Monday, October 20, 2008

Global financial crisis and Turkey

When there is a global financial crisis going on, our small daily duties may seem even pettier than usual. This is what happened to me – digging up data and news reports about Turkey as usual, I had an urge to drop what I’m doing and understand what is really going on in the global economy.

Unfortunately (or luckily) not everyone’s job involves developing a good understanding of the dynamics of the global economy. Even academics or finance professionals do not have to consider the currents of the global economy or how their area of research or daily tasks fit into the macro picture. Even central bankers focus on their own country, but not on global imbalances. The trade-off seems to be between joining the machine by specialising in a small, manageable section (this is what the overwhelming majority of us do) or becoming more of a popular intellectual, who is watching the great currents without going into specific knowledge of technicalities.

More extensive media coverage and analysis about financial markets, especially during this crisis, makes academics and technocrats household names, and leaves people wondering how the crisis could affect their lives directly. People grow more curious about how this crisis came about, and what its resolution will take. The public seems to have renewed interest in the regulation of the economy, a phenomenon that is reversing the neoliberal populism trend. We can say that politics is re-coupling with economics. I will use this post to think through the situation myself, largely drawing upon a special report that appeared in the Economist recently.

It might be surprising to some, including myself, to see how defaults on subprime mortgages, spurred by the bust of a bubble in the housing market, could spread to the entire financial system. The answer lies in the structure of financial markets. Using the opportunities provided by technology, banks created complicated products to pass on loans to other investors, rather than keeping them on their books (securitisation). This way, a very small amount of capital can be lent and re-lent multiple times. The extensive trading of these products, such as the infamous credit-default swaps, spread the risk across the financial system. In the end, nobody knew whether their counterparty held these toxic products or how each product was valued, and this led to widespread panic. Banks stopped lending to each other, and the leveraging trend of the past few years was reversed: Now everybody wanted to de-leverage, not only refraining from extending new credit, but also trying to get their cash back as soon as possible. That’s what spurred governments to bail-out their troubled financial institutions with public money, as these institutions were not able to obtain funding from markets. The argument for government intervention goes that these institutions were systematically too important (too inter-linked to every other institution in the system) to fail.

With hindsight, critics claim that financial engineering and innovation got out of hand, leading banks to take on risks they could not manage, with dire consequences for the whole system. The ideological underpinning for a free market economy is de-regulation, which supposes that market forces will allocate resources most efficiently if left on their own. However, economic theory calls for regulation when part of the costs of an economic activity are not internalized by the company or country undertaking it. As the crisis has demonstrated, more effective regulation and oversight are needed in financial markets. What shape the new regulations will take, and which new national and international institutions will be responsible for implementing them, is unclear at the moment. To fight with over-leveraging, the Economist calls for an overhaul of regulatory and oversight institutions (especially in the US), increasing the banks’ capital ratios, and changing tax codes that favour debt over equity for companies and households.

But bankers and regulators are not the only ones to blame. The monetary policy of central banks, most notably the Federal Reserve, exacerbated the bubbles in the economy. Low short-term rates, for example, inflated the housing bubble by making adjustable-rate mortgages cheaper. Moreover, high savings of emerging markets like China and Russia, as well as the Gulf states (due to export revenues, thanks to currency management in the Chinese case and the surge of oil prices in Russia and the Gulf) flooded into the US and Europe, driving long-term interest rates down. Meanwhile, emerging markets, which pegged their currencies to the dollar, suffered from the Fed’s loose monetary policy, leading to overheating in their economies. Even countries with a floating exchange rate, such as Turkey, enjoyed significant capital inflows.

How will the crisis affect an emerging market like Turkey? Very shortly, the reversal of capital inflows will expose the structural weaknesses of our economy. We enjoyed tail winds until 2007, but now we are faced with strong head winds. The difficulty, however, does not stem from the banking sector. Our banking sector is relatively shielded thanks to regulatory reforms introduced following the 2000/2001 banking crisis, which established the independent Banking Regulatory and Supervision Agency (BDDK) and brought more stringent capital requirements and internal auditing standards for banks. However, foreigners hold a large share of the Turkish banking sector (around 40%), a channel through which the crisis could spread into Turkey.

The main problem for us is the large external financing needs emanating from the current account deficit and large external debt. Rollover of foreign debt will be more costly, and finding FDI and portfolio investments will be more difficult from now on. The Istanbul stock market (IMKB) was down by 10% last week, and 21 % last month alone. The lira is also depreciating rapidly against the dollar and the euro, and this coupled with global credit crunch leaves the corporate sector, which holds a lot of FX-denominated debt, and local banks, vulnerable.

The slowdown in the world economy will influence the size of our trade deficit. Our exports to the European Union, our main trading partner, have already slowed down considerably. This effect, however, will be offset by several factors. Domestic demand for consumption and industrial inputs will decline. Significantly, our imports will also cost less, thanks to the diminishing price of oil and other commodities. (By the way, the Economist thinks earlier surge in oil prices was more due to rising demand and government subsidies than speculation on commodity futures. Food prices rose due to biofuel production and export bans.)

The crisis will force everyone to take a good look at themselves, reflect on what went wrong and clean up their act. For Turkey, this will mean addressing the structural problems in the economy. If it leads to meaningful reforms geared towards reducing the administrative and tax burden on the private sector, increasing the domestic saving and investment ratios, and improving the efficiency and value-added in the economy, then we can really look back and remember the crisis as an opportunity. This would also mean sustainable growth and less unemployment, which lingered around 10% even as our economy was growing by 9.4%, 8.4% and 6.9% in 2004, 2005 and 2006 respectively.

The same goes for every country in the world. A crisis situation presents the opportunity to build a system that is more consistent and coherent, and hence more stable. We learn more about human nature and economics as time goes by, we are not nearly there yet. We have to do our best and go forward.

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