Deepak Gopinath
January 2001
Institutional Investor Magazine

In the past, a number of Turkey's economic reform programs didn,t work out because of a failure to fix the banking problems," says Bill Rhodes, who ought to know. Last month the Citibank vice chairman presided over a hastily called meeting in New York of creditors to that nation's banks, in an effort to cobble together a liquidity lifeline as panicked investors pulled funds from the country. A few days later a $1 billion, 11-bank loan, co-led by Citi and Deutsche Bank, one of Turkey's biggest creditors, was signed in London.

The loan followed a rapidly assembled $10.4 billion bailout package announced on December 6 by the International Monetary Fund. Though that agreement boosted investor confidence, its funds were earmarked for the central bank's reserves , to be used to support the Turkish lira, not to bolster financial system liquidity. As part of the IMF deal, Turkey agreed to jump-start its privatization program and to clean up the banking sector by, among other measures, selling banks under government management.

"The Turkish program with the IMF is a good one because it puts emphasis on accelerating privatizations and also tackling the banking problem in a timely fashion," says Rhodes. "Today the government understands the need for a safe and sound banking system."

The Turkish crisis erupted after many of its banks got caught on the wrong end of highly leveraged bets. The banks had been gambling on the success of the country's disinflation program, borrowing short on both local and international markets and investing long in Turkish government securities, setting up currency and maturity mismatches. The bet worked until late

November, when banks cut credit lines to Demirbank, a medium-size Turkish institution, worried that it, like ten banks already in receivership, might be insolvent or illiquid. Demirbank was forced to sell Treasury bills to raise cash. Concerned international banks pulled out of the overnight market, sending interest rates soaring to nearly 2,000 percent, which increased banks, funding costs and eroded the market value of the securities they owned. The market seized up as investors rushed into dollars, sparking a run on the currency.

The central bank rushed to provide liquidity, temporarily suspending an IMF-imposed policy that put a cap on the central bank's net domestic assets. But to no avail. Between November 20 and 30, when the central bank returned to its monetary policy rule, it lost $7.2 billion in reserves.

The government seized Demirbank, promising to accelerate the privatization of Türk Telekomünikasyon and Turkish Airlines while enlisting IMF backing. U.S. Treasury Secretary Larry Summers, statement that "Turkey's financial stability

is important to the U.S." helped calm the markets. By mid-

December overnight interest rates had dropped to 60 percent, and more than $1.5 billion had returned to the economy.

Turkish central bank governor Gazi Erçel, who made urgent trips to Frankfurt and New York to line up support, takes pains to downplay the crisis. "The plane was flying in very clear air when it hit turbulence," he says. "I hope we do not hit that type of clear-air turbulence, because at the initial stage the airplane starts to fall." But, he adds, "no airplane has crashed because of that. The pilot can control the plane and continue."

It's still not all blue skies for Turkey. Interest rates remain high, the banking system hasn,t completed deleveraging, and the country remains vulnerable as long as it uses a pegged exchange rate to anchor its disinflation program.

"I expect the [IMF] package to be reopened," predicts Mohamed el-Erian, an emerging-markets fund manager at Pacific Investment Management Co. "The government will probably have to revisit the use of the exchange rate as a nominal anchor and revisit the amount of funding available to Turkey."

Erçel disagrees. "The sole and only instrument in our hands to build confidence is the continuation of our disinflation program," he says. "Turkey has enormous positive potential. We have a market-oriented economic system, we are important geopolitically and connected with the European Union, and Turkey is not a balance-of-payments-crisis-type country."

Despite his optimism, Erçel admits that managing the exchange rate arrangement is a problem for emerging-markets countries. "The best alternative for Turkey is to join the EU and the European monetary union and then get rid of that kind of exchange rate management responsibility to the hand of the European Central Bank."