Ec 1400 - Turkey Imf Briefing

Tarun Singh TF: Stephen Donnelly To: IMF Executive Directors From: Horst Kohler Re: Turkish Plea for IMF Assistance Issue: The issue at hand at the IMF’s (International Monetary Fund) upcoming emergency meeting is regarding the most recent Turkish financial crisis. The Turkish government has asked for IMF assistance in the midst of their most recent financial crisis due to the state’s takeover of Demirbank, the 11th bank to be taken over by the state. An agreement to provide aid to the tune of the $10 billion proposal will help the Turkish government combat the crisis, which has been caused by a lack of investor confidence. The aid is to be given in the form of a loan and is intended to restore consumer confidence in the short term as Turkish financial markets begin to stabilize. One of the IMF’s main roles is to provide temporary economic assistance to countries with balance of payment difficulties. The crisis has caused the Turkish government to spend $6 billion to defend the crawling peg against the lira. If the current trend continues, Turkey’s Central Bank will run out of reserves forcing a sharp devaluation in the lira. However, this can be averted by providing Turkey with financial assistance so that Central Bank does not deplete all its reserves. Opponents of this strategy, including the Cato Institute argue that the IMF is outdated due to the collapse of the Bretten Woods system and that Turkey has had a poor record of reform. Either way, the stakes in this case are high, and could affect not only Turkey but threatens to spread to surrounding regions as well, thus it is crucial that the proper decision be made. Relevant Interests:

There are three principle players who have a keen interest in whether the IMF provides Turkey with assistance: the Cato Institute, the USA and other IMF member states, and Turkish government. Cato Institute: The Cato Institute’s position on assistance to Turkey is largely driven by the institution’s distaste for the IMF as a whole. It is not as concerned with whether the Turkish economy is need of aid as much as it is critical of the process as a whole. The Cato Institute cites the fact that this case marks the 19th time Turkey has asked for IMF assistance, and uses this as evidence that providing aid creates moral hazard. The Cato Institute believes that providing aid to bail out countries in crisis distorts incentives for investors. Investors are not punished for making bad investment decisions and instead know that the IMF will bail them out. Furthermore, the IMF’s creation of a line of credit that is to be used in the case of a crisis is seen as a further distortion of real incentives as investors know that there is money already set aside for assistance. Instead, the Cato Institute believes in direct two-party negotiations (without the IMF) and cites that countries have undertaken more reform after IMF assistance was discontinued rather than during periods of assistance. USA and other IMF member states: Unlike the Cato Institute, the primary concern of the USA and other IMF member states is to avoid a global economic crisis. The USA believes that a failure to address the economic crisis in Turkey could lead to the crisis spreading to Russian and other Eastern European countries. The US realizes the risk involved in failing to address the crisis immediately and instead looks at the positive reforms Turkey had undertaken before the present crisis. Before the fall of Demirbank, Turkey had moved to a crawling peg on the lira in an effort to slowly devalue

the currency to market levels, had aimed to lower CPI to within single digits by 2002, and had taken extraordinary steps to reduce inflation in the minimum wage. The US looks at this information, and sees Turkey as wanting to undertake economic reforms but understands that this cannot happen unless economic assistance is provided. Further, Turkey is seen as a key geopolitical player, providing a link between Europe and Asia. Turkey has been recently approved to start negotiations for becoming an EU member state and many believe this is enough incentive for Turkey to take its economic reforms seriously. Turkey: Like the IMF member states, Turkey’s primary concern is economic stabilization. The current crisis has halted all gains that Turkey had been making towards a fair exchange rate, and has depleted Turkey’s foreign exchange reserves. Turkey points out that the crisis was caused by the failure of one bank, and that this sparked a downward trend in investor confidence. The lack of confidence eventually led to a 40% decline in the stock market over a two-week period while interest rates hit as high as 1,950%. Turkey was left with no choice but to deplete the reserves to defend the crawling peg. Once Turkey’s Central Bank can no longer fund such a defense, it will be forced to drop the peg against the lira- causing wider economic panic. Turkey has put forth a letter of intent that highlights a litany of reforms the Turkish government is willing to undertake to ensure that such a crisis does not emerge again. The letter includes a desire to privatize more government-controlled sectors, including telecom, while keeping stricter control of inflation. Controlling inflation is not an easy task for Turkey, as it means lowering wage increases for government workers as well. However, there is an attractive carrot dangling over Turkey’s head, and that carrot happens to be potential membership in the EU. Our Position:

Given the interests of the relevant parties, it would be in the best interest of the IMF Executive Board to provide Turkey with economic assistance. The economic risks of not helping Turkey are too great, and we believe there is enough incentive for Turkey to undertake serious economic reforms to prevent a similar situation in the future. Recommended Strategic Approach: Although flattered by the Cato Institute’s analysis of the IMF as an institution, now is not  the time to completely rewrite an economic system. The risk of this financial crisis spreading to  other countries is a grave threat to international economic stability. We believe that if the IMF  fails to act now, the further collapse of the Turkish system would be detrimental to global investor  confidence. Thus, instead of accepting Turkey’s request for $10 billion in aid, we are granting  Turkey $10 billion in immediate interest plus another $10 billion in a line of credit to be used if  needed. This aid should sufficiently address investor confidence issues and allow Turkey to  return to its implementation of economic reforms. The Moral Hazard Question While we understand the Cato Institute’s concern over moral hazard, we have to recognize  that this type of aid is not without precedent. The IMF has provided money to other countries  such as Mexico who were facing similar circumstances in order to avert a global crisis. Further,  because there is precedence for IMF assistance for Turkey and other countries, we do not believe  providing aid would further distort incentives as perceived by investors. Investors are already  aware of cases in which the IMF has intervened to provide assistance and we believe they have 

already considered this. It is important to remember that investors do not like to see market  failure and IMF assistance is in no way a complete insurance scheme for investors, but rather a  loan, which is to be repaid. Even if we were to accept the moral hazard issue as being a  significant problem, we do not believe an impending market crisis to be the time to address such  issues. Instead, Turkey’s pledge to undertake significant market reforms is seen as a step forward  and a move in the right direction. Therefore, we do not see moral hazard as being a significant  issue and we do not see this move as creating a new, unparalleled precedence. Trusting Turkey The Turkish record on reform has not been perfect. However, recent history has shown  that Turkey is willing to undertake difficult economic reforms for the sake of economic stability.  Furthermore, it is no secret that Turkey is eager to join the EU. Fortunately, one pre­requisite the  EU has placed on Turkey is that of ensuring economic stability. Thus, we believe the Turkish  government is serious about undertaking reforms as is seen with its promise to lower inflation  rates while further privatizing government run companies.   Why the Extra Money? The lack of investor confidence has spiraled out of control to a point where even a  positive decision by the IMF can be interpreted as bad news. By providing the extra line of credit,  we hope to assure investors that the IMF supports Turkish economic stability and has faith in the  Turkish markets. Further, we recognize the effects of the most recent earthquake in Turkey and 

the potential for oil prices to increase in the near future, especially if a war were to materialize in  the Middle East. Thus, in order promote investor confidence and to avoid pitfalls due to  unforeseeable circumstances we believe the line of credit is appropriate. Moving Forward: We expect this aid, coupled with Turkish reforms to be enough to satiate investors and to  restore short­term economic stability. We believe this will help prevent an exacerbation of the  crisis by keeping the crisis limited to Turkey, and will prevent other IMF member states from  being significantly affected. We hope this move will help prevent future economic crisis, as it  should provide investors with confidence that the IMF is not going to let an economy collapse. If  Turkey undertakes economic reforms as promised, we are hopeful that they will not need further  assistance in the future.