Existing vulnerabilities are not as strong to trigger a domestic crisis unless unusual steps are taken in the field of economic policy.

What does the word "crisis" imply? Monetary crisis implies the steep jump in the exchange rate and the collapse of the exchange rate regime due to a speculative attack increasing the foreign exchange (FX) demand. This movement is accompanied with sharp rises in interest rate. Financial crisis on the other hand refers to an earthquake in the financial sector, in which some financial institutions bankrupt and the rest suffer severe evaporation in capital. The process generally involves withdrawal of huge amounts of deposits from banks. Following these developments, the economy starts to shrink rapidly and unemployment rate shows an upward trend.

There need to be vulnerabilities

In this context, any jump in interest rate or any steep upwards movement in exchange rate must not be considered as a "crisis". Of course, if you are pursuing a fixed exchange rate regime, a jump in the rate implies the collapse of the regime, and thus is a crisis. However, in floating exchange rate regime we cannot call any steep movement of the rate a crisis.

For me, crisis means that "existing vulnerabilities' cause a considerable increase in unemployment and significant economic contraction (or recession) due to some triggering shocks. In other words, there must be certain vulnerabilities facing the economy. Moreover, triggering shocks must be witnessed, either domestic or external. We must witness economic contraction (or recession) and rise in unemployment rate due to the damage caused by shocks. This definition also has missing elements, but I believe that this is more or less what is witnessed in most of the crises.

I said there need to be certain vulnerabilities. For instance, the banking sector might be problematic. Triggering factors or global risk perception might have caused a sudden jump in the risk perception against the economy which might force financial investors to immediately get rid of the financial assets issued by your country. They might try to sell the financial assets in your domestic currency to purchase FX. This reduces the value of domestic assets and pushes up the interest and exchange rates, pushing the banking sector into trouble and halting the credit supply. Meanwhile, the corporate sector starts to witness severe problems and face difficulty in fulfilling their obligations before banks. This intensifies the problems of the banking sector. In short, bankruptcies, laying-offs, and fall in production follow.

Even if the banking sector is not as troubled as I portrayed, a crisis might hit if that fiscal policy is kept permanently loose. In the case that a triggering factor spreads the perception that "the fiscal policy of the country in question is not sustainable and that the country will face difficulty in paying its debts" similar developments will appear again.

The outcome can be similar despite the absence of an evident banking sector problem or substantial public debt or budget deficit: if the current account deficit has been high in the last couple of years and is financed via short term capital inflows and if fixed exchange rate regime is pursued, the country will be prone to speculative attacks. Similarly, a triggering factor might lead to the disposal of financial assets and a rapid switch to FX.

Triggering factor

As you might have noted, I have mentioned a triggering factor in each scenario. In general, the illusion that "everything will remain as they are now" is dominant in countries like above. However, certain domestic developments, awkward statements following these, or change of external circumstances might suddenly push up risk perception and trigger the process that will result with economic contraction and high unemployment.

Turkey does not suffer any problem in fiscal policy or financial sector. The chief problem is high current account deficit. So far some measures have been implemented to tackle this. These can be reinforced if a part of revenues earned from the tax amnesty are used to ease the public debt. Under these circumstances, a crisis in Turkey does not seem likely. Existing vulnerabilities are not as strong to trigger a domestic crisis unless unusual steps are taken in the field of economic policy. And the debt ceiling crisis between the Democrats and Republicans in the US is expected to smooth over.

This commentary was published in Radikal daily on 30.07.2011