Download global financial crisis and its effects on turkey

GLOBAL FINANCIAL CRISIS AND ITS EFFECTS ON
THE TURKISH ECONOMY
Küresel Finansal Kriz ve Türkiye Ekonomisine Etkileri
ÖZ
Araştırmanın Temelleri: Finansal istikrarsızlık kuramları, gelişmekte olan ülkelerde meydana gelmiş finansal krizler,
2008 küresel finansal krizi ve bu krizin Türkiye ekonomisine etkileri.
Araştırmanın Amacı: Gelişmekte olan ülkelerde meydana gelmiş finansal krizleri ve 2008 küresel finansal krizini
finansal istikrarsızlık kuramları ışığı altında değerlendirmek ve 2008 finansal krizinin Türkiye ekonomisine etkilerini
tespit etmek.
Veri Kaynakları: Literatür taraması yapıldı. Finansal istikrarsızlık kuramları ve gelişmekte olan ülkelerde meydana
gelmiş finansal krizler hakkında kitaplar, makaleler, raporlar ve konferans notları kaynak olarak kullanıldı. Veri elde
etmek için internet taraması yapıldı. İkincil veri kullanıldı.
Ana Tartışma: Gelişmekte olan ülkeler, 1990’lı ve 2000’li yıllarda finansal istikrarsızlıklar ve krizler yaşadılar. Bu
finansal krizler, hızla reel ekonomiye sıçrayarak ağır makro ve mikroekonomik problemler yarattılar. 2008 küresel
finans krizi gelişmekte olan ülkeleri finansal krize sürüklemektedir. Finansal istikrarsızlık kuramları, gelişmekte olan
ülkelerde yaşanmış finansal krizler ve 2008 finansal krizi hakkında son derece değerli bilgiler sağlamakta ve küresel
finansal krizin gelişmekte olan ülkeler üzerindeki etkilerini tahmin etmemize yardımcı olmaktadırlar.
Sonuç: Finansal istikrarsızlık alanında yapılmış teorik ve ampirik çalışmalar, 2008 finansal krizinin gelişmekte olan
ülkeleri finansal krize sürükleyebileceğini göstermektedir. Özellikle, yüksek cari açık, aşırı değerlenmiş para, yüksek
dış borç, finansal piyasalarda düzenleme ve denetim eksikliği ve döviz cinsinden kısa vadeli borcun döviz rezervlerine
oranının yüksekliği gibi faktörler gelişmekte olan ülkelerin finansal krize girme olasılığını arttırmaktadırlar.
Anahtar Kelimeler: Finansal istikrarsızlık kuramları, finansal krizler, gelişmekte olan ülkeler, küresel finans krizi,
Türkiye.
ABSTRACT
Bases of Research: Theories of financial instability, financial crises in developing countries, global financial crisis of
2008 and its effects on the Turkish economy.
Purpose of the Research: To evaluate financial crises in developing countries and the global financial crisis of 2008
under the light of theories of financial instability and to determine the effects of the financial crisis of 2008 on the
Turkish economy.
Resources of Data: Literature review was made. Books, articles, papers, conference notes about the theories of
financial instability and financial crises in developing countries were used as sources. Internet search was also
conducted to obtain data. Secondary data was used.
Main Discussion: Developing countries experienced financial instabilities and crises in the 1990s and 2000s. These
financial crises created serious macro and microeconomic problems by quickly spreading to real economies. Global
financial crisis of 2008 has been dragging developing countries into financial crises. Theories of financial instability
provide invaluable information about the financial crises in developing countries and the global financial crisis of 2008
and help us to estimate effects of the global financial crisis on developing countries.
Conclusions: Theoretical and empirical studies about financial instability indicate that the global financial crisis of
2008 can drag developing countries into financial crises. Particularly, factors such as high current account deficit,
overvalued currency, high foreign debt, lack of regulation and supervision in financial markets, and high ratio of
foreign exchange short-term debt to foreign exchange reserves increase the possibility that developing countries enter
into financial crises.
Key Words: Theories of financial instability, financial crises, emerging countries, global financial crisis, Turkey
1. INTRODUCTION
In March 2008, the Federal Reserve Bank of the U.S. extended a $55 billion loan to
JPMorgan to save the investment bank Bear Stearns from bankruptcy. Then, the U.S. government
imposed a conservatorship on the private mortgage giants Fannie Mae and Freddie Mac by
extending an unlimited credit line. Lehman Brothers, with assets around $600 billion, declared
bankruptcy in September. Merrill Lynch was taken over by Bank of America. Washington
Mutual, country’s largest savings bank, was put into receivership. The Federal Reserve took 80
per cent stake in the world’s largest insurance company, AIG by giving it an $80 billion loan to
prevent a series of defaults in the financial derivatives, which are described as “financial weapons
of mass destruction”.
Financial crisis quickly spread to developed and developing countries all around the
world. Turkey was one of these countries. Turkish stock exchange dropped, Turkish Lira
depreciated more than 20 per cent against dollar, and industrial production fell more than five per
cent.
What happened? How did the only superpower of the world come to the brink of
economic collapse? And what will happen next? In this paper, financial crises in emerging
countries and current global financial crisis will be examined under the light of theories of
financial instability. Effects of the current financial crisis on the Turkish economy will be
investigated. In Section 2, theories of financial instability will be explained. In Section 3,
financial crises in Mexico, Argentine, Indonesia, Malaysia, Philippines, Thailand and South
Korea will be examined. In Section 4, financial crises in Turkey in 1994, 2000 and 2001 will be
compared with the financial crises in other emerging countries. In Section 5, development process
of current financial crisis will be explained. In Section 6, scenarios about the future of the U.S.
and global economic system will be built. In Section 7, effects of current financial crisis on the
Turkish economy will be investigated.
2. THEORIES OF FINANCIAL INSTABILTIY
Factors that led to financial instabilities and crises in developed and developing countries
were examined from different perspectives and various theories were constituted. Different
aspects of these theories may be useful to understand the global financial crisis of 2008 and its
potential effects on the Turkish economy.
According to monetarist perspective, because of the importance of money markets in
financial systems, fluctuations in money supply affect the financial system directly. Policy errors
of monetary authorities create fluctuations in money supply that lead to financial instabilities.
Regime shifts of monetary authorities, unlike the business cycles, make in advance risk-pricing
impossible. Bank failures lower confidence to the financial system. This affects bank deposits,
lead to a reduction in the money supply and create financial instability. (Friedman and Schwartz,
1963)
Different from the monetarist approach, debt and financial fragility approach does not put
monetary factors at the heart of the problem. Debt approach suggests that financial instabilities
are related with business cycles. Stages that lead to financial crises are an initial positive credit
shock (including financial innovations that increase credit supplies and velocity of money)
stimulating debt, lenders’ wrong risk-pricing, an asset bubble, a negative shock triggering the
bursting of the bubble and a banking crisis. (Kindelberger, 1978; Minsky, 1977)
Post-Keynesian financial instability theories suggest that financial crises occur at the
turning points of business cycles. In capitalist systems, long lasting economic growth transforms
the stable financial structures into instable financial structures that depend on speculative and
Ponzi financing. This transformation increases the possibility of financial instability. (Minsky,
1977)
Uncertainty approach regards the uncertainty as the determining element of financial
instability. This approach suggests that, unlike the cycles, risk-pricing and probability analysis
can not be applied to rare and uncertain events such as policy regime shifts. Financial innovations
contain similar problems since they are not tested in a downturn. Confidence decline, which is
strongly related with uncertainty, can trigger disproportionate responses in financial markets in a
stressful environment created by adverse shocks. (Shafer, 1986)
According to credit rationing approach, financial crises occur as a result of increasing
credit rationing after a period of excessive loosening in credit conditions. Intensifying
competition among lenders may distort risk perceptions and loosen credit conditions excessively.
Financial institutions can underestimate risk because of various psychological and institutional
factors. Adverse shocks can lead to sharp increases in credit rationing, which creates financial
instabilities. (Guttentag and Herring, 1984; Herring and Wachter, 1999; Herring, 1999)
Asymmetric information approach focuses on the moral hazard and adverse selection
concepts, which are related with the interaction between the lender and barrower. Since barrowers
have more information about their projects, they have information advantage over lenders. When
lenders can not evaluate barrowers with respect to their quality because of insufficient
information, they determine an average interest rate. Since this interest rate level is higher than
the qualified barrower would like to pay, the qualified barrower withdraws from the market,
which decreases the efficiency of the market.
Increasing interest rates and uncertainty aggravate adverse selection and moral hazard
problems. During bank panics, problems associated with asymmetric information intensify
because of declining liquidity and increasing interest rates and uncertainty. (Stiglitz and Weiss,
1981; Mishkin, 1991)
According to bank runs approach, the fundamental reason behind the crises is panic runs
on highly leveraged institutions such as banks and the subsequent liquidity crises. (Diamond and
Dybvig, 1983) The same liquidity problem can occur in securities markets when every market
player sells. (Davis, 1994; 1999; 2008)
Role of international capital flows in financial crises is increasingly investigated. It is
suggested that speculation against a depreciation of a fixed parity can lead to a financial crisis
when foreign exchange reserves are insufficient. (Krugman, 1991) Authorities try to resist
depreciation by increasing interest rates; nonetheless insufficient foreign exchange reserves
trigger the financial instability. Another factor that is emphasized is the financing of the public or
private sector in foreign currency. Foreign currency debts can aggravate the financial instability
because of foreign currency short positions.
Role of institutional investors is also increasingly investigated. Institutional investors lead
the capital inflow into an emerging market. Nonetheless, when these investors lead the capital
outflow, huge problems arise in the financial sector, which quickly spread to real economy.
(Davis and Steil, 2001) Contagion is an important factor that accelerates the spread of financial
crises to other countries when there are cross-country similarities. (Glick and Rose 1998)
3. FINANCIAL CRISES IN EMERGING COUNTRIES
Emerging countries experienced financial instabilities and crises in 1990s and 2000s.
Turkey in 1994, 2000 and 2001, Mexico in 1994-95, Argentina in 1995, and East Asian countries
including Indonesia, South Korea, Thailand, Malaysia, and Philippines in 1997, experienced
serious financial instabilities and crises, which quickly spread to the real sector. Disruption of
flow of credit reduced investments and consumption. Reduction in investments and consumption
cut the demand and supply, slowed down the economy and dragged many firms to bankruptcy.
Confidence to the financial system was undermined leading to a decline in savings and an
increase in capital outflow.
Even if each country had different socio-economic background, financial crises had
common characteristics. They all started with financial panic (and/or attack) and sudden capital
withdrawals. Then, real economy was hit and economy slowed down. Panic (and/or attack) led by
foreign investors was the critical element that dragged these economies into crises.
These countries were recipients of large volumes of capital inflows before the crises.
These capital flows suddenly changed direction before the crises. This sudden and unexpected
change created demands for the payment of outstanding loans that led these loans into default.
Sudden reversal of capital flows was the common characteristic of financial instabilities
and crises in emerging countries. But why had the capital flow changed direction suddenly?
Different scholars identify different reasons for the sudden change in the direction of capital.
Some scholars argue that sudden shifts in international market conditions such as interest rates,
commodity prices and trade conditions diminished the ability of debtors to pay their loans. Others
argue that political and economic instability in debtor countries changed creditors’ perception of
risk with regards to the ability of the debtor country to service the foreign debt. Some scholars
argue that foreign investors’ panic (and/or attack) was the critical element.
In the Mexican case, foreign investors’ confidence fell especially because of the
uncertainty created by the elections in Mexico in 1994. Capital inflows slowed down significantly
in the second quarter of 1994, which increased the probability of currency depreciation. After a
small depreciation, the Mexican Central Bank continued to peg the exchange rate. Result was the
decline of reserves from $28 billion in the beginning of 1994 to $10 billion in December 1994.
Reserves further declined in mid-December after the election and the government change.
Mexican central bank stopped pegging the exchange rate.
Realizing that the Mexican government had only $6 billion of reserves to pay its $28
billion short-term debts, international creditors panicked (and/or attacked). Although $28 billion
was only 10 per cent of Mexico’s GDP, Mexico could not find new barrowers to service the $28
billion debt and came to the brink of default in early 1995. An international loan led by IMF was
given to Mexico.
Mexico was solvent, but illiquid. The case that it was a liquidity crisis can be supported
by the fact that after a decline in economic growth in 1995, economy recovered strongly in 1996
and 1997. The exchange rate depreciated in 1995, but appreciated in 1996 and 1997. The same
pattern can be seen in foreign investments and in the stock exchange.
Sudden reversal of capital flows and foreign investors’ panic (and/or attack) were once
again the determining factors this time in the Argentine financial crisis. Mexico crisis had already
created a tense environment. Elections in May 1995 and lack of confidence to Argentina’s
commitment to pegged exchange rate deteriorated the situation. Capital outflow suddenly
exploded. Whole financial system came to the brink of collapse. International loan led by IMF,
World Bank and Inter-American Development Bank was given to Argentine. Just like Mexico,
after a contraction in 1995, economy grew fast in 1996 and 1997. The same pattern can be seen in
foreign investments. After capital outflows in 1995, capital inflows increased swiftly in 1996 and
1997. Once again, the problem was not solvency, but illiquidity. Both countries had not sufficient
foreign exchange reserves to service their short-term foreign exchange debts.
East Asian crisis has many similarities with the crises in Mexico and Argentine. The East
Asian crisis came after years of fast economic growth. Financial reforms had been started in the
early 1990s. These reforms had loosened regulation and supervision over the financial system,
opened the door wide for short-term international loans and made these countries vulnerable to
international financial shocks.
Instead of growth, they faced with “self-distorting foreign exchange market operating
through attacks of speculative hot money flows into the fragile and shallow asset markets, luring
the residents in an ever-ending spiral of debt accumulation”(Yeldan, 2008: 2) Many scholars now
argue that financial liberalization was the proximate determinant of the financial crises in
emerging countries. (Prasad, 2007:185) (Daniel and Jones, 2007: 202) Actually, countries such as
China that had received much less short-term capital inflow since they had not reformed their
financial institutions and opened their economy to external financial shocks had escaped from the
crisis with the least damage. Countries that grew fastest were those that rely less on capital
inflows. (Rodrik and Subramanian, 2008: 16)
After the East Asian economies liberalized their financial systems; capital inflow, especially
short-term international loans, started to pour in. These capital inflows appreciated local
currencies, expanded bank lending and in an insufficiently regulated and supervised environment
made these countries much more vulnerable to a shock created by a reversal in capital flows.
Indeed, when the capital inflow suddenly stopped, foreign investors’ panic (and/or attack)
problem surfaced this time in this part of the world. Capital market liberalization brought
instability, not growth. (Tabb, 2008: 49)
Capital inflows in South Korea, Malaysia, Indonesia, Thailand and Philippines had
surpassed 6 per cent of GDP between 1990 and 1996. Bank lending had expanded very rapidly
making these countries vulnerable to the reversal of capital flows since share of short-term debts
in capital inflows were increasing. Indeed, ratio of short-term debt to foreign exchanges reserves
was greater than one in Thailand, Korea and Indonesia that were hit hardest.
Financial crisis started in South Korea and Thailand in early 1997. In South Korea,
Hanbo steel could not pay its $6 billion debt and declared bankruptcy. Other companies such as
Sammi Steel and Kia Motors also could not pay their debts, which put banks under pressure. In
Thailand, problems started in the real-estate sector, which put financing companies, which were
heavily exposed to property market, under pressure. Thailand baht came under attack in late 1996
and early 1997. Thai government’s steps were not enough to stop the bleeding in reserves, which
further decreased foreign investors’ confidence. Foreign investors’ panic (and/or attack) led to
capital outflows all across the region. Currencies of South Korea, Indonesia, Thailand and
Malaysia depreciated more than 20 per cent against dollar. This created a vicious cycle. Capital
outflow put banks and financial companies under more pressure since they were not able to roll
over their existing debts. Servicing foreign debts also became more difficult since demand for
dollar from domestic financial institutions had accelerated the appreciation of dollar against local
currencies. Crisis of confidence among foreign investors quickly affected the real economy
ruining economic interests and created a panic on a global scale. (Chang and Goldman, 2008:44)
Policy errors of governments and international institutions worsened the situation. Initial
IMF programs, which focused on decreasing fiscal deficits and money growth, and on closures of
insolvent financial institutions, intensified the crisis. Only after international institutions and
investors changed their strategy and focused on debt restructuring, international funding and
financial sector restructuring, the crisis started to settle down.
In sum, it can be argued that the critical element in financial crises in emerging countries
in 1990s was foreign investors’ panic (and/or attack). Other factors such as overvaluation of
pegged exchange rates, ratio of short-term debt to foreign exchange reserves, a rapid build-up of
bank credits to the private sector, financial reforms that led to lack of regulation and supervision,
asset bubbles, and policy errors of governments and international institutions prepared the
background for the financial crisis.
4. FINANCIAL CRISES IN TURKEY
Financial crises in Mexico, Argentine, and the East Asian countries have many common
features with the financial crises in Turkey. Turkish economy had similar macro and
microeconomic problems. Nonetheless, foreign investors’ panic (and/or attack) was once again
the critical factor.
Turkish Lira was overvalued because of the pegged exchange rate. In 1994, Turkey’s
ratio of foreign exchange short-term debts to foreign exchange reserves was 2.06, which is even
more than two. Turkey had also taken financial liberalization steps. Lack of regulation and
supervision in the financial system was another common feature. Turkish banks had taken foreign
exchange short-term loans from international markets and given loans to private sector in Turkish
Lira. Turkey’s ratio of current account deficit to GDP was 3.3 per cent in 1994. Ratio of current
account deficit to GDP was 7 per cent in Mexico in 1993, 4.9 per cent in South Korea, 3.3 per
cent in Indonesia, 4.9 per cent in Malaysia, 4.7 per cent in Philippines and 7.9 per cent in
Thailand in 1993. Short-term debt had increased very rapidly in Turkey in 1993, a year before the
crisis.
Financial crises in 2000 and 2001 had similar characteristics. Ratio of current account
deficit to GDP had reached 4.9 per cent by September 2000. As in the Mexico, Argentine and the
East Asia countries, foreign direct and portfolio investments had fallen before the crisis. As in the
1994 crisis, Turkish private banks were taking short-term debts in foreign currency from
international markets and giving loans to the Turkish private sector in TL. Inflation had risen over
25 per cent. These developments prepared the background for financial panic (and/or attack).
International creditors did not roll over debts. Near $5 billion portfolio investments left the
country. Turkish economy ran into the familiar problems of exchange-rate-based stabilization
programs implemented also by other emerging countries. (Akyuz and Boratav, 2003) Devaluation
expectations grew, which further increased foreign exchange demand. Central Bank increased
interest rates rather than giving liquidity. Interest rates went up rapidly. This led to the collapse of
a major bank and increased speculations that other banks could also collapse. This created panic
and overnight interest rates went up as high as 210 per cent in November 2000. Stock exchange
also collapsed. Central Bank gave liquidity to the market, which stopped the crisis temporarily.
A political crisis in 19 February, 2001 restarted the temporarily paused crisis. The pegged
exchange rate system was abolished. Dollar appreciated from 688000 TL to 962000 TL.
Overnight interest rates went up as high as 6200 per cent. The stock exchange crashed. In a
financial crisis context, Central Bank’s monetary authority functions were restricted and Central
Bank lost the control of the currency.
As can be seen from the development process of financial crises in Turkey in 1994, 2000
and 2001, over-valued pegged exchange rate, lack of regulation and supervision of financial
system after capital market liberalizations, high current account deficit, high foreign exchange
short-term debt, rapid build-up of loans to private sector prepared the background for a financial
crisis. Nonetheless, foreign investors’ panic (and/or attack) was the critical factor. When the
speculative attack started, monetary authorities and government were late to leave the pegged
exchange system, which accelerated capital outflows and aggravated the crisis. (Ozatay, 1996:25)
As in other emerging countries that were hit by financial crises, macro and microeconomic
indicators were worsening. Nonetheless, they were not “bad enough” to create financial crises in
such magnitudes without the critical element of foreign investors panic (and/or attack).
Theories of financial instability provide different perspectives about the financial crises in
Mexico, Argentine, Indonesia, Malaysia, Thailand, South Korea, Philippines and Turkey.
As monetarist approach suggests, improper policies of monetary authorities and
government create fluctuations in money supply and affect financial instability. Increases in
money supply created inflation and increased interest rates in Turkey prior to the financial crises
in 1994, 2000 and 2001, which boosted uncertainty and created financial instability. As
monetarist approach anticipated, bank failures created panic, led to a decline in money supply and
aggravation of the financial crisis.
Debt approach also provides invaluable information about the dynamics of financial
crises. As debt approach suggested, an initial positive shock such as the liberalization of capital
movements that stimulated debt was an important factor in almost every financial crisis. Lenders’
wrong risk-pricing as can be seen in the credits given to private sector created an asset bubble
such as the real estate market bubble in Thailand. A negative shock such as the capital outflow
triggered the bursting of the bubble and led to a banking crisis.
As post-Keynesian financial instability theories put forward, in capitalist economic
systems such as the East Asian economic systems, long lasting growth transformed stable
financial structures to instable financial structures that depend on speculative and Ponzi financing.
As the theory suggested, after a robust economic growth in early 1990s, financial institutions in
East Asian started to barrow short-term debt in foreign currency and give loans to private sector
in local currency, which created an instable financial structure.
As the uncertainty approach anticipated, uncertainty such as a political instability or a
lack of commitment to continue the pegging of the exchange rate decreased confidence and
triggered disproportionate response in financial markets such as sudden reversal of capital flows.
As the credit rationing approach suggested, because of psychological and institutional
factors, financial institutions in countries hit by crises had loosened credit conditions excessively
and given huge amounts of credits in local currency to private sector by using the funds they
provided from international creditors in foreign exchange. Adverse shocks such as the sudden
capital outflow led to sharp increases in credit rationing and contributed to the deepening of the
financial crises.
As the asymmetric information approach anticipated, because of the adverse selection
problem, financial institutions in countries hit by the crises had provided credits to the risky
projects of local private companies. When these companies started to collapse, declining
confidence level immediately affected other parts of the economy and aggravated the crisis.
Deposit guarantees and loans from international institutions created moral hazard problems.
As the bank runs approach put forward, panic runs on highly leveraged institutions such
as banks created illiquidity and triggered financial crises. Panicked foreign investors sold
excessively in the securities market, intensified the liquidity problem and aggravated the financial
crisis.
International capital flows were very effective in triggering financial crises in emerging
countries. Particularly, speculation against depreciation of a fixed parity and insufficient foreign
exchange reserves was among the determining factors in financial crises in Turkey, Argentine,
Mexico, and East Asian countries. Public and private sector debt in foreign exchange, especially
the short-term ones, played a significant role in financial crises. Rapid reversal of capital flow by
foreign investors was the critical factor in financial crises in emerging countries.
5. CURRENT GLOBAL FINANCIAL CRISIS
After Lehman Brothers declared bankruptcy and Bear Stearns, Fannie Mae, Freddie Mac,
Merrill Lynch, Washington Mutual, and AIG came to the brink of collapse, confidence to the
financial sector and real economy fell sharply in the U.S. Even the renowned investors argued
that the possibility of a total financial collapse was higher than any time. (Green, 2008: 46)
Interbank loan market froze. Some economists voiced the depression possibility. (Coy, Reed and
Ewing, 2008:28) U.S. government took emergency steps to stop the financial crisis.
The U.S. Treasury set up a financing program to auction Treasury bills to raise cash for
the Fed. This program was set up to help the Fed to enhance its liquidity operations and manage
its balance sheet. The U.S. Treasury and the Fed have effectively underwritten almost the entire
financial system including banks, insurance companies, money market funds, commercial paper
market, and housing market. They set up Troubles Asset Relief Program (TARP) to buy toxic
assets and to partially nationalize troubled banks. They also created Money Market Funding
Investor Facility (MMIFF), Commercial Paper Funding Facility (CPFF), and Asset Backed
Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF).
They tried to solve the crisis of confidence problem. The size of financial markets,
relative to the governments, had become so huge that there was no other means of maintaining
stability than to establish a psychology of confidence. The U.S. government tried to project to the
markets a sense that they know what they are doing. (Continetti, 2008:40)
Why did the U.S. government take such unprecedented actions? Because, in the words of
Professor Roubini (2008):
“What we are facing now is the beginning of the unraveling and collapse of the entire
shadow financial system, a system of institutions (broker dealers, hedge funds, private equity
funds, SIVs, conduits, etc.) that look like banks (as they borrow short, are highly leveraged and
lend and invest long and in illiquid ways) and thus are highly vulnerable to bank-like runs; but
unlike banks they are not properly regulated and supervised, they don’t have access to deposit
insurance and don’t have access to the lender of last resort support of the central bank.”
How did the U.S. economy come to this point? It is generally accepted that bursting of
the asset and credit bubble was the fundamental factor that triggered the global financial crisis.
Fed’s policies that kept the Fed funds rate too low for too long had created excessive liquidity.
Nonetheless, liquidity was necessary, but not sufficient. In the words of Posen (2007:11), “You
need water to grow roses, but rain alone does not produce a rose garden.” Excessive liquidity,
together with the lack of supervision and regulation in the housing and derivatives market, led to
the biggest financial crisis in the U.S. since the Great Depression.
House prices increased continuously until 2008 because of the increasing demand created
by Fed’s very low rates. The ratio of home prices to annual level of rent paid, which is normally
between 9 and 11, reached an extraordinary level of 14.5 at the end of 2006 indicating the
existence of a bubble in housing market. (Cecchetti, 2008:2) Because of lack of regulation and
supervision, number of sub-prime mortgages (mortgages that are given to people with low credit
ratings) had surged. After interest rate hikes, sub-prime mortgages started to default, which
created a loss in the financial system that is estimated to be at least $400 billions. House prices in
20 U.S. metropolitan areas fell 16 per cent in July from a year earlier. Around 7.5 million
homeowners fell into negative equity, which means their houses are worth less than the loan they
took out to pay for it. Disclosures increased 71 per cent in September and created a huge amount
of loss for the financial system and triggered the collapse of many highly leveraged financial
firms. Unregulated new financial instruments such as Credit Default Swaps (CDS) that are
defined as a contractual agreement to transfer the default risk of one or more reference entities
from one party to the other (Mengle, 2007:1) intensified the crisis. Lack of transparency
regarding the assets backing these instruments made it very difficult for the investors to identify
and evaluate the risks. (Engelen, 2008: 69)
Collapse of giant financial firms such as Lehman triggered another wave of write-downs.
The crisis spread to Europe as many European banks, which had bought staggering amounts of
high-yielding structured securities including U.S. subprime mortgage papers, started to collapse
(Engelen, 2008:59). All these unprecedented events diminished confidence to the banking and
financial system. Opacity and complexity of the exotic securities on financial balance sheets that
amount to $50 trillion further increased the systemic crisis risk. (Zuckerman, 2008:92) Consumer
confidence also sank. Investors rushed to liquidity because of the uncertainty with regards to the
amount and location of toxic assets. Interbank loan market was frozen. Corporate barrowing costs
have gone up substantially as rates increased and banks took unprecedented precautions such as
tying corporate loan rates to credit-default swaps, which raised barrowing costs further more.
Unemployment increased. More than 80 per cent of states in the U.S. reported job losses in
September.
Stock exchanges all around the world collapsed. Investors started to pull money out of
hedge funds, which started another wave of sell-offs in stock exchanges all around the world.
According to E. Roman, the co-chief executive of Europe’s biggest hedge fund GLG, hundreds of
hedge funds came to the brink of collapse. (Mason, 2008) Consumer confidence level dropped to
historically low levels. Consumer expenditure declined. Defaults on other forms of consumer debt
such as credit cards, auto loans, and consumer loans increased. Many banks were closed.
Interaction of financial system and the real economy started a vicious cycle. Financial system
slowed down the real economy and slowing economy created further complications for the
financial system.
According to the Bank of England, cost of the global crisis amounted to $2.8 trillion. The
Bank of England estimated that losses for U.K. banks on mortgage-backed securities and
corporate bonds topped £120 bn. Global stock markets lost $6.5 trillion on October 6 and 7.
(Gumbel, 2008:32) The crisis also affected emerging markets. Local currencies depreciated
against dollar because of dollar demand, which had many negative spillover effects. Some of the
emerging countries such as Hungary and Ukraine signed agreements with IMF. Some countries
such as South Korea unveiled their own bailout plans.
The financial crisis triggered such a big crisis at the global level that according to the
UN’s International Labour Organization (ILO) (2008):
“Twenty million jobs will disappear by the end of next year as a result of the impact of
the financial crisis on the global economy...Construction, real estate, financial services, and the
auto sector are most likely to be hit, according to the ILO's estimate which is based on
International Monetary Fund projections for the world economy.”
Different from the financial crises in developing countries, current financial crisis is
global in scale. Foreign investors’ panic (and/or attack) did not trigger the crisis as it did in
developing crises. Nonetheless, international capital flows and foreign investors’ panic can
trigger financial crises in emerging markets. Actually, many emerging countries have already
come to the brink of financial collapse. Similar to financial crises in developing countries, lack of
regulation and supervision, which led to fancy financial instruments and housing market bubble
in the U.S. market, triggered the financial crisis. (The Economist, 2008) Former SEC Chair also
emphasized the role of lack of regulation on the global financial crisis. (Siegel, 2008)
Theories of financial instability provide invaluable insight into the current financial crisis.
As the credit rationing approach suggested, financial institutions in the U.S. underestimated risk
of sub-prime mortgages and loosened credit conditions excessively. Sub-prime mortgages started
to default and functioned as the adverse shock. Financial institutions increased credit rationing
excessively, which intensified the financial crisis.
Similar to the uncertainty approach arguments, once the largest financial institutions in
the U.S. started to collapse, drop in the confidence level created by the uncertainty about the
health of the financial sector, triggered disproportionate responses in financial markets.
As Post-Keynesian approach put forward, long lasting economic growth transformed the
stable financial structures into instable financial structures that depend on financial innovation
such as Credit Default Swaps (CDS) and other derivatives. CDSs brought the giant financial
institutions to the brink of collapse, which shook all the economy.
As the debt approach suggested, initial positive credit shock stimulated sub-prime
mortgages, led to lenders’ wrong risk-pricing, created a housing market bubble. Interest rate hikes
burst the bubble and triggered the financial crisis.
As the asymmetric information approach anticipated, moral hazard played a very
significant role in the collapse of big financial institutions. Banks took on overly risky projects
since they expected that government will bail them out if necessary. (Sinn, 2008:61) Adverse
selection also played a big role. Banks issued securities with attractive nominal interest rates but
unknown repayment probability. These securities were backed by sophisticated portfolios
containing good and bad assets. Banks sold “lemon” bonds. (Sinn, 2008: 61)
6. SCENARIOS ABOUT THE FUTURE OF THE U.S. AND GLOBAL
FINANCIAL SYSTEM
6.1. A V-Shaped Mild Recession in the U.S. That Will Not Last More Than a Year
The U.S. economy slows down and enters into recession. Nonetheless, economic
fundamentals start to improve by early 2010. Consumer confidence stays at low levels throughout
the 2009, but starts to improve in the first quarter of 2010. Consumption starts to grow slightly in
the first quarter of 2010. House prices fall 15 per cent in the first half of 2009, but then stabilize.
Foreclosures start to decline in the second half of 2009. Unemployment rate surpasses 8 per cent,
but starts to decline by the first half of 2010. U.S. government bailout and stabilization programs
increase the budget deficit; nonetheless, it stays below $1 trillion.
Current account deficit
declines. Credit markets loosen. Banks and financial companies start to give loans to consumers
and companies. Company profits decline, but there are no big collapses.
Global economy grows slightly below 3 per cent in 2009. Developed economies
including the U.S., the U.K., France, Germany, and Japan contract in 2009. China’s growth slows
down to 7 per cent.
6.2. A U-Shaped or L-Shaped Deep and Long Recession in the U.S. that Will Last At
Least Two Years
The U.S. economy slows down substantially and enters into deep recession. Consumer
confidence declines further and consumption reduction continues. Since consumption constitutes
70 per cent of the U.S. economy, GDP is affected negatively. Housing market deteriorates further.
House prices continue to decline. Foreclosures accelerate.
Housing bubble, via the wealth effects, had led to an increase in consumption and a
reduction in private household savings. (Roubini, 2006:347) Mortgage equity withdrawals
(MEWs) totaled over $1 trillion dollar. Drops in house prices stop this mechanism and decrease
consumption. This further hurts the U.S. economy, 70 per cent of which depends on consumption.
Since it is estimated that $1 decline in housing wealth leads to five to six cents decline in annual
consumption, deteriorating conditions in the housing market accelerate the contraction of the U.S.
economy.
Credit conditions continue to tighten. Banks are reluctant to give credits because of
deteriorating credit quality in recession. Customers’ ability to repay loans decrease significantly.
Banks’ own funding problems and deleveraging further deteriorate the credit market. Monetary
policy loses effectiveness. Some banks, insurance companies and financial institutions collapse,
which intensifies the crisis through CDS (Credit Default Swap) market.
Pension funds were also hit hard at this crisis. The bursting of housing and stock market
bubbles decreased the value of pension funds. This directs people to stay longer in the workforce
and save for retirement. This decreases consumption significantly since savings rate of U.S.
households is negative two per cent of GDP. To save for their retirement, people reduce their
consumption. Savings rate moves to five per cent, which means an around seven per cent decline
in consumption and further contraction of the U.S. economy.
The bursting of the asset and housing bubble affect the U.S. economy negatively through
unemployment channel. Unemployment significantly increases since deteriorating conditions in
the housing and the financial sector slash jobs in the real estate, construction, and finance sectors.
Increasing outsourcing in recent years makes it harder to create jobs.
Credit crunch led highly-leveraged banks and financial institutions such as hedge funds to
deleverage. Deleveraging further deteriorates credit conditions and further slows down
investments and GDP growth. Unwinding of carry trade positions, which have been estimated at
around $1trillion, further intensifies the financial crisis. (Panitchpakdi, 2008:23)
Falling house prices increase the number of mortgage holders with negative equity. This
creates a vicious cycle by further accelerating disclosures, by increasing the supply in the housing
market, where there is already excess supply, and by further decreasing house prices.
U.S.’s twin deficit problems intensifies as budget deficit explodes and financing of the
current account deficit requires around $50 billion foreign investments a month. U.S. government
issues government bonds at unprecedented levels, which increases interest rates substantially.
Recession, declining demand and insufficient credit drive many companies into
bankruptcy. This creates new complications for the corporate bonds and Credit Default Swap
(CDS) market.
Financial and economic crisis in the U.S. economy slows down the global economic
growth substantially. Europe is the most affected region and shrinks. Many banks and financial
institutions collapse, many of them are nationalized. Increasing unemployment levels force
governments to take protectionist measures, which may trigger the rise of economic nationalism.
(Cable, 2008: 10) Protectionism leads to a decline in international trade and starts another vicious
cycle.
6.3. A Depression Comparable to the Great Depression
Deteriorating conditions in the housing and financial markets lead to a systemic crisis and
catastrophic collapse of the financial system. Declines in housing prices accelerates, disclosures
skyrocket. Bankruptcy of banks, financial institutions and insurance companies trigger a crisis in
the $55 trillion Credit Default Swaps market.
Economic contraction, declining house prices and wealth, falling demand and increasing
defaults in credit cards, consumer loans, auto loans accelerate the collapse of banks and financial
companies. Stock exchange crashes and intensifies the crisis via wealth effect. Interest rates
increase sharply because of huge amounts of U.S. Treasury bonds supply. This triggers another
crisis in the derivative markets, which amount to $596 “trillion” as of December 2007 according
to official figures of Bank of International Settlements (BIS).
Exploding budget deficit topping $1.5 trillion and current account deficit, which can not
be financed because of a global depression, lead to printing dollar at unprecedented levels. U.S.
dollar loses its reserve money status.
Foreign investors’ confidence in the U.S. financial and economic system continues to fall
since the U.S. Treasury and the Federal Reserve print more money and issue more treasuries to
fund their bailout plans and to prevent a systemic failure. Nonetheless, global investors may not
be willing to absorb another trillion dollars in U.S. debt. (Rogoff, 2008:51)
Publicly issued debt of the U.S. is currently $5.3 trillion. More than 50 per cent of this
debt is already owned by foreign investors and governments. U.S.’s total public debt, including
IOU’s and unfunded obligations including social security and Medicare, is more than $30 trillion;
while its GDP is $14 trillion. The U.S. mortgage holdings are $14.8 trillion, including $3 trillion
of commercial mortgages. Local government debt is $3 trillion. Consumer and corporate debt is
$20.4 trillion. So, non-federal loans amount to $38 trillion. Default of only a small fraction of
theses debts may intensify the systemic crisis.
7. GLOBAL FINANCIAL CRISIS’S EFFECTS ON THE TURKISH ECONOMY
Global financial crisis affects and will affect the Turkish economy through many
channels. Magnitude of the effect depends on the policies of the Turkish authorities and the path
of the global financial crisis. If the recession in the U.S. and Europe does not last more than a
year, magnitude of the effects will be limited. If the global financial crisis transforms into a
systemic crisis, it will be hard to estimate the consequences since global financial and economic
system will be restructured. If the U.S. and Europe enters into a deep recession that lasts at least
two years, Turkish authorities should take serious precautions such as debt restructuring since
reflections of the global crisis on the Turkish economy will be very serious.
Some international institutional investors such as hedge funds and pension funds lost
more than 30 per cent of their values because of the sharp declines in the global markets. They
started to sell stocks, bonds and equities in emerging markets. This is fallowed by capital
outflows and appreciation of dollar against local currencies. Turkey is one of these emerging
countries. Turkish Lira also depreciated against dollar more than 25 per cent.
Turkish Lira was overvalued before the crisis. Figures about the magnitude of
overvaluation vary between 10 and 65 per cent. Depreciation of TL may have been positive in
terms of competitiveness of export oriented sectors. Nonetheless, slowing global economy,
especially slowing European economy, may hurt exports since destination of more than 50 per
cent of Turkey’s exports is European countries. Depreciation of TL may also lower imports and
current account deficit. Nonetheless, even if current account deficit will probably decline next
year, it is expected that it will top $50 billion by the end of 2008.
Financing of current account deficit may be harder because of increased costs and lower
availability in the international capital markets. The financing of budget deficit may face similar
difficulties. Increased costs and lower availability of international finance capital will also tighten
the domestic credit market.
Capital inflows amounted to $185 billion during the last six years. It was $11 billion in
2003, $23 billion in 2004, $40 billion in 2005, $57 billion in 2006 and $55 billion in 2007.
Turkey is one of the emerging countries, where foreign portfolio investments exceeded direct
investments. (Kenen, 2007:182) Sudden reversal of capital flow may present difficulties for the
Turkish economy.
Turkey’s total foreign debt is $284 billion. Public foreign debt is $93 billion while private
sector foreign debt amounted to $191 billion. Of $191 billion, real sector’s share is $125 billion.
Short-term foreign debt of real sector, which raises concern, topped $50 billion as of July 2008.
Private sector’s foreign exchange short position is around $80 billion. Nonetheless, according to
the Chairman of the Turkish Central Bank, Durmus Yilmaz, only $40 billion of this amount is
risky.
Financing of foreign currency debt may be problematic in a global financial crisis context.
Especially, private sector’s rapidly increasing short-term foreign currency debt should be
carefully monitored.
The share of foreign participation in the Turkish banking sector is 43 per cent according
to the Central Bank of the Republic of Turkey (CBRT) report on financial stability. If global
financial crisis deepens, high level of foreign participation may cause additional complications
for the Turkish financial system.
The Financial Strength Index (FSII) is computed by the CBRT. It forms an aggregate
indicator from six sub-indices (asset quality, liquidity, exchange rate risk, interest rate risk,
profitability, and capital adequacy) to determine the direction of the financial strength of the
banking sector. Even if the FSI dropped to 116.4 in March 2008, it is still high indicating strength
of the banking sector. One negative aspect of the Turkish banking sector is non-performing loans.
Non-performing loans increased by 20.1 per cent by the end of 2007 and reached TL 9.8 billion.
The CBRT conducted scenario analysis to understand the effects of interest rates
increases and appreciation of exchange rates on the banking sector under two different scenarios.
“Under Scenario A, it is assumed that Turkish lira depreciates by 30 per cent against other
currencies, the interest rates for the Turkish currency and foreign currencies increase by 6 and 5
points, respectively, and Eurobond prices decline by 5 per cent.
Under Scenario B, it is assumed that Turkish lira depreciates by 30 per cent against other
currencies, interest rate increases are twice the interest rate fluctuations observed during the 2006
May-June period, and Eurobond prices decrease by 5 per cent.” (Central Bank of the Republic of
Turkey [CBRT], 2008: 60)
According to scenario analysis, as of March 2008, losses increased under Scenario A and
decreased under Scenario B, compared to the figures at the end of the 2007. Capital adequacy
ratio (CAR) declined only one percentage point under both scenarios. CARs of the 10 largest
banks did not fall below the legal limits, which may indicate the strength of the banking sector.
Nonetheless, banking sector should be carefully monitored in a serious global financial crisis
environment.
Slowing global economy may bring inflation down in Turkey because of declining
demand and decreasing commodity and energy prices. Nonetheless, interest rates may increase
because of financing of the budget and current account deficits in the context of a tightening
global credit market. Industrial output declined 5.5 per cent in September. Economic growth may
slow down well below 4 per cent in 2009, which may lower tax revenues. Increasing interest rates
and interest payments may be additional burdens for the budget.
Global financial crisis may hit many sectors in the Turkish economy. Crisis has already
started to affect real economy in Turkey, especially export-oriented sectors such as automotive
and textiles. Automotive companies cut or even stopped production. They also fired and retired
employees. Other sectors were also affected negatively and took similar steps.
Orders in many sectors including the manufacturing sector decline. Purchasing Manager
Index (PMI) fell sharply in September, which indicates a worsening condition for the
manufacturing sector.
According to Turkey Foreign Trade Association, if financial crisis continues, exports may
fall more than 20 per cent in the coming 12 months.
Drops in commodity prices have been
affecting steel, chemical, and cement industries negatively because of inventories and because of
declining value of exports in dollar. It is expected that current account deficit will drop because of
declining energy, capital goods and intermediate goods imports.
It is expected that Turkey’s housing sector will be affected negatively. Nonetheless,
housing sector will not affect the financial sector very negatively as it did in the U.S. because of
the different structure of the housing sector in Turkey.
8. CONCLUSION
As the financial crises in emerging countries in the 1990s and 2000s illustrate, foreign
investors’ panic (and/or attack) is the critical element that triggers financial crises. Micro and
macroeconomic factors such as overvaluation of pegged exchange rates, high ratio of foreign
exchange short-term debt to foreign exchange reserves, a rapid build-up of bank credits to the
private sector, financial liberalizations with lack of regulation and supervision, high current
account deficit, and asset bubbles prepare the background for the financial crises. Nonetheless,
these factors were not sufficient to create financial crises in magnitudes seen in financial crises in
emerging countries without the critical element of foreign investors’ panic (and/or attack).
So, monetary authorities and governments have to improve the macro and microeconomic
indicators not to create a suitable environment for speculative attacks. Nonetheless, these
measures may not be sufficient in a global financial crisis context. Mechanisms that would limit
the effects of sudden capital outflows should be constructed since deepening global financial
crisis may lead to substantial capital outflows from the emerging markets regardless of the health
of the micro and macroeconomic indicators.
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