Financial crises in emerging markets

Contents

List of Tables

1 The Issue

2 Financial Crises in Emerging Markets: A Basic Theoretical Framework
2.1 Emerging Market Economies
2.2 Financial Crises in Theory

3 The Turkish Case
3.1 Prior to the Crisis: The Economical Background
3.1.1 Financial Liberalization
3.1.2 The Banking Sector
3.1.3 The International Monetary Fund and Desinflation Efforts
3.2 Februay 2001: The Crisis
3.3 The Aftermath of the Crisis

4 Conclusion

References

List of Tables

1 Net Private Flows to Emerging Market Economies

2 Budget Deficit and Transfer Payments

3 Selected Economic Indicators

1 The Issue

The increase in capital mobility is expected to serve the intergration of emerging markets like Turkey into the international financial community, by providing new sources of investment in those markets. The arguments in favor of capital mobility and flows to developing or emerging market economies are mainly based upon the neoclassical theory. At the aggregate level, capital movements from developed to developing countries are said to improve the efficiency of world resource allocation. Opening the door to the pool of global capital, is said to increase foreign investment and result in an expansion of aggregate income, which then raises domestic savings and domestic investment and thereby creates a cycle in which there is sustained economic growth. Financial integration, so to say, serves the link between local savings and investment as well as it may provide indirect benefits due to reform programs such as banking sector regulations, tightened macroeconomic policies, and a strengthening of the domestic financial market.

But while international capital offers major benefits to the recipient economies, it also barries significant risks. These risks lie in the violability of potential reversals of investments and capital flows, the sensivity to herding effects, and in the increasing dependency on external events associated with the international environment.

Albeit all the efforts to intergrate emerging markets smoothly into global financial markets, many of the emerging market economies have experienced severe financial crises during the 1990’s. Mexico in 1994, Thailand, Indonesia and South Korea in 1997, Russia and Brazil in 1998, Argentina in 2000 and in February 2001, Turkey.¹

Particularly in the aftermath of the Asian crisis of 1997, widespread concerns about financial integration have been marked by many political and academical observers. Because the experienced large scale financial crises, heavily disrupted the flow of loans to domestic households and enterprises, reduced domestic investment and consumption, and by undermining confidence in domestic financial institutions, they caused a decline in domestic savings and, eventually, resulted in massive capital outflows. Leaving illiquid economies behind. The integration of emerging markets into international financial markets, therefore, must be viewed as a double-edged sword: indeed, the access to international capital may provide opportunities of economic growth , but it also carries risks, which, according to Dornbusch (2001), in many cases far outweigh its benefits.

The 2001 financial crisis in Turkey, has a number of features in common with other crises in emerging markets that implemented exchange rate based stabilization programs. Such programs typically use the exchange rate as a credible anchor for inflationary expectations. But in order to fight inflation by using an exchange rate anchor, a country needs to attrack foreign capital, which often necessitates higher domestic interest rates then those, implied by the foreign interest rate and the expected rate of depriciation. Such policies are therefore likely to rely on speculative short term capital inflows, attracted by arbitrage opportunities, to finance their growing public external deficits. We will see that the Turkish financial markets became more and more dependent on these short term capital inflows, since Turkey started to liberalize and integrate into international financial markets in the early 1980’s. Thus, the case of Tu¨rkey provides a helpful historical example to understand the causes and triggering mechanisms of a financial crisis in a country that is in transition, meaning, it is in process of deepening its economic and financial integration with global markets.

This paper attemps to picture the economical background of Turkey prior to the 2001 crisis, and then analyze the main characteristics of environment in which such a large scale financial crisis could break out. The following section will firstly introduce an overview of the basic theoretical literature on financial crises in emerging markets, as this may contribute towards a better comprehension of the economical interrelations of the theoretical framework in which the Turkish financial crisis is embedded. Section 3, then, provides the Turkish case in detail. To familiarize the reader with the economical and political enviroment in which the crisis could occur, the first subsection will provide a brief account of the Turkish economy prior to the crisis, special emphasis will be on the financial liberalization proccess and the resulting changes in the banking sector. The tide of events of the crisis itself as well as its economical consequences and policy responses are part of the second and third subsection respectively. The paper will be concluded by summing up the essential causes and main characteristics of the crisis and an attempt to assign its place in the theoretical framework.

2 Financial Crises in Emerging Markets: A Basic Theoretical Framework

2.1 Emerging Market Economies

Before presenting a basic theoretical framework of financial crises in emerging markets, it might be usefull to shed light on what is ment by an emerging market. The term emerging markets was introduced in 1981 by Antoine van Agtmael², it defines an emerging, or developing, market economy as an economy with low to middle per capita income according to the World Bank classification system.³ Such countries constitute approximately 80 percent of the global population, but currently represent only about 20 percent of the world economy.

Emerging market economies are considered as in transitionan, in a meaning that they are in the process of moving from a closed to an open market economy. Unappropriate banking regulations and supervision, uneffective legal systems, and high volatility in the exchange and growth rates are key characteristics of these markets. Governments of emerging market economies along with international institutions like the World Bank and the International Monetary Fund therefore encourage policy reforms and stabilization programs. These programs are typically designed to guide the economies to stronger and more competitive economic environment and to higher transparency and efficiency in the functioning of their financial markets. The recommendations for financial infrastructure mainly focus on the creation of competent regulatory institutions and are commonly implemented together with pegged or targeted exchange rate regimes to give a stabilizing anchor to their infant financial institutions.

The increasing integration of emerging markets into the pool of global capital over is shown in Table 1. Net private capital flows to emerging markets have increased by a factor of ten since the 1990’s and were about 502 billion US Dollars in 2006. This very well reflects the growing dependancy on foreign capital flows for emerging market economies and simultaneously the increasing importance of these economies in the financial community. According to Agtmeal (2007), nearly one of ten of Fortune magazines current leading 500 global corporations came from emerging markets in the year 2007. In general, it can be held that what is and what is not an emerging market depends rather on the maturity of its institutions, then on the size of the economy or per capita income.⁴

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Table 1: Sour ce: Institute for International Finance.

2.2 Financial Crises in Theory

The question what causes financial crises in emerging markets, had been in focus of a large number of contributions in international economics. One of the first to bring that topic into the spotlight was Paul Krugmann (1979).⁵ In his model, which later has been called the first generation model, he focuses on inconsistencies between an exchange rate peg and domestic economic fundamentals, such as excess creation of domestic credit, typically caused by fiscal imbalances and inconsistent macroeconomic policies. According to his model financial crises necessarily occur in countries with a pegged exchange rate regime. Liquidity problems, triggered by a speculative attack against the currency: if a devaluation is expected to occur soon, both foreign and domestic depositors rush to withdraw their bank deposits and convert them into foreign currency deposits abroad and thus accelerating the speed of devaluation and forcing the central bank to illiquidity as it has to sell out its foreign currency reserves. The model fixes the timing of a speculative attack. The Time the atack occurs are at the point were the remaining reserves before the attack are just enough to satisfy the foreign currency demands of market participants during the attack.

Obstfeld (1986) among others, describe financial crises as shifts between multiple monetary equilibria, occuring in response to a self fulfilling speculative attack. In their model, the shift in expectations of the market participants, may have been independet of the soundness of fiscal imbalances and inconsistent macroeconomic policies, but may reflect arbitrary and unpredictable factors. Herding effects then, intensify such events, as with imperfect information one investor might follow another one, if he is believed to have superior information. A shift in expectations can, therefore lead to a bank run or an exchange rate devaluation that otherwise might not have occurred. The timing of the attack can no longer be determined, as it is no longer unique. In these so called second generation models financial crises can take place even though the current policies are not inconsistent with the exchange rate peg.⁶ Attacks on the currency can still be successful because the costs of maintaining a currency peg, in form of high domestic interest rates, rises in response of the attack. In times of economic slowdowns, high interest rates become more and more problematic for the governments and speculative attacks become more likely. Chang and Velasco (1998) emphazise the threat due to a weak domestic banking sector, particularly in emerging market economies. Although banks may take advantage of the interest rate and risk differentials in the domestic market, they have to lend long term, making them subject to bank runs as they may not hold suffcient foreign exchange to cover all their liabilities. Raising interest rates increases short term funding costs for banks, whereas the higher proceeds from loans on the other hand might be dubious due to the on average longer maturity of loans relative to deposits, and the increasing share of bad loans during an economic slowdown.

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¹ Prior to the 2001 crises, Turkey experienced several financial crises in the early 1980’s as well as in the 1990’s.

² Antoine W. van Agtmael was deputy director of the capital markets department of the World Bank’s International Finance Corperation when he came up with the phrase emerging markets during an investor conference in Thailand, saying ”People looked down upon the Third World. It sounded so distasteful. I felt we had to use a more uplifting term”.

³ A Table of all World Bank member economies with a population above 30.000 and their income classification can be seen in the World Bank World Development Report (2002), p.241.

⁴ See van Agtmael (2007), for a discussion on the change in the definition of emerging markets, and an analysis on their increasing share of global gross domestic product.

⁵ A detailed discussion of the generation models can be, for example found in Krugman (1979), for the first generation model; Obstfeld (1986) for the second generation model; Chang and Velasco (2001) for the third generation model.

⁶ During the years 1992 and 1993, for example, some European countries faced speculative pressures on their exchange rates pegs to the Deutsche Mark. At that time, these countries had stable foreign exchange reserves and in some cases at least, such as France, macroeconomic policies, which were not obviously inconsistent with the stability of their currencies against the Deutsche Mark.