The Structure of a Financial Crisis Essay

This essay has a total of 4765 words and 24 pages.

The Structure of a Financial Crisis

The Structure of a Financial Crisis

Lessons from Turkey

BY AYBEK GOREY (*)



INTRODUCTION


The year 2001 had been unlucky for Turkey. Apart from the crisis in 1994 and November
2000, the country had to face another financial crisis, causing problems in the management
of its economy. Why does a country delve deep into financial crisis? What are the possible
immediate triggers for both the current and potential new crises? What precautions should
be taken for the key issues like the fragility of the financial and banking system,
belated reforms and privatisation, rampant corruption, exchange rate policy? And how can
the governments satisfy the markets and people to undertake these reforms?


The current crisis has not hit the country overnight. This article figures out the
weakness of the system, years of neglect and mismanagement, possible solutions for other
developing countries.


One has to bear in my mind that even evaluating the aftermath of the 1994 crisis, Turkey
was a rising star, with aspirations towards full membership to the European Union. Among
the potential applicants of EU membership, - mostly the Transition Economies of Eastern
Europe- Turkey was the mere applicant with a functioning Customs Union with the EU back in
1995. With a relatively large and dynamic market, having high hopes for rapid economic and
social progress, Turkey seemed a valuable candidate for the European Integration. Now
after the 2000 November and 2001 February crises, the shrinking of the economy suggests
that Turkey can only catch up with the figures of year 2000, as far as the year 2004, let
alone the EU membership and further growth. To indicate why such a failure has been
suffered, we have to go back to the roots of mismanagement. And that begins with the
problems of Privatisation practices.


THE INITIATION OF PRIVATISATION
Privatisation has proved to be a successful method for improving institutions and
maintaining corporate efficiency all around the world. But under certain conditions either
privatised firms can get into serious difficulties or delaying the privatisation programs
could trigger economic crises, together with the impact caused by years of mismanagement,
not undertaking the progressive reforms and corruption - as experienced in some of the
transition economies of Eastern Europe, Central Asia, Far East, and as is the case in this
article, in Turkey




THE FIRST DECADE OF SUCCESS

The past decade forced the public sector to its knees, all around the world. Though Turkey
was not a transition economy, the winds of change has affected the public sector like in
all other developed and developing economies. However, unlike the Transition Economies,
Turkey embarked on a prospective plan to privatise a major part of the public sector in
the mid 80's and laws enacting and enabling the privatisation of the State Owned
Enterprises (SOE) in late 1985, was an important breakthrough. In the 1990's privatisation
went ahead but caused disappointment in many sectors. Most privatised firms could not
improve their performance and some that succeeded, had been profitable already as SOEs.
But that was not the only problem the country had to face. Turkey had already begun to
face significant problems regarding the Privatisation Policy in the 1990's. These
mentioned problems not only aroused from the aggregate demand concerning the SOE, and the
negative effect of investment but the ongoing debate carried by the opposing political
parties in the Parliament.


The governments have overcome several difficulties and successfully resumed privatisation
in the beginning of the second decade. Though the outcome was promising, the program
proceeded more slowly than the original plan. In 1993 for example, a net revenue of US$
543 millions was raised through several privatised firms including two electric companies,
two communications equipment manufacturers, a supermarket chain and four cement factories.
In 1994 a total of approximately US$ 412 million was raised through the sale of an
automobile manufacturer, remaining cement factories by international offering resulted in
US$ 330 Million. In 1995, a total of US$ 573 million was raised. Sales during this year
included entities in the sugar, cement and magnesium industries, as well as a state bank.
In 1996, a total of approximately US$ 300 million resulting from disposal of entities in
the cement, zinc, forestry and textile industries had been realised.

TABLE
TABLE
PRIVATISATION GROSS REVENUES
. Years 1986 -1995 1996 1997 TOTAL
. ($) ($) ($) ($)
-Block Sale 1,274,950,286 217,990,000 239,150,000 1,732,090,286
-Asset Sale 203,539,351 71,765,349 114,920,934 390,225,634
-Public Offering 433,197,263 0 0 433,197,263
-International Offering 330,000,000 0 0 330,000,000
-I.S.E Sale 522,453,459 1,988,800 0 524,442,259
-Incomplete Asset Sale 2,139,819 0 0 2,139,819
TOTAL 2,766,280,178 291,744,149 354,070,934 3,412,095,261

Source: Turkish Treasury, Privatisation High Council Results




THE SECOND DECADE OF FRUSTRATION AND FAILURE

New problems have been faced in 1994, and the privatisation program was subject to certain
legal problems, as result of the new Privatisation Law introduced. The new legislation
established the Privatisation High Council (PHC) for presenting proposals and determining
plans. A critical turning point was reached when the privatisation plan for Turk Telecom
was proposed. Under the new Privatisation Law in May, 1995, Turk Telecom shares were
decided to be privatised. And in June 1995, Turk Telecom was reserved into the
privatisation portfolio and studies for further assessment have begun.


On February 28, 1996, the Constitutional Court annulled and banned the execution of some
articles of Law No:4107. As a result of this decision, PHC had no longer reserves the
authority for transferring and selling the shares. The tender process of advisory services
of Turk Telecom was cancelled.


After completion the necessary amendments on August 5, 1996 a new law has been enacted. In
accordance with this law, 49 % of Telecom (TTAS) shares were announced to be privatised as
follows;


10% assigned for the Directorate General of Postals,
5% to employees,
34 % to strategic investors and equity offering

The international consortium leaded by Goldman Sachs was chosen as the consultant firm in
the evaluation process of Turkish Telecom and an agreement was signed under these terms.
But the Constitutional Court has rejected the petition for cancellation of some articles
of the Law regarding the reform and privatisation of Turk Telecom. This rejection, while
eliminating further obstacles for the privatisation of Turk Telecom, may be considered a
turning point for further economic reform and financial liberalisation in Turkey, because
it was the inauguration of an era in which Domestic Politics affected the Privatisation
Program negatively. Had Turk Telecom been privatised in that period, it was expected to
raise revenue a few times more than the whole 1986-1995 period and thus encourage the rest
of the privatisation program to be realised, including the large state banks. But even in
early 2002, new plans are still effortlessly undertaken to privatise Turk Telecom, yet the
revenue expected is far lower than the first enactment date due to the changing market
trends in the international markets.


2) THE NEARING CRISIS

A major problem of the Turkish economy -- shared with many of the transition and
developing economies -- is the high inflation rate. In a low inflation rate economy, the
income redistribution effect of privatisation is substantial, thus can gain large public
support. In many developed economies, including the most obvious example in Britain,
unlike the developing economies, privatisation had clearly improved both the overall
economic performance and corporate efficiency. In the developed countries, even the
privatised large firms have marginal consequences in terms of the whole economy.
Government interference had been minimised thanks to the relatively transparency of the
process. Most economies with high inflation rates also suffer from rampant corruption, so
neither efficiency nor transparency can be maintained in these countries. Corrupt
management practices prevent a radical reform of corporate management. And the slowdown of
economic growth affects the public negatively.


Following the Turk Telecom failure, in 1999, the negotiations for the privatisation of
several large SOEs was still going on. Yet the major reason for the economic crisis that
occurred in 2001 - and is still continuing with several impacts - was proved to be the
banking sector. The Turkish private banking sector went awry rapidly; and many banks -
some of them privatised in the last decade- were gutted of their funds; illegal loans were
thought to be granted; while the bank owners were accused of transferring money to their
own companies - some of which were again privatised in the last decade- and capital was
completely wasted due to the loans not being repaid. A number of bank owners were taken
into custody for questioning and even formally arrested and charged; and banks went into
state receivership overnight. These momentous operations resulted in new regulations for
the banking & financial sector. Nineteen private banks, which were thought to have been
robbed and whose capital structures were found out to be fragile, were turned over to the
Savings Deposits Insurance Fund (SDIF). A new Institution called as BBR (Board of Banking
Regulations) was installed to inspect and audit the operations of SDIF. The government's
aim was to strengthen the capital structures of these banks and sell the appropriate ones
immediately. During the process various banks merged under the same roof and the
government succeeded in selling some of these banks. The net gains from these selling
operations helped to net approximately $20 billion for SDIF.



But the need for deeper reforms in the financial sector has assumed much greater urgency
since the dramatic crises of November 2000 and February 2001. The economic crisis created
by the somewhat poor state of governance in the financial sector, has brought to a boil
the long simmering potential of the sector to undermine macroeconomic stability. Inasmuch
as the gradual balance sheet strengthening of the large state banks, prior to their
privatisation dominated concerns until recently, the need to analyse and solve the crisis
in private banking seems to impose very large fiscal costs on the budget.


The impact of the crisis on inflation control proved to be grave. Turkey experienced
another failure of an exchange rate-based stabilisation, originally a three year program
announced approximately 14 months prior to the February 2001 crisis. The principal aim of
the government was to end high inflation dominating the economy for two decades. The
government was forced in February 2001 to abandon the currency peg at once, which had been
based the anchor of the fiscal strategy, thus sparking an immediate devaluation of the
national currency, the lira, by around 32% in the following week. The program had started
out with unprecedented political backing, managed to achieve some highly impressive
initial results and the public opinion widely held provided a far better chance of
prosperity than several previous internationally supported programs. Yet the outcome was
the worst failure in the history of the country.


Considering past events, it's clearly figured out that the weakened banking system and
tendency to over-reliance on inflows of hot money left the country defenceless and highly
vulnerable to potential crises of confidence. This has resulted in the currency peg's
failure to hold position when the inevitable tensions of such a rapid adjustment emerged.
The unpredicted devaluation delayed the government's plan and promise to achieve
single-digit inflation. The simultaneous interest rate increase and the banks' liquidity
preference indicted large bank balance sheet losses and severe fiscal stress.



The tensions climaxed in a crisis first in late November 2000. This first crisis was also
deeply rooted in the country's lacking economic system, but the primary cause of the
stress was a mixture of the banks' portfolio losses and liquidity problems in a few banks,
which addressed a loss of confidence in the entire banking system both in the markets and
public eye, as well as the foreign investors.


The Central Bank then acted to inject massive liquidity into the system, violating its own
quasi-currency board rules effective for several decades, it created fears that the
program and currency peg were no longer sustainable, and the extra liquidity merely flowed
out through the capital account and drained reserves. This first panic was arrested only
with a $7.5 billion IMF emergency funding package which is over and above the original and
standard $4 billion stand-by loan. Then the coalition government backed and reaffirmed the
commitment to the previous inflation package expectations, promised to speed up
privatisation efforts and financial sector reforms, eventually took over a major bank
assumed to be the origin of the current liquidity problems, and announced a new and
unpredicted guarantee for all liabilities of the banking sector, either private or state
owned.


The grave situation experienced seemed to stabilise by January 2001, while the government
claimed nearly all of the $6 billion that had assumed to exit the domestic markets in the
crisis flowed back and national reserves were again reconstituted. Nonetheless, the
investors were now demanding incredibly higher interest rates as compared with these
before the crisis, while indicating an upward shift in the current country risk premium.
What's more, virtually the recent capital inflow was fixed on short-terms, mostly
overnight basis, deprived of suggestions towards a possible residual devaluation fear. The
investors' confidence in the ongoing programme was not positively restored, despite
several government pronouncements and IMF support.


In this defined critical financial environment, a public row between President and Prime
Minister occurred on February 19 2001, seemingly centred on the President's
anti-corruption campaign, at once guided the way to the perception that the governing
coalition and consequently the programme was threatened and found deciphered. Renewed
crisis followed. Nevertheless, the Central Bank stuck well to its quasi-currency board
rules, seemed reluctant to act as lender of last chance, and assumed that banks would be
eager to expend their foreign exchange reserves for the purpose of obtaining national
currency. However this misadministration resulted in record overnight interest rates,
peaking at approximately 5000% on February 21. The banking system, already intensely
depressed by the first crisis, faced a terrible breakdown as the markets experienced the
interbank payments system's ceasing to function altogether.


The following day the distressed coalition government concluded a floating for lira, and
publicly announced the official end of the exchange rate-based stabilisation programme.
Free floating of the currency was presumably the only convenient solution. The market
confidence that would have been required to sustain the crawling peg strategy was not
present. Acknowledging this certainty as soon as possible has allowed the government to
initiate such floating regime with most of the intact possible reserves, instead of
depleting them in a futile attempt to defend the peg. The authorities were forced to
initiate anew to plan the outlines of a programme in light of the new currency framework.



3) THE IMPACT ON THE STATE & PRIVATE BANKS
Continues for 12 more pages >>