Turkish crisis a global threat

March 02, 2001|By David H. Feldman

WILLIAMSBURG, Va. --Turkey's lira plunged 36 percent in value against the dollar last week, and overnight interest rates there reached a stratospheric 6,100 percent.

The crisis began as a political spat within the Turkish leadership. Fearing that the dispute might jeopardize Turkey's reform agreement with the International Monetary Fund, foreign investors pulled cash out and the central bank was forced to pump one-sixth of its reserves into the currency markets to defend the lira. The Feb. 22 collapse marked the central bank's surrender.

This is a clear reminder that financial systems in developing nations are fragile and a warning that not all of Federal Reserve Chairman Alan Greenspan's waking moments can be devoted to President George W. Bush's proposed tax cuts.

What's at stake if our NATO ally's financial system self-destructs? A currency collapse of this magnitude could easily lop off 6 percent of the Turkish economy's purchasing power and then cause a severe recession.

Many Turkish firms' debt obligations are in foreign currency while their revenues are in local currency. Firms that were perfectly sound the day before find themselves effectively bankrupt. Unfortunately, many of the firms in these straits are banks.

As in many developing nations, Turkish banking practices and regulations are looser than in Europe or the United States. It is harder for investors and the public to tell the good banks from the bad ones. Some should be reorganized, and banking authorities recently seized control of a foundering small bank in a move that only spotlighted the vulnerability of the country's banking system. The crisis threatens insolvency indiscriminately, and the resulting credit crunch could spread bankruptcy throughout the economy.

In an age of internationally mobile capital, financial problems in one country can spread to others. This is one of the important lessons of the East Asian financial mess that started with the collapse of the Thai baht in July 1997. The contagion could be transmitted in at least two ways.

Foreign investors often dump the assets of other emerging economies whenever exchange rate instability in one nation threatens asset values. To fend off this speculative pressure and to preserve their own exchange rates, these innocent bystander nations must raise domestic interest rates or spend their central bank reserves.

If they fail, they become the next object lesson for skittish investors. This herd behavior is quite rational if investors lack clear information, such as reliably audited balance sheets or trustworthy government accounts, that would permit them to discriminate between better and worse risks. So far, we haven't seen herd panic, and Turkish markets are momentarily calm. But the massive $25 billion Turkish loan request suggests the crisis is still unfolding.

Turkey's major trading partners now face the prospect of Turkish exports selling at fire-sale discounts. In the long run cheap imports are a good thing, but the immediate effect is industrial dislocation, unemployment and pressure for trade barriers. If asset holders among Turkey's trading partners expect the currency crisis to worsen their own trade balance, it may generate speculative pressures on those currencies as well.

This is not a theoretical exercise. In our own hemisphere, Argentina's current slump can be traced at least in part to last year's currency woes in Brazil. Argentina faced the choice of devaluing the peso and destroying years of hard-won inflation credibility, accepting tighter credit markets and the decline of local industries that compete with Brazilian goods, or putting up trade barriers that would destroy the nascent free trade areas in the region. They opted for higher interest rates and recession.

The United States seemed immune from the last round of currency crises because the Federal Reserve acted aggressively to cut U.S. interest rates and the booming U.S. economy cushioned the downturn abroad.

Higher foreign interest rates and sputtering economies overseas are more of a threat now that Mr. Greenspan no longer has the high-flying economy as an ace up his sleeve.

And contagion isn't restricted to emerging market economies. Given the precarious state of Japan's banking system, we can only hope no spark sets it alight before the U.S. economy rights itself. Otherwise, the soft landing so desired by President Bush could harden very quickly.

David H. Feldman is a professor in the department of economics at the College of William & Mary.

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