Turkey: The 2001 Financial Crisis

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Includes: TKF, TUR
by: Simon-Peter Noble
Summary

Unlike 1994, stocks didn’t bottom in US Dollar terms at the peak of the crisis.

The banking crisis in 2000 appeared to have been ameliorated with IMF support, but things got much worse in 2001 after a political crisis which effectively broke the crawling peg.

The turmoil provided good investment opportunities for the medium term.

Turkish financial crises occurred in 1994, 2001, and 2009, with real GDP declining by around 5% on each occasion before a V-shaped recovery. This article analyzes the 2001 crisis for a deeper understanding and to see where stocks (TUR) bottomed. This article is the second in a series of three, where I look at the “Made In Turkey” crises from 1994, 2001 and 2018, respectively. In the final article that covers 2018, I’ll discuss the parallels and identify the differences between the three crises.

The 2001 Crisis

The simplified chain of events was as follows:

  1. The Turkish government’s fiscal deficit deteriorated significantly from 1995 to 2000.

Source: ­­­A Template For Understanding Big Debt Crises

2. The domestic banking system was used to fund the government’s deficits, banks increasingly borrowed offshore to lend lira to the government, leading to a rise in foreign exchange debt as a percentage of GDP.

Source: ­­­A Template For Understanding Big Debt Crises

Bank balance sheet vulnerabilities built up from 1995 to 2000. First, they increasingly borrowed short term, offshore and unhedged, to lend Lira to the government, increasing maturity and currency risks. Second, asset exposure to government debt became proportionally excessive; if interest rates rose, the price of their government debt assets would fall reducing equity. This increased single-party interest rate risk. State banks had the additional problem of “duty losses” where the government was borrowing from them, not disclosing this within Treasury finances, and not paying the state banks back.

Source: Central Bank of Turkey & Ankara University

3. As bank balance sheets were increasing their vulnerability to a shock, the real exchange rate was strengthening, adding another risk factor to the economy.

Source: Central Bank of Turkey & Ankara University

4. Moving to 1998, non-performing loans started to increase significantly, threatening the health of the banking system. To offset this, an IMF stand-by credit of US$4 billion was approved on December 22, 1999, in exchange for structural reforms.

Source: Central Bank of Turkey & Ankara University

5. Knowing that the banking system was vulnerable to interest rate risk, market participants tested the lira’s crawling peg knowing that the Central bank couldn’t substantially raise interest rates to defend the currency without creating a systemic banking crisis. The central bank defended the crawling peg in November of 2000 but lost 20% of its reserves in the process.

Source: Central Bank of Turkey & Ankara University

Source: Central Bank of Turkey & Ankara University

Despite the central bank’s defense of the currency, they’d treated the symptoms but not the disease; fears were growing about the banking system’s exposure to interest rate, maturity and currency risk. Market fears went to the next level when a mid-sized private bank named Demirbank was unable to borrow at the interbank market because of its excessive reliance on overnight funding. Due to erroneous IMF stipulations covering net domestic assets, the central bank couldn’t lend to Demirbank which exacerbated the panic. Because Demirbank was a market maker for government debt, its balance sheet was dominated by government securities which it had to sell when its credit lines shut down. The forced selling combined with less market making, caused secondary market interest rates on government debt to spike. Rising interest rates caused the “stop-losses” for structured foreign exchange denominated loans to kick in, spurring further government security sales. Foreign currency demand spiked as lira-denominated government debt securities were used as collateral for foreign exchange borrowing. Secondary market interest rates increased further. These events in confluence caused the overnight rate to spike, to 873% even though Turkey was adhering to an IMF program.

Source: Central Bank of Turkey & Ankara University

Source: Investing.com

6. In December of 2000, Demirbank was nationalized, a fate which came to more than 13 banks. IMF ceiling limits on the central bank were changed to support the banking system. Reserves were immediately boosted with $7.5 billion from the IMF which temporarily calmed the markets.

Source: Central Bank of Turkey & Ankara University

Source: Central Bank of Turkey & Ankara University

The banking crisis was the prelude to the main game.

7. On February 19, 2001, a political crisis emerged involving Turkish Prime Minister Bulent Ecevit and President Ahmet Necdet Sezer. Sezer appears to have accused Ecevit of corruption, resulting in Ecevit demanding a public apology. This political rupture raised doubts that the government would adhere to the requirements of the IMF Program; this resulted in the stock market falling 14%, the overnight rate spiking to 6200%, and the recent IMF reserve additions evaporating as the central bank defended the crawling peg once again.

Source: Investing.com

Source: Central Bank of Turkey & Ankara University

Source: Central Bank of Turkey & Ankara University

8. The crawling peg became unsustainable and had to be abandoned or the central bank would have depleted its reserves. The peak of the 2001 crisis arrived when the lira was floated on February 23, 2001, enduring a significant devaluation.

Source: Central Bank of Turkey & Ankara University

The devaluation, the point of maximum fear, was when the stock market effectively bottomed in terms of lira.

Source: Investing.com

But unlike 1994, you had to wait at least eight months before the lira fully devalued to buy the bottom in US Dollar terms.

Source: Central Bank of Turkey & Ankara University

There was significant fallout from the devaluation; inflation and unemployment spiked, many banks were nationalized as their exchange rate, maturity and interest rate risks were hit by a perfect storm, the governor of the central bank resigned, the undersecretary of the Treasury resigned, and the economy minister was replaced. GDP growth plummeted, unemployment and inflation rose, public debt rose from 38% to 74% of GDP from state bank losses and nationalizations throughout the period.

9. In May 2001, a new stand-by agreement was signed with the IMF which restored confidence.

10. Real GDP, FX debt, the fiscal balance, core inflation, real short rates, reserves, and capital inflows all improved dramatically over the next five years as the crisis was the catalyst for economic discipline, reform and political change.

Source: ­­­A Template For Understanding Big Debt Crises

Source: ­­­A Template For Understanding Big Debt Crises

Source: ­­­A Template For Understanding Big Debt Crises

Source: ­­­A Template For Understanding Big Debt Crises

Source: ­­­A Template For Understanding Big Debt Crises

Source: ­­­A Template For Understanding Big Debt Crises

Source: ­­­A Template For Understanding Big Debt Crises

11. Notably, the current account balance deteriorated significantly in the years after the crisis which sowed the seeds for 2018’s crisis, which I’ll discuss in the next article.

Source: ­­­A Template For Understanding Big Debt Crises

Key Findings From 2001

Like 1994, the time to buy stocks was when the currency had collapsed, reserves had plummeted, the overnight rate was elevated, and inflation was extremely high. In US dollar terms, you would have tripled your money in 3-4 years if you bought at the low. The key difference between 1994 and 2001 is that stocks didn’t bottom in US dollar terms at the peak of the crisis, you had to wait at least eight months for the lira devaluation to run its course, within the new paradigm of a floating exchange rate.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long DP Eurasia on the London Stock Exchange which is the exclusive master franchisee of the Domino's Pizza brand in Turkey, Russia, Azerbaijan and Georgia.