Financial Liberalization in Turkey

©International Monetary Fund. Not for Redistribution

5

Financial Liberalization i n Turkey

RU$D0 SARAGOGLU

Until the end of the 1 970s, successive Turkish governments pursued an inward-oricn tcd growth strategy. Howe\'er, changes in the world economic conditions after the mirl-l970s and the domestic economic crisis that followed forced the authorities to review and eventually abandon the u·aclitional economic policies. In 1980, the government launched a structural adjusu11ent program that was based on free market pl"inciples and an outward approach to economic policies. During the period 1981-199 1 , a series of liberalization measures were started, as were institutional changes to implement the new economic su·ategy. Although the focus of this paper is on interest rate libei·alization within the context of a general llnancial sector reform, the process started with reforms of the foreign trade sector, bOLh expons and imports. The liberalization of trade and the concomitant innease in the volume of foreign transactions played an instrumental role in the design and implementation of financial sector reforms.

The policymakers believed that structural adjusunent policies could not be implemented successful!) unless llnancial markets were deep and mature enough to meet the llnancing needs of an outward-oriented economy. Therefore, a series of reforms were undertaken to develop the Turkish financial system. The main focus was to enhance the operational and allocati\'c cfficieucy of the S)'Stcm through liberalization and increased competition. These 1·efonns also aimed at enhancing monetary policy effectiveness, particularly in stabilizing the value of the Turkish lira.

Before 1980, Turkey experienced a high degree of financial repression, charaClerizcd by negative real interest rates; credit rationing; lack of capital markets; excessive reliance on cenu·al bank resources for public seCLor financing requirements; severe resLrictions on foreign exchange operations; and a high level of taXation on financial income and

1 1 1


1 1 2 RO§dO Sara�oglu

transaCtions. All deposit rates, and to a large extent loan rates, were determined direct!)' by the government, with no relation to the current inflation rate. Moreover, priority sectors, such as those producing import substitutes. could access subsidized resources under a number of' complex and selective credit schemes.

During the earliest attempt to liberalize irllerest rates, in July 1980, loan and deposit interest rates were liberalized and certificates of deposit were introduced. Although this reform program was launched against the background of' tight monetary policy and restrictive demand management policies, tJ1e government acted somewhat in haste and failed to prepare the necessary supporting infrasu·ucture. Soon after the liberalization measures were announced, banks in general, and smaller banks in particular, started to compete f'or deposits, offering high interest rates without paying much attention to how they could utilize these high-cost deposits. Increasingly, brokerage houses, which were only lightly regulated, also began competing for deposits. Borrowers were already uuder pressure because of' shrinking domestic demand and were unable to acUust their operations to reflect the sharply higher financing costs. These developments brought the financial system 1.0 a crisis in 1982, when some of' the smaller banks and most of the brokerage houses collapsed. ConsequenLiy, monetary poliC)' was relaxed and changes were made in certain regulations. In particular, interest rates were brought, once again, undet· the control of the central hank.

The financial crisis of 1982 had several far-reaching effects on the financial markets. The magnitude of nonperf'orming loans became a major problem. In rcaCLion to the financial crisis, overcautious regulations were reinstalled by the authorities, and the reform process slowed clown. The crisis clearly showed that reforms could produce undesired resulL� when implemented without an adequate regulatory and supervisory framework, and illusu-ated the importance of the timing and speed of reforms. Nonetheless, financial market rdorms continued throughout the decade, in part benefiting from the lessons learned from these early attempts.

lnterbank Money Market: The Background

The need to develop an interbank money market was first felt by the management of the central bank in 1984 and 1985, when Turkey had a stand-by arrangement with the IMF and the cenu·al bank was experiencing difficulties in conu·olling monetary developments even Ll1ough the performance criteria witJ1 the IMF were being observed. In particular, this was because the central bank could not obtain signals from Ll1e banking system on whethet· the monetary policy stance was tight or loose.


Financial Liberalization in Turkey 1 1 3

At that time, the banking system was highly segmented for a variety of reasons, some more political Lhan economic. Public sectot· banks were reluctant lO lend to private banks not only on the basis of their assessment of commet·cial risks but, perhaps more important, because of political considerations. Similarly, private banks tended LO minimize their transactions with other commercial banks because of competition. In panicular, many of the private Turkish commercial banks belong to industrial groups. Competition and rivalry berween these groups often resulted in some reluctance on the part of their banks to deal with each other directly, and, in particular. almost completely prevented interbank lending. As a result, Lhere was no interbank market in Turkey.

The central bank was the only counterpart accepted by everyone. Banks often deposited excess funds directly at Lhe central bank, which was paying a fixed interest rate on "excess reserves," or reduced their outstanding obligations to the cenu·al bank. Because the central bank's credit was in the form of collatcralized loans and the remuneration served was accrued on average daily outstanding balances, commercial banks had an incentive to deposit collateral with the central bank up to their rediscount quotas, while utilizing the funds only when the)' had a cash shortfall. Thus, the central bank had no control over the reserve money up to the amount determined by the rediscount quotas. Moreover, Lhe central bank was monitoring Lhe outstanding volumes of reserve money and the other aggregates from its own balance sheet but had no way of knowing whether the observed magnitudes reflected a relatively tight or loose monetary policy stance since interest rates were not providing feedback from the market.

Given the segmentalion of the banking system and considerations stemming from the local culture and political environment, the central bank management realized that the central bank had to play an active role in developing Lhe interbank money market. Since Lhe central bank was the only acceptable counterpart for intcrbank transactions, from both the borrower's perspective and the lender's, it had to act as a "blind broker"' in the market. which meant that the central bank was taking the credit risk. Since Turkish law does not allow the cenu·al bank to lend without collateral, it was necessary to identifY acceptable collateral that was readily marketable and of good quality, and thus eligible from the central bank's point of view. This collateral was government securities. A market in government securities Lherefore had to be established and sufficient time allowed for the market to develop and deepen lO a volume high enough lO support the intcrbank money market. This is the main reason why the auctioning of government securities and the establishment of a secondary market in government securities started before the interbank money market was instituted.


1 1 4 RO�dO Saraf1oglu

Government Securities Market

The auctioning of Turkish government securities started on May 29, 1985. The auctions were designed to be held on a weekly basis. Initially, auctions wctT resu·ictcd to securities with one-year matlu·i ty. The securities had no interest coupon and were sold at a discount. Bids presented hv commercial banks at the auction included the amount bid and the price as a percent of par value for each amount. Initially. settlcmem took place the week aJter the auction but when the supporting elecu·onic infrasu·ucture was completed, settlement was changed to the following day.

The auctioning of government securities was an immediate success. The treasury, almost always in need of cash, had suddenly seen the benefit of being able to raise large amounts of funds from the market without being accused of ''expropriating bank's money," since interest rates were now market determined . . In fact, although the funding costs of the treasury went up, the impact on the overall level of interest rates was beneficial because the commercial banks could no longer make up what they were losing in their lending to the government at belowmarket rates from their lending to the private sector.

Toward the end of 1986, in response to demands from market participants for shorter-term debt instruments, the auction system was revised and the "programmed auction system" was introduced. Under the programmed auction system, the treasury auctioned government securities with maturitics of 12, 9, 6, and 3 months on a rotating basis every Wednesday. This enabled market participants to know in advance which maturities were to be issued and on which dates and thus gave them the opportunit) to imprO\'e their cash and liquidity management. Interest rates increasingly staned to reflect the markets' perceptions of expected rates or inflation, the treasury's funding needs, and tl1e availability of short-term funding for government security portfolios.

More important from the central bank's point of view, a reference market-determined interest rate had finally emerged. This allowed the central hank to determine more accurately the relative tighu1ess of its monetary policy stance, which was a guide for the implementation of' monetary polic}. This was especially true after the interbank market was established in 1986 and the central bank started to conduct open market operations as explained below.

Operations of the lnterbank Market

The interbank money market started in April l986, a11d within a few months the volume of transactions reached significant levels. The market was organized with the central bank as the intermediary. The par-



lies to a transaction did not know each other's identity and therefore, from a legal standpoint, their counterpart was the central bank. The cemral bank operated as a broker, that is, it borrowed only when it could on-lend the proceeds at the same interest rate. Such a strategy allowed the central bank to have a full picture of the prevailing liquidity conditions in the system. Moreover, because the central bank was assuming the credit risk, it charged a brokerage commission to both parties in a transaction. Over the years such commissions constituted a not insignificant amount of revenue for the central bank.

In any interbank market, clearing and settlement are delicate issues that need to be addressed early on. Without a facility to prevent gridlock, the entire system may come to a halt if a bank fails to repay and all the other banks down the chain end up being unable to fulfill their obligations because their borrowers cannot repay their loans. In Turkey, since the central bank was acting as an intermediary, such gridlock problems were avoided. The central bank repaid its obligations in the morning when the market opened, but did not require that the funds that were due to it be paid until the close of the day. This amounted to extending an intraday overdraft facility to the banking system. This intraday overdraft facility also helped the market w grow and deepen rapidly, tl1ereby allowing the central bank to undertake open market operations in the money market in sur-prisingly large volumes.

When commercial banks in Turkey u·ade in the interbank market. they essentially l>orrow and lend to each other their free balances at the central bank. These free balances can be viewed as the excess reserves of commercial banks. To facili tate the developmenL of the government securities market and the interbank money market, the central bank also implemented a number of regulatory measures, such as introducing daily averaging of balances of free deposits and taking holdings of governmcm securities into account to measure compliance with the liquidity requirement.! The averaging of daily balances at the central bank encouraged the banks to manage their liquidity more actively, for example, by taking net positions during the week in order to maximize their· pror.ts. In fact, as the market deepened, banks started to take advantage ofintraday movements in interest rates, borrowing in the morning and selling in the afternoon or vice versa. The markel, for a number of reasons, came to be dominated by overnight u·ading, although the central bank tried to encourage trading at longer maturities.

1The liquidity ratio requires commercial banks to hold a portfolio of government securities whose weekly average of daily market values must be greater than or equal to a certain percentage of banks' outstanding liabihhes subject to the liqutdtty requirement at the end of each week. The compliance period lags the measurement date by two weeks.


1 1 6 RO�di.i Sara�oglu

The access to the imerbank market organized under the umbrella of the cenu·al bank was for many years restricted to banks. Nonbank financial intermediaries and other non bank institutions were not allowed to participate in the intcrbank market. This was because the policy of the cemral bank was to allow only banks to have a current account with itself. Since the interbank market is essentially a market where balances at the central bank are traded, an institution without a current account at the central bank cannot really participate in the market. Conversely, if an instiwtion is allowed to have a deposit account with the central bank, then that institution can easily participate in the interbank markel. The decision of the management of the central bank not to open deposit accounts to non bank institutions effectively restricted participation in the interbank market to banks only.

An important consequence of the establishment of the interbank market and of auCLioning government securities was the acceptance by politicians and the population at large of frequent interest rate fluctuaLions, in response to a number of factors, such as the level of excess liquidity, expectations of inflation, perceived risk, and the maturity of loans. Moreover, the auctioning of government securities, which meant the government was borrowing at market-determined interest rates, made the true costs of government deficits more visible.

Open Market Operations

The establishment and subsequent deepening of the in terbank money market, together with the broadening of the secondary market in government securities, allowed the introduction of open market operalions with government securities in 1987. The introduction of open market operations led to a significant change in the conduct and implementation of monetary policy. This started the shift to a marketoriented monetary policy based on management of the total reserves of the banking system. Through outright purchases and sales of government securities and through repurchase agreements, the central bank began to regulate banks' liquidity.

Although the development of market-based monetary instruments increased the effectiveness of monetary policy, the use of such techniques led, from lime to time, to conflicts with the treasury. When the central bank sold government securities to drain excess liquidity, the treasury often objected on the grounds that the central bank was raising interest rates on government securities and therefore provoking a deterioration of the public sector position. As a result, the central bank, over the years, concentrated increasingly on the interbank money market to conduct its open market operations.



Since the central bank was acting as a blind broker, i t was natural for it to start transacting in the interbank market on its own account, thus taking net positions. This amounted to conducting open market operations in the interbank market, a technique that is widely used in Europe. In many ways it is far more efficient than conducting open market operations in the secondary market of government securities, especially when central bank interventions are large. This has the added advantage or having a relatively limited impact on other markets, such as the government securities market, in the short run. Increasingly, open market operations in the interbank market came to be the major instrument for shorl-lerm liquidity management. Naturally, when the necessary conditions were met, the central bank could-and did with some consistency Lhroughout the period 1988-1993-use outright open market operations. Ultimately it is the managers of the central bank's open market desk who decide the combination or instruments that should be used on a given day, rather than the top management of the Bank, since the former are close to the market and can better gauge the impact of alternative instruments on the market. Therefore it is also essential for the open market desk managers to be completely familiar with the central bank's monetary policy and to understand the constraints under which the top management of the central bank makes its decisions.

Securities Market and the Stock Exchange

During the 1980s, legal and institutional arrangements were introduced LO foster the development of security markets. The reform process began in 1981 with the enaCLment of the Capital Market Law. Following the enactment of the law, the Capital Market Board was established in 1982 to regulate, develop, and supervise the capital markets.

During the period 1982-1986, the legal and institutional framework of the securities markets was formed. The Capital Market Law gave the Capital Market Board the authority to regulate the primary markets. It is the Board that issues communiques defining the disclosure standards for new issues and insu·uments. To provide protection to investors, intermediaries in the securities markets must meet certain operational standards. In additional, the Capital Market Board also established some principles r-egarding the financial reporting system. An optional general accounting plan was prepared for corporations. And in 1983, a new legal framework for the regulation of secondary markets was implemented, empowct-ing the Capital Market Board to initiate the establishment and to regulate all operations in these markets. Finally, the Istanbul Stock Exchange was reopened in 1985 and became operational in 1986.


118 Ru�du Sara�oglu

Following the formation of the legal framework in the first half of the 1980s. several mechanisms, including tax incenlive measures, were de

vised LO promote the deepening of the securities markets. The following steps were taken.

l . The double ta.xalion of dividends was prevented. In 1985, the corporate income Lax rate was raised to 46 percent, and it became the only tax on dividend income. The government was given the authorit)' to lower this rate to 40 percent as an incen tive for public corporations, and in 1 987. the tax laws were amended to grant additional incen lives. Most notably, the government was given the authority to lower the income tax rate to 35 percent (30 percent for publicly owned corporations) for small sha•·eholders.

2. In 1985, capital gains on shares become exempt from taxes if the security was listed on an exchange and had been held by the seller for at least one year. ln 1987, capit.al gains from the sales of securilies sold through licensed in termediary agencies we1-c also made tax free. PremiLilllS emanating from stock issuing also became u'lX free for any stock listed on an exchange that does not disu·ibutc dividends to shareholders.

3. interest income on governmem securities held by individuals became tax free. but subject to a l O percent withholding tax i f held by corporations.

Along with the development of the securities markets, a number of other new insu·uments have been introduced in Turkey, such as finance bills, participation certificates of mutual funds, hank bills, bank guaranteed bills, and certificates of revenue partnership. Several large industrial corporations have started borrowing from the securities markets in order to meet their financing needs. Morco' er, some of these co•·porations have also begun to rely on equity financing and to open up their companies to the public. The panial libcralizaLion of the capital account i n August 1989 also contributed to the growth of the securities markets by allowing nonresidents to invest in domestic securities quoted on the capital market.

Foreign Exchange Regime

The integration of the Turkish financial system with international markets has been one of the major objectives of financial market reforms. Over the years, regulations were changed in a systematic manner with the objective or liberalizing the foreign exchange regime. Earlier in the reform process, during 1980-1983, the reforms entailed the elimination of multiple exchange rate practices; provicling the commercial banks with more discretion in managing their foreign exchange positions; and allowing exporters to retain a portion of their



earnings i n the form of foreign exchange deposits with commercial banks.

In 1 984, a major step in liberalizing the foreign exchange regime was implemented, whereby commercial banks were allowed to engage in foreign exchange operations and transactions in proportion to their foreign exchange liabilities. Finally, and most important, banks were allowed ro open foreign exchange deposit accounts to resirlents, and restrictions on foreign travel and investment from abroad were greatly eased and simplified.

To prevent the banks from taking excessive risks and to ensure a regular inOow of foreign exchange for the central bank, in 1986 new measures were implemented to regulate the foreign exchange positions of the banks. With these measures, the following were accomplished:

l . All foreign exchange purchases of banks, including purchases from export and invisible receipts, became subject to the surrender requirement;

2. The liquidity requirement, which obliged banks to hold a specified portion of their short-term foreign liabilities in the for m of liquid foreign assets, continued;

3. An exchange rate risk ratio, aiming to bring the foreign exchange assets and liabilities of banks into balance, was in troduced; and

4. Banks were required to extend at least 50 percenL of their foreign exchange deposits as foreign currency credits to residents, with the ob

jective of promoting foreign exchange generating aCLivities. (This rule was abolished in 1990.)

Following these m�jor steps, Turkish banks' operations in foreign currency have grown substamially and foreign exchange deposits have become a major component of broad money.

A negative aspect of the rapid growth of foreign exchange deposits was that the implementation of monetary policy became increasingly complex and difficult. In order to comain monetary expansion rhrough the accumulation of foreign exchange deposits, these deposits were made su�ject to rcscnc requirements in 1986. Moreover, although interest eamings from foreign exchange deposits were not initially subject to taxation, a 5 percent withholding tax was i ntroduced as part of the policy measures taken in February 1988 to reduce currency substitution, and this withholding tax was increased to 10 percent i n 1989.

An important development in the ongoing liberalization process was the opening of an ofCicial foreign exchange market, also under the auspices of the central bank, in September 1988. Participants in the market are the banks and the authorized foreign exchange bureaus. The opening of this market was important because i t allowed the exchange rate for the Turkish lira to be determined according to demand for and


120 Ru�du Sara�oglu

supply of foreign exchange and it made possible more efficient management of the banking sector's foreign exchange reserves. Moreover, this reform completed the operational framework, allowing the central bank to implemenl monetary, exchange r·ate, and interest rate policy through market mechanisms. With the inauguration of the foreign exchange market, the infrastructure that was necessary to liberalize interest rates on deposits was completed. As expected, the government followed up quickly and deposit interest rates were liberalized at the end of October 1 988.

The liberalization of the Turkish foreign exchange regime continued in 1989 and 1 990. An imponant step was the August 1989 issuance by the government of Decree No. 32, regarding capital account u·ansactions. This was followed, in March 1990, by the formal acceptation of the obligations of Anicle VIII of the IMF's Articles of Agreement. With these changes:

I . Residents were permitted to buy foreign exchange from banks and other authorized financial institutions. They wet·e also allowed to freely use their foreign exchange accounts;

2. onrcsidents were allowed to buy and sell Turkish securities quoted on the domestic stock exchange or government securities through intermediat·y institutions operating in Turkey. They wet·e also permitted to transfer income and the sales proceeds of these securities abroad through banks and other authorized financial insrjtutions;

3. Residents were permitted to purchase shares that were quoted on foreign stock exchanges or government securirjes issued by foreign cou!1lries through authorized financial institutjons. They were also allowed to transfer the foreign exchange required to purchase such securities abroad;

4. Control on capital movements (rules governing credit inflows to and outllows from Turkey) was cased substantially; and

5. Banks were allowed to freely determine the foreign exchange rates that they use in their operations.

With these reforms, the liberalization of the current account was achieved and, although the Turkish lira is not yet fully convertiblesome transactions of the capital account are not yet liberalized-it reached a high level of external convertibility.

Changes in Prudential Framework

The Turkish financial system is dominated by banks, and the financial sector reforms only strengthened the privileged position of those institutions. The Capital Market Law in particular, by allowing the banks to engage in all types of capital market activities, increased the banks'


Financial Liberalization in Turkey 121

dominance in the financial system. Consequently, the development of the capital markets has broadened the spectrum of the banks' activities. The result is a system of universal banking in which banks are allowed to engage directly in all financial activities except leasing and insurance activities. However, banks actually own most of the leasing and insurance companies and therefore are also present, even if indirectly, in those activities.

The shift to the implementation of monetary policy through indirect instruments as outlined above, coupled with the establishment of foreign exchange and interbank money markets and the liberalization of the foreign exchange system, has encouraged banks to improve their asset and liability management policies. Increased competition has also encouraged banks to develop a quality consciousness and thus improve the quality of services they offer to their customers. Thus, banks have been adopting advanced technology in their operations at an increasing pace and have invested in human capital through regular u-aining programs for their staff. The outcome has been encouraging.

In Turkey, ban king activities are regulated by the Banking Act of 1985, which contains provisions regarding the establishment and capital structure of banks, branch banking, foreign ban king, deposits, credits and other invesunents, deposit insurance, and the transfer, merger and liquidation of banks. In line with the Banking Act, accounting and reporting standards and the principles of auditing and supervision were also established through the joint efforts of the treasury, the central bank. and the Banks Association.

The establishment of a domestic bank requires authorization from the Council of Ministers. A bank must be founded in the form ofajoint stock company with no fewer than lOO shareholders. The opening of new branches requires prior authorization by the treasury.

The Banking Act requires a minimum amount of net worth (capital and reserves) for the establishment of a bank. I n addition, certain amounts of capital are to be provided for each branch, depending on the population of the city in which each branch is to operate. These minimum amounts are subject to periodical adjustment.

The same rules apply to foreign investors when they establish a bank in Turkey. Foreign banks are allowed to enter the market by opening branches in Turkey, but as for domestic banks, the permission of the Council of Ministers is required. The total number of branch offices a foreign bank can open is limited to five. The establishment of representative offices-which are not allowed to accept deposits or engage in banking activities-b)' foreign banks is subject to the authotization of the treasury.

According to the Banking ACL, banks are subject to lending limits in order to avoid excessive r·isk concentraLion. The total cash and noncash


122 Rii�dii Sara�oglu

credits and other invesunents of a bank cannot exceed 20 times the net worth of that bank. There are also limits on the credits extended to individual customers, on the bank's own equily participation, and on the magnitude of large loans.

Banks are required to maintain their accounts and prepare their financial statements in accordance with the unified accounting and reporting principles introduced in 1986. They are required to submit these statements to the treasury and the central bank on a regular basis. Furthermore, banks are also subject to auditing by independent auditors. Reports prepared by these auditors are submitted to the treasury and the central bank.

The policy changes that were introduced as part of the liberalization process led LO major structural changes in the banking S)'Stem. One m� or objective of these changes was to increase the efficiency of the system through the fostering of competition among banks. This was achieved. However, with the liberalization of the financial system there has also been an increase in the risks faced by banks. These •·isks involve credit risk from their customers, market risk as a result of the liberalization of imerest rates, foreign exchange risk arising from their net position in foreign exchange, and funding risk because of the possibility of competition for deposits.

In view of these increased risks and their more complicated structure, new legal arrangements were introduced to enhance the stability and soundness of the banking system. To strengthen the financial structure of the banks, the "Capital AdequaC)' Ratio" was introduced in October 1989, in accordance with the guidelines of the Basle Commiuee on Banking Supervision. The initial 5 percent capital adequacy ratio introduced in 1989 was gradually increased w 8 perccm by 1992. Moreover, international standards were introduced in 1988 for the classification of loans and for provisioning nonpcrfonning loans.

Simultaneously there were attempLs to strengthen banking supervision. On-site bank supervision is carried out by the Sworn Bank Auditors, who are associated with the treasury. The Sworn Bank Auditors check the application of the Banking Act and other relevant laws by the banks, review the conduct of all types of banking operations, and identify and analyze relations between bank assets, claims, net worth, liabilities, profit and loss accounts, and other factors affecting the financial structure of banks.

The central bank, which conducts off-site supen·ision, gathers the financial data required for supervision, examines the financial standings of banks, and submits its views to the Prime Minister together with its suggestions if and when necessary. The Ban king Dcparunen t of the central bank was reorganized in 1989, with the objective of undertaking


Financial Liberalization in Turkey 123

prudetHial supervision of hanks. Its task differs from that of the Sworn Auditor� in the sense that it conducts on-site inspections as frequently as needed. with the main emphasis on prudential issues rather than compliance with legal requirements.

If. as a result of the audits, it becomes clear that the financial structure ora bank is being eroded, the treasury may ask the bank's board of directors to introduce certain measures, which are delineated in the Banking Act, in order to improve the financial structure of the bank. If the financial structure continues LO deteriorate despite the introduction of these measures, the Council of Ministers may require that the bank be transfcrn.:d LO new owners or merged with another bank.

Concluding Remarks

The process of liberalization in Turkey is significant in several respects. First, it is impressive that a developing country, within nine years after it was forced to reschedule its external debt due to a severe payments crisis, was able to liberalize not only current transactions but most capital account transactions as weii, and accept the obligations of Anicle \'Ill of the IMF's Articles of Agreement. Second, the process or rcl'orm was initiated by the government and with strong political support, and the reform process continued on track for many years. In particular, the central bank played an active role in the Transition to a market-oriented poliC)' fran1ework, and its initiatives rapidl)' found support in the financial system. Third, the implementation or the reform process was undertaken with clear objectives and targets, and these objectives and targets were articulated and explained to the market participants. Such close dialogue bet:\veen the officials and the market participants enabled the reforms tO gain rapid acceptance.

On the negative side, from the point of view of macroeconomic management, TUI-kC)' was suffering from chronic fiscal deficits before the liberalization process, and the monetary constitution of the country enabled easy monetization of these deficits. Moreover, after long years of financial repression (during most of the 1960s and 1970s) the financial system, relative to the G1 P or the budget, was small at the onset of the reform process. Thus, in Turkey, even moderate fiscal deficits in relation to GNP often led to excessive monetary expansions-in the sense of large percentage inncases-and therefore high inflation rates. Successive governments, even the most reform-minded ones, failed to address the problem or fiscal deficits and consequently Turkey continued to �uffer from high inflation and-with the liberalization of interest rates-high interest rates.


124 Ru�u Sara�oglu

When the government started borrowing through auctions, the fiscal problem became even more acute as interest rate payments increased rapidly. From Lime to time, faced with the fiscal dilemma, the government tried to interfere with market mechanisms and dictate the level of interest rates to the market. This policy not only failed to be successful in bringing about the desired results, but also led to increased uncertainty, with a concomitant increase in the risk premium-one of the components of the overall level of interest rates in the country.

An additional complication in macroeconomic management emerged after the liberalization of capital account transactions. Economic agents now had the option of keeping their financial assets in other countries' financial systerns. Initially, a perceived increase in the level of uncertainty and risk caused savers to switch out of Turkish liras into foreign exchange, but still within the Turkish financial system. However, any continuation of market tensions or perceptions of incr-easing risk prompted savers to shift from the Turkish financial system to those that were perceived to be more stable.

Often, the politicians failed to understand the implications of liberalization of both the financial and the foreign exchange systems on the conduct of the macroeconomic management of the country. They often did not realize that macroeconomic management tools that might be appropriate within a closed economy were no longer efficient or even effective in an open one. This fundamental failure to understand the need for a change in the policy mechanism and to appreciate the constraints imposed on the policy options by the liberalization of the fOt-eign exchange system led the Tw-kish economy to exper-ience a severe financial crisis in 1994, followed by the deepest recession since the Second World War. This serves as a dramatic example of the importance of policymakers understanding fully t.he policy implications of liberalization before they embark on reform.

Financial Liberalization in Turkey

Documents