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 – 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 and three times vs 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= (CPI t /CPI 0 )/(e t /e 0 ) - 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 Estimation Output 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 C DHCPI Q Q R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Akaike info criterion Sum squared resid Schwarz criterion Log likelihood F-statistic White Heteroskedasticity-Consistent Standard Errors & Covariance VariableCoefficientStd. Errort-StatisticProb. Q Durbin-Watson stat Prob(F-statistic)

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 = *DHCPI *Q *Q *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