Prepared By: Rosli Hasan, N0or Hidayu Rasman & Hanim Azira Mohd TaibPrepared For: Dr. Catherine Ho

Case Summary The case analyze the 3 sectors leading to the Turkish Lira crash

in 2001. First : Banking Sector

Licensing- not highly regularize

Upon approval, borrow heavily on USD denomination loan in an international market with low interest.

Reinvest in Government Bond on Lira denomination with higher rate.

The Lira devalue, banks struggle to repay their borrowings eventually will collapse.

Uncovered interest arbitrage (UIA) widely in practice.

Case Summary

UIA activities effect the Turkish financial System

USD/Lira seems to be stable even Turkish Inflation rate higher than US. The devaluation of Lira was prevented due to government intervention and conversion of large quantities of dollar (loan) into Lira

Government deficit budget was finance via selling of bond . Bought by their Bank, prevent the market to warn the government of the growing debt.

Devalue of Lira, leave the bank unable to fulfill their loan commitment when it fall due.

Case Summary Second : Economic Death Spiral Upon Failure to repay the debt obligations, a

major Bank collapse. IMF was called for the rescue.

The economic reform was initiate as market is open up, external debt to reduce, government ownership in state enterprise need to reduce, banking system need to clean up.

Case Summary Third : The Turkish Kriz Political instability created by open

confrontation between Turkish President and his PM over corruption issue.

This result in capital outflow of USD5 billion. Investor confidence was shattered.

Lira collapse ,together with the economy.

Huge negative balance of payment in 2000.

Question 1: Was the Turkish lira’s collapse the result of balance of payment crisis, an inflation crisis, a political crisis, or an economic crisis?

Answer In our opinion, the Turkish lira’s collapsed as a result of

balance of payment crisis, inflation crisis and political crisis. Balance of Payment Crisis:

- the deficit on balance of payment grew dramatically in 2000, to over $9.8 billion, from a deficit in 1999 of only $1.4 billion. - capital account liberalization through a designed stabilization program with IMF forced the government to finance the deficit through government bonds- Real interest rates on government bond soared; creating arbitrage opportunities for private banks to exploit the difference between the high rates on government securities compared to foreign borrowing and domestic deposits. - In the end, the rising interest rates then forced the government to borrow more money by issuing new government securities to meet the interest payments.

Answer…

Political Crisis

- On February 18, 2001, a public argument erupted between President Sezer and Prime Minister Ecevit.

- The president had accused the prime minister of being "too passive" in the fight against corruption, of trying to prevent an investigation of the banking sector and of "not respecting" laws. Mr Ecevit said President Sezer had "levelled grave accusations against him, using impolite language" before the start of a meeting of the National Security Council.

Prime Minister Ecevit

President Sezer

Answer…

- The prime minister and the cabinet are furious at President Sezer, who has asserted his constitutional right to call for investigations of his own by appointing a board of directors to probe the transactions of state-owned banks over the last 10 years.

The following day February 19,2001 international investors pulled out over $5 billion of capital out of the country.

- The Turkish central bank’s total foreign exchange reserve, $20 billion, was unable to sustain a defense at this rate of capital flight.

-Three days later, on February 22, 2001, the exchange rate system collapsed and Turkey declared that it was going to implement a floating exchange rate system. The lira’s value immediately plummeted from TL685,000/$ to over TL1,000,000/$.

Answer…Inflation Crisis

- Turkey has 50 years of history of high inflation and unsuccessful disinflation programs.

- In cooperation with the IMF, Turkey designed in 1998 a stabilization program to reduce inflation. - The IMF stabilization program included a crawling peg designed to devalue the currency in line with targeted inflation. However, virtually every other target was met, and they were succeed in reducing the inflation rate from 64% to 39.03% .

- However, in February 2001 following the public war between Turkey's Prime Minister Bulent Ecevit and President Ahmet Necdet Sezer, a new wave of capital outflows led to the collapse of the economic program. Jittery investors pulled $5 billion out of Turkey on February 19th alone.

- In the aftermath of the February crisis, the lira collapse and inflation started increasing again to 68.53%. Without attempting a complete assessment of the IMF program, it is evident that it failed to achieve its stated purposes: to reduce inflation.

Question 2: Describe precisely how the Turkish banks were performing uncovered interest arbitrage. Do you feel that this was inappropriate investment policy?

Answer… Highly public sector borrowing to finance the balance of

payment deficit has created an uncovered interest arbitrage opportunities for the Turkish private bank to exploit the difference between the high rates on government securities compared to foreign borrowing.

The Turkish banking system was notoriously corrupt in the latter part of the 1990s.

Uncovered Interest Arbitrage by Turkish Banks:(1) Throughout 1998, 1999 and the first half of 2000, many Turkish banks borrowed large quantities of dollar outside Turkey(2)The banks then converted the dollar proceeds into Turkish lira (3) Then, purchased the government bonds as investment.

The bank will continue to make its profit as long as the Turkish lira held its value.

The Uncovered Interest Arbitrage Diagram: Value of Lira Maintain

The Uncovered Interest Arbitrage: Lira lost its value

Answer…

In our opinion, this was an inappropriate investment policy.

This is because the earnings of the banking sector were highly dependence on the highly yielding government bonds.

For example, Demirbank was heavily concentrated in government debt instruments business and acting as a market maker to defend its position and it was not active in traditional banking business of collecting deposits and distributing loans.

This risky mode of investment can be found in the balance sheets of all private banks. This risky mode of investment made the Turkish banking system vulnerable to a jump in

exchange rate and interest rate.

QUESTION 3: How could the Turkish banks be contributing to financial crisis if they were purchasing Turkish government bonds and helping finance and support their own government?

Borrowed money at low dollar rates and reinvesting in much higher government bond rates in Turkish Lira.

It helped finance and support their government to finance their budget deficit and created significant profit for the bank.

When the Turkish bank invested their money to government bond, indirectly it will help government to generate economic activities from that money.

The situation is temporary since the continuing demand for Turkish government bonds increased the government’s debt. It also allowed the government to fund increasing budget deficits at manageable costs.

It giving more badly since the growing external debt obligation of Turkish banks was caused the instability of the banking system.

Once the obligations came due, and many of the bank debts were callable in that the international banks could demand repayment overnight, the rush to exchange lira for dollars for debt service would drive the exchange rate down dramatically.

The lira’s was collapse since the balance of payment current and financial accounts recorded major swings in their relative values.

According to that problem, international banks not affordable to collect their debt from Turkish bank. It caused international banks suffered from the Turkish Bank’s high debt and also effected their financial.

From this situation, it showed that Turkish Bank contributed to financial crisis.

QUESTION 4: Which do you think is more critical to a country such as Turkey: fighting inflation or fighting a large trade and current account deficit?

Fighting a large trade and current account deficit more critical rather that fighting inflation.

In February 2001, there was deteriorated of the Turkish current account balance. Therefore, Turkish bank borrowed money from international bank to stabilize their current account. However Turkey government not affordable to pay its international debt, it allowed the government to fund increasing budget deficits at manageable costs.

It affected it’s current account deficit.

Then, when international bank bring back their capital to their country, it caused Turkey’s inflation increased and exchange rate down dramatically.

It can say that, because of current account deficit, Turkey experienced high inflation rates.

Turkish government turned to IMF for help. Unfortunately, it was undertake a privatization program whereby it reflected the political and trade relations.

Turkish hard to fighting a large trade because European Union was unfair and discriminatory barriers since they were not in the spirit of membership.

It caused Turkish experienced economic crisis and was only attempting to slow the growing current account deficit.

Turkey still can survive when fighting inflation if Turkish banks not acquired the dollar-debt obligations from international banks.

Question 5: The quote from Corporate Finance, although noting the outside possibility of a devaluation, was largely positive regarding Turkey’s future in January 2001. What would you have predicted at that time? The pending $7.5billion IMF support package and

standby arrangement are likely to ease market concerns about the credibility of Turkey’s stabilization program, particularly in view of the revitalize privatisation agenda and strengthened fiscal targets for 2001. The Turkish Lira has strength on the back of IMF funding.

On three-month view, however, expect the Lira to return to track inflation performance suggesting a level of below TL750, 000 by end of March. An outside probability of full blown currency devaluation- similar to that in 1993- cannot be discounted, however.

Answer We would have predicted that same, given the current

situations, (January 2001). The IMF bailout saves the banking sectors, bring the stability and restore the investors sentiments.

However, the change of political situations ruins everything. In February 01, the investors pull out investment s worth USD5 billion, prompt the Turkish Central Bank to defense the Lira value but its too big to handle.

Last choice ,they float the currency in order to restore the stability, leaving the market force to determine the value of lira.

Answer….

Immediate result, the Lira value plummeted from TL685,000/USD to over TL1,000,000/USD.

The value continue to fall, bank collapsed, economic activity halt and registered negative growth.

In long term, the floatation of currency will bring the growth to the economy but in practicality the government will intervene as they will not allow the market forces to determine the value of the currency if it will bring harm to the economy

The government will not allow the Lira to gain against USD, as it will deter the flow of investment.

Conclusion In conclusion there are many factors that

determine the value of currency. Dr David Aviel, Professor of International

business in his paper, on foreign exchange markets, currency devaluations and the Malaysian strategy. List the followings factors

a) Inflation b) Balance of trade c) Government budget defisit

Conclusion….

d)Excessive money supply

e) External liquidity problems

f) Currency Black Market

g) Spot rate and forward rate

h) Fiscal and Monetary policy

i)Political situations

j) History of devaluation