The IMF Does Monetary Policy In Turkey But Is It Enough?

It has been one of the chief concerns for many who criticize the International Monetary Fund (IMF). For years, critics of the multi-national institution have voiced their displeasure at how the IMF has encouraged countries to recklessly devalue their currencies in an effort to foster an export-driven recovery. The IMF has traditionally rationalized that currency devaluations can help a country to promote quicker economic growth by making that country's exports cheaper on international markets.

But quite often, any short-term benefits that may accrue to a country as a result of increased exports are quickly eroded or overtaken by the spiraling inflation that appears inside of a country's borders as fuel, clothing and other necessities eventually skyrocket in price as wholesalers, retailers, laborers and producers - realizing that their country's currency is losing value, demand more in return from consumers.

The IMF's most famous episode in encouraging such monetary mismanagement took place in 1997 when the institution encouraged and applauded a decision by both Thailand and Indonesia to devalue their currencies - two decisions responsible for the so-called Asian Crisis which devastated financial markets around the world from 1997-1999.

And more recently, the IMF privately persuaded Zimbabwe to devalue its currency in August of this year- a move that the country is still reeling from.

Many financial analysts and economists in the US and abroad have appropriately pointed the finger at the IMF's tone-deaf approach to monetary policy but have had little to show for the exercise although the IMF has, for nearly two years now, stated that it is learning from its past mistakes.

They have had nothing to show for their complaints that is until now…maybe.

The IMF's recent arrangement with Turkey has caused many to begin to believe that the institution has partially seen the light and is determined to never walk down the disastrous path it traveled three years ago.

The component of the Turkey-IMF deal that has gotten the most attention from IMF critics is the monetary regime that the IMF has proscribed for the country of 66 million people.

Yes, the IMF has taken that bold step in recognizing the role that monetary policy can play in the economic development of Turkey and actually mandated that Turkey accept a monetary policy framework that simulates the type of monetary regime that the IMF has long opposed.

The IMF has ordered Turkey to implement what is known as a crawling peg.

A crawling peg is monetary regime whereby a domestic currency is allowed to appreciate or depreciate against another currency or basket of currencies, over a set period of time. The currency or basket of currencies to which the domestic currency are tied in the peg arrangement, is known as the "anchor".

In Turkey's case, the Turkish lira is being allowed to depreciate slowly, until 2003, against a currency basket made up of the US dollar and the European Union euro.

In its December 9, 1999 Letter of Intent with the IMF, the Turks promised to have a preannounced "crawling" depreciation for 18 months, at which time they would move to a more flexible rate.

The crawling peg can instantly give a country credibility because it gives investors and producers and even consumers a sense of predictability, as they are now able to gauge the rate of inflation or deflation that will creep into all of their transactions.

So, a depreciating peg does not help a struggling country by eliminating inflation but rather by controlling the rate of inflation. If the anchor currencies are not inflating or deflating dramatically, then the crawling peg, if it works properly, eliminates all sudden and erratic fluctuations in the value of a domestic currency.

But the IMF did not stop with just a traditional crawling peg, it took the unusual step of ordering that Turkey implement a framework whereby the crawling peg actually behaves like a currency board -an arrangement that the IMF, in the past, has fought tooth and nail against, particularly in 1998.

In 1998, currency board expert Steve Hanke, professor of applied economics at Johns Hopkins University, at the request of then-Indonesian President Suharto, prepared plans to institute a currency board in order to address the hyperinflation that had gripped the country.

The IMF vehemently opposed Dr. Hanke's efforts as part of a West-led effort to remove Suharto from power.

But two years later, after doing almost everything in its power to prevent a currency board from being instituted in Indonesia, the IMF is actually forcing Turkey to get as close as one can get to having a currency board.

And in a sense, who can really blame the IMF for moving in the direction of an idea that it once opposed? This is especially true in light of the dismal record that the IMF has with Turkey.

As Steve Hanke put it in a recent opinion editorial in the Financial Times, "Since 1961, Turkey has signed 17 IMF agreements and has broken them all- a perfect record of failure".

The IMF, recognizing its horrendous track record in Turkey, obviously realized that something different and dramatic had to be done in order to arrest Turkey's spiraling inflation rate. Turkish inflation has averaged over 80% in the last 8 years and has sent Turkish interest rates through the roof, as high as 2,000% on overnight interbank interest rates.

In light of these extremely difficult problems, the IMF decided to depart from its traditional negligence of monetary policy.

But it is essential to remember that although the IMF-mandated crawling peg in Turkey partially behaves like a currency board, it is not a currency board.

An orthodox currency board is not a pegged regime at all.

It is really a fixed-rate regime where a domestic currency is tied to a foreign currency at a fixed rate of exchange. There is no schedule of appreciation or depreciation, no matter how slow and gradual. And every day the central bank, under a currency board, must show that it has sufficient foreign currency reserve backing to honor the fixed exchange rate between the domestic and foreign currency.

What makes the IMF crawling peg behave like a currency board is a one-of-a kind provision in the IMF agreement with Turkey, which essentially orders the Turkish central bank to freeze its Net Domestic Assets (NDA). Since by definition, net change in the monetary base is equal to the change in the central bank's net foreign assets plus the change in the central bank's net domestic assets, a promise to freeze net domestic assets means that the monetary base (the monetary base is usually defined as bills and coins in circulation plus banks' cash on hand and their reserve balances) can only increase to the extent that the central bank acquires more foreign reserves.

This is like a currency board arrangement, without a fixed exchange rate, and without a strong institutional framework to make sure that the central bank keeps its promise.

The set-up actually worked as advertised but soon hit a major bump in the road when several criminal cases inside of Turkey began to uncover decades of bank mismanagement, causing several Turks to take capital out of the country.

Then, at the same time, one of the mid-sized banks in Turkey, Demirbank, which had been doing business with Turkey's biggest banks, suffered a loan crisis that eventually led to its lines of credit with the larger banks being cut. This caused Demirbank to sell Turkish treasury bills in order to obtain badly needed cash.

But this was no ordinary sale of treasury bills due to the fact that Demirbank has held as much as 10% of Turkey's domestic debt. When Demirbank moved to sell its bills, others were shaken and followed.

Normally, under similar circumstances a country's central bank would have stepped in to provide emergency liquidity to a bank as important as Demirbank. But because of the IMF-NDA provisions, which in effect capped the growth of the supply of domestic currency, no help was available to Demirbank and its only option was to sell-off its domestic debt holdings.

Demirbank's liquidity crisis caused others to rush to the Turkish central bank and sell Turkish liras in exchange for US dollars. This caused Turkish lira to be drained out of circulation at the very same time that they were needed to ease interbank lending.

Steve Hanke explained how the crisis began and effectively broke the crawling peg arrangement in his Financial Times op-ed, "...the new set-up worked like a charm while the central bank was following the currency-board-like rules. Inflation and interest rates came down hard. Then, confronted with external drains of foreign reserves, the central bank decided to break the rules on November 17. To offset the decline in the foreign component of the monetary base it began to pump up the domestic component of the base by injecting liquidity into the system. As a result the NDA exceeded its end-of-December target by more than $3 billion."

But this injection of emergency liquidity was viewed as inflationary in nature and only inspired investors to get out of Turkish lira and into euros and dollars, taking even more foreign reserves out of the Turkish central bank and out of the country.

Within two weeks over $7 billion of Turley's original $24 billion of foreign currency reserves had been taken out of the country.

But what happened in Turkwy is a common scenario, repeated several times throughout the world under a pegged exchange rate regime where a country is simultaneously trying to manage monetary policy and a foreign exchange rate.

Under a pegged exchange rate when capital outflows become excessive, a central bank attempts to offset the decrease in the foreign component of the monetary base (in Turkey's case, US dollars) with an increase in the domestic component of the monetary base (in Turkey's case, the lira).

Balance-of-payments crises erupt as the central bank begins to offset more and more of the reduction in the foreign component of the monetary base with domestically created base money. At that point it is only a matter of time before investors and speculators spot the glaring contradiction between exchange-rate and monetary policies, eventually forcing a devaluation.

And that is what happened in Turkey.

Although the IMF-mandated fixed NDA provision delayed the injection of domestic liquidity in an effort to ease the loss of foreign capital, the injection eventually did occur and Turkey was headed in the direction of a devaluation had not Demirbank been taken over by the Turkish government and had not the IMF promised an additional $7.5 billion in emergency funds - the almost exact amount of foreign capital that fled the country.

Mr. Hanke believes that the time has arrived for Turkey to move away from its hybrid monetary regime and move without ambiguity toward a fixed exchange rate regime. He advises, " Turkey must abandon its ersatz currency board and install the genuine article".

Others agree with much of Hanke's analysis of the problem on the monetary policy front but also believe that the IMF actually undermined its own efforts with monetary policy by demanding that Turkey embark on a counterproductive fiscal policy.

Michael Darda, an intenational economist at the consulting firm, Polyconomics Inc. has been observing the economic ramifications of Turkey's arrangement with the IMF since its inception and warned Polyconomics' clients, months in advance of Turkey's most recent crisis, that Turkey's crawling peg/currency board regime would be in trouble due to the adverse implications of the IMF framework for Turkey's fiscal policy.

In a recent conversation with BlackElectorate.com Mr. Darda said, "If Turkey were following a pro-growth fiscal policy and implementing supply-side tax rate reduction, the capital flight that characterized the latest financial crisis would not have occurred."

" Back in October we warned our clients about the counterproductive fiscal-austerity policies that the Turkish government was preparing to embark upon. By that time the IMF had successfully persuaded the Turkish government to impose a 8% tax on bank lending (increased from 3%) and a 40% tax (increased from 25%) on "luxury" vehicles, on the misguided notion that consumption needs to be slowed in order to reduce the trade deficit and Consumer Price Index (CPI). The IMF believes that the tax hikes and credit controls will achieve four goals: enlarge the tax base, reduce the fiscal deficit, shrink the current account-deficit, and cool inflation. In reality, as we have seen time and again, giant taxes on consumer lending have precisely the opposite effect: they curtail growth, thereby reducing the tax base, enlarging the fiscal deficit, and decreasing demand for local currency. The latter, of course, leads directly to increased pressure on the currency, which increases devaluation/inflation risk."

Mr. Darda continued, " In addition to all of this, the government is now moving to institute growth-smothering marginal income tax rate increases. There was simply no talk anywhere within the Turkish government, in Ankara or Istanbul, about using fiscal policy to expand incentives to produce, while using monetary policy simply to stabilize prices. Raising tax rates after decades of inflation is the worst possible blunder Turkey could have committed. The bottom line is that the entire Turkish political class is being straight-jacketed by the IMF."

Mr. Darda believes that even though Turkish monetary policy hit a bump in the road, increased demand for the Turkish lira could have been generated with the implementation of a supply-side fiscal policy. He argues persuasively that as much energy should be devoted towards increasing the demand for a currency through an appropriate fiscal policy as is devoted to managing the supply of a currency through monetary policy.

Mr. Darda recommends that among other policy initiatives, Turkey should remove or lower its taxes on consumer lending; remove harmful revisions it is adding to its self-employment tax; and scrap its plans to hike the top marginal tax rate by 5-10%.

Marginal income tax rates are important, due to the fact that in a country like Turkey where inflation is present, citizens end up losing a greater portion of their incomes as inflation causes them to creep into a higher tax bracket as they demand and receive nominally higher wages in an effort to maintain purchasing power. Raising marginal tax rates in a country like Turkey where bracket creep is taking place is extremely harmful to economic growth as it actually provides a disincentive to work among laborers and producers.

And so, while the IMF may be moving away from its historic lack of responsiveness to monetary policy, it appears that the results that its advice produces will be the same as the days of old, unless the multinational institution moves completely toward fixed-exchange rate regimes like an orthodox currency board while they simultaneously move toward a growth-oriented fiscal policy that rewards risk-taking, unleashes productive capacity and which alleviates inflation pressures on wage -earners.

The IMF may be learning its lessons the hard way but certainly not any harder than the nations who are crushed under the weight of its bad advice and policy experimentation.

Hopefully we will not have to add Turkey to the trail of nations devastated by IMF obtuseness.

Cedric Muhammad

December 20, 2000

Here is the latest update on the Turkish IMF arrangement from this morning's Turkish Daily News:

Turkey's fragile money markets are expected to recover to some extent with the $4.19 billion International Monetary Fund (IMF) and World Bank credits which should enter Turkey on Dec. 22. Yet economists say this money is only a drop in the sea for a country that has a public deficit of $30 billion.

Professor Erol Manisali said that in a country where the foreign currency reserves decline from one day to the next and the public deficit grows quickly, it is not possible for the economy to improve and bank interest rates to fall.

Professor Turkel Minibas also said that the credit would be insufficient for Turkey. The decision about the $2.8 billion part of the $10.4 billion aid promised by the IMF, of which $2.9 billion is in supplemental credits and $7.5 billion is part of the standby, is expected to be taken in the executive committee meeting of the IMF on Dec. 22.

It is on the same day that the administration of the World Bank will discuss the financial sector adjustment loan.

The breakdown of the money expected to come to Turkey on Dec. 22 is as follows: $2.8 billion from the IMF, $390 million from the first part of World Bank credits and $1 billion from foreign banks, all of which amounts to $4.19 billion.

Istanbul University faculty member Manisali stated that the money expected to enter Turkey would boost morale only to a very small extent, and said: "The public sector deficit is over $30 billion at this point. How is it possible for such a small amount to have a positive impact on the economy when there is a major deficit?"

Stating that the aid would not cause bank interest rates to go down, Manisali said that it was not possible for the banks, which give 75 percent interest with a maturity of six months, to lower the interest rates. 'It won't be sufficient for the Central Bank' Minibas stated that the money, which will be given by the IMF and the World Bank, would make markets feel better psychologically.

Noting that the credit was given for offsetting the liquidity shortage but not for improving the markets, Minibas said, "But it has been allowed for one time that the money should be given to the market before the holiday in order to offset a possible liquidity shortage by the banks." Pointing out that the credit would be given to Turkey one day before the 10-day holiday, Minibas said that it was not meaningful to give the credit right at this time.

Minibas argued that the Central Bank would keep the money in the safe. Stating that the money would not cause bank interest rates to go down, Minibas said that it was not possible for the interest rates to fall to the same level as in November.

Pointing out that the interest rates are more flexible at the present but they would have a tendency to increase because of the 10-day holiday, Minibas said: "The existing situation in the interest rates will continue until the middle of January. It is not known what will happen next."

Wednesday, December 20, 2000