Capital Flows, Finance-Led Growth and Fragility in the Age of Global Liquidity and Quantitative Easing

The Case of Turkey

Özgür Orhangazi and Gökçer Özgür

Özgür Orhangazi is associate professor of economics at Kadir Has University in Istanbul. Gökçer Özgür is a faculty member in the Department of Economics, Hacettepe University in Ankara. This blog post summarizes a Political Economy Research Institute (PERI) working paper, available here.

As U.S. Federal Reserve Chair Janet Yellen laid the ground for the Fed’s expected interest rate rise, a major concern in the global economy has been how the “developing and emerging economies” will be affected by rising interest rates in the United States. The Financial Times  has recently noted that “[b]y some estimates, $7tn of QE dollars have flowed into emerging markets since the Fed began buying bonds in 2008. Now, a year after the Fed brought QE to an end, companies in emerging markets from Brazil to China are finding it increasingly hard to repay their debts.”

In fact, starting with the Fed’s tapering announcement in 2013, these economies have been on the edge. Turkey is among these economies. Economic growth in Turkey has been dependent on capital inflows since the financial account liberalization in 1989. Inflows of capital led to periods of growth followed by reversals in capital flows and three major financial crises–1994, 1998 and 2001. Following the 2001 crisis, the government brought budget deficits under control through primary budget surpluses and extensive privatizations, reformed the banking system in an effort to increase its resilience, moved to a more flexible exchange rate regime and began increasing its foreign exchange reserve accumulation. In a couple of years, Turkey began receiving large amounts of capital inflows and, after a brief interruption at the time of the global financial crisis, these inflows reached record levels. A long period of economic growth (only interrupted in 2009 by the global crisis), strong bank balance sheets, low levels of government debt, a flexible exchange rate system, and high foreign exchange reserves made the economy seem less vulnerable and more stable compared with the earlier era.

However, the post-2001 growth has been dependent on (mostly short-term) capital inflows and the emergence of an increasingly financialized economy, in which growth has come to depend more and more on the expansion of private sector debt and asset price appreciation. Strong capital inflows and external debt accumulation fueled the domestic credit expansion and asset price rise. Hence, a capital-inflows-dependent, finance-led growth model emerged in the 2000s. This model led to an accumulation of fragilities both in terms of the external accounts and within the domestic economy.

Three particular issues deserve attention in this regard (see figures below):

First, similar to the earlier experiences of both Turkey and other developing and emerging economies, the economy is still subject to a sudden stop risk. In fact, the risk is now higher as the country received record volumes of capital inflows, mostly in the form of short-term investments.

Second, a main difference this time around is that the private sector (including both banks and nonfinancial corporations) has significantly increased its foreign exchange borrowing and is now faced with a large net open position, increasing the risk of currency mismatch. Moreover, the nonfinancial corporate sector’s foreign currency denominated debt to the domestic banking sector render both sectors fragile at the same time.

Third, capital-inflow-dependent, finance-led growth model led to a significant expansion in credit to the private sector. The banking sector’s credit to deposit ratios climbed up, nonfinancial corporations’ debt to tangible asset ratios and household debt to disposable income ratios rapidly increased, leading to an accumulation of a range of financial fragilities in the economy.

Orhangazi-Ozgur fig1

Orhangazi-Ozgur fig2

As such, “this time is different” for the Turkish economy as the fragilities do not originate from public sector debt, weak bank balance sheets or a fixed exchange rate regime, but rather from the dependence of the economy on foreign capital inflows and private-sector credit expansion. Containment of a negative shock is more difficult as the fragilities do not lie only in the government budget or the banking sector but are more dispersed in the economy. Given the finance-led nature of economic growth, even in the absence of a shock, a slowdown in credit growth is likely to lead to negative consequences for the economy. All this makes it fundamentally more difficult to foresee chain reactions and increases the possibility of a prolonged slowdown accompanied by corporate as well as individual bankruptcies and debt deflation. The accumulation of fragilities in this capital-dependent finance-led growth model may give way to a financial crash or a prolonged slowdown, depending on how capital flows evolve. Reversal of capital flows, a bust of the credit boom, problems in banks, NFCs or household debt payments could each lead to different results.

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