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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

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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

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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

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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

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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”

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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

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The Balance Sheet Effect Model of Currency Crisis

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The Classical Mundell Flemming

Framework • (1)   y=d(y,i) + NX(eP*/P,y)

• (2)   M/P=L(y,I)

• (3) i=i*

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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

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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

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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

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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

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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. 1994 – 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. 1987 and three times vs. 1994 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

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Empirical Testing of the Balance Sheet Effect in the Case of Turkey

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The Variables

• Investment – as measured by the gross capital formation

• HCPI= (CPIt/CPI0)/(et/e0) - 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

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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 -0.476791 0.143641 -3.319324 0.0017

DHCPI 2.950792 0.789090 3.739486 0.0005

Q1 -1.087536 0.225829 -4.815756 0.0000

Q2 1.874560 0.253766 7.386952 0.0000

R-squared 0.831850 Mean dependent var 0.096607

Adjusted R-squared 0.818398 S.D. dependent var 1.228359

S.E. of regression 0.523462 Akaike info criterion 1.629803

Sum squared resid 13.70062 Schwarz criterion 1.812288

Log likelihood -39.81958 F-statistic 61.83852

White Heteroskedasticity-Consistent Standard Errors & Covariance

Variable Coefficient Std. Error t-Statistic Prob.

Q3 1.208776 0.162309 7.447368 0.0000

Durbin-Watson stat 2.022949 Prob(F-statistic) 0.000000

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InterpretationEstimation Command:

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LS(H) DINVEST C DHCPI Q1 Q2 Q3

 

Estimation Equation:

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DINVEST = C(1) + C(2)*DHCPI + C(3)*Q1 + C(4)*Q2 + C(5)*Q3

 

Substituted Coefficients:

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DINVEST = -0.4767909993 + 2.950791862*DHCPI - 1.087535506*Q1 + 1.874559665*Q2 + 1.208775582*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

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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

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Lessons for other countries

• An expansionary policy of real depreciation will work only if the external financing of the private sector is not important