DEVELOPMENTS IN 1990 s

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1 MACROECONOMIC MANAGEMENT WITH OPEN CAPITAL ACCOUNTS: THE TURKISH CASE FAIK OZTRAK Director TUSIAD-Koc University, Economic Research Forum HIGH LEVEL SEMINAR ON CRISIS PREVENTION, SINGAPORE, JULY 1, 26 DEVELOPMENTS IN 199 s Turkey liberalized fully the capital account in s was a lost decade with extreme volatility High and variable inflation (8%) Growth below potential with extreme volatility (4%) Financial markets, interest and exchange rates went through large swings associated with boom-bust cycles in international capital markets 1

2 DEVELOPMENTS IN 199 s PSBR have doubled from1 percent to 2 percent and there was a rapid build-up of public debt Poorly supervised financial system, depending on high interest rates on government debt and carrying large fx open positions DEVELOPMENTS IN 199 s 13 Inflation 1 Growth CPI -1 GNP 1 Interest rates and Change in FX Rates Capital Inflows( $) and Growth (%) IOR FXR(Right Axis) 2-8. Capital Inflows Growth (Right Axis) -1 2

3 EXCHANGE RATE BASED STABILIZATION (2) At the end of 1999 an exchange rate based stabilization program was launched The program with a pre-announced exit strategy from the peg reduced the inflation and interest rates. While domestic demand is booming current account worsened due to a rapid appreciation of the currency EXCHANGE RATE BASED STABILIZATION (2) Peg reduced the exchange rate risk, induced capital inflows, increasing open positions and vulnerabilities in weakly regulated banking sector The first test of the peg by speculators came in late 2.The ensuing currency and financial crisis encountered in February 21 led to the collapse of the program 3

4 EXCHANGE RATE BASED STABILIZATION (2) GROWTH (Annual %) INFLATION (%) GNP 3 JANUARY APRIL JULY OCTOBER JANUARY 1 CPI T-BILL RATES(%) AND REER (9=1) Average March June September December March 1 REER (CPI) T-Bill Rates (Right Axis) Current Account Deficit and Net Private Capital Inflows (Annualized, $ Billion) JANUARY APRIL JULY OCTOBER JANUARY 1 CAD PCI (Right Axis) INFLATION TARGETING AND FLOATING EXCHANGE RATES (21-) In response to crisis government changed the economic management team and launched an ambitious program to establish quickly reform credentials and bolster investor confidence The program was based on floating exchange rate, strong and sustained fiscal adjustment, a strong emphasis on dissinflation and front-loaded structural reforms IMF supplied substantial outside financial assistance Increased liquidity in international markets reduced the cost of borrowing Single party government increased percieved political stability Strengthened EU anchor improved expectations 4

5 INFLATION TARGETING AND FLOATING EXCHANGE RATES (21-) To deal with financial crisis; A blanket guarantee for the liabilities of the taken-over private banks was introduced State banks were re-capitalized ($ 3 billion) Weakest private banks were intervened Supervisory and regulatory framework strengthened in line with international best practices THE OUTCOME UNDER THE NEW Positive Recovery has been rapid, growth resumed in 3 quarters. Annual average growth was more than 7, % during 21- A dramatic decline in inflation to single digit levels not seen since 197 s Rapid improvement in financial market confidence as witnessed by a substantial decline in interest rates Substantial decline in government debt

6 THE OUTCOME UNDER THE NEW Growth (Annual % Change) Inflation ( Annual % Change) GNP / CPI Interest and Maturity in Trasury Auctions Public Debt/GNP (%) Maturity (Days, Right Axis) Interest rate (%) ,% 1,% 8,% 6,% 4,% Net Gross THE OUTCOME UNDER THE NEW Negative Rapidly widening current account and trade deficits Substantial private capital inflows mainly in the form of portfolio investments and debt, sensitive to sudden climate changes in international markets Rapid appreciation of the currency and increasing unit labor costs in $ despite increases in labor productivity Increasing downward rigidities in inflation Slow down of the structural reforms 6

7 THE OUTCOME UNDER THE NEW Current Account and Trade Deficits ($ Million) CAD TD (Right Axis) Net Private Capital Inflows ($ Million) Real Effective Exchange Rate (97=1) Unit Labor Cost Index CPI Based 12, 11, 1, 9, 8, 7, 6,, 21Q1 22Q1 23Q1 24Q1 2Q1 $ TL Lessons to be drawn Flexible exchange rate does not prevent appreciation and ensuing deterioration in external balance in case of large inflows, creating new vulnerabilities Politicians prefer to watch boom cycles as the market s discipline on them weakens Sterilization of the inflows by the central bank is costly and inflation targeting central banks prefer to rely on appreciation, There is a need to control inflows through a coordinated game between central banks, financial supervisors and fiscal authorities 7

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