The Internal and External Transfers of the Turkish Economy: A Financial Computable General Equilibrium Analysis*

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THE INTERNAL AND EXTERNAL TRANSFERS OF THE TURKISH ECONOMY: A FINANCIAL COMPUTABLE GENERAL EQUILIBRIUM ANALYSIS'

Gat Ipek Tum; Department of Economics Midd/e East Technical University Ismetlnonu Bu/van 06531 Ankara. TURKEY

After the introduction of 1980 stabilization program, both the internal and external transfer problems gained importance for the Turkish economy. This study analyses interactions between the real and financial sectors of the Turkish economy within the framework of a Financial Computable General Equilibrium model, based on 1990 data. In the model, real and financial sub-models are

interrelated through various channels such as flow of funds. interest rate and monetary policy. One of the main conclusions to be drawn from the analyses is that in the case of fixed real wages the adverse effects of policy changes on the economy are much larger compared to the case of fixed nominal wages.

I. INTRODUCTION furkey has been one ofthe less developed countries which faced a major debt crises It the end of the 1970s. relatively earlier than the others. The 1980 stabilization Jrogram introduced under the auspices of the International Monetary Fund mainly limed to reshape the inward-looking protectionist development strategy towards m outward-oriented market-based one. The program included drastic measures to ;tabilize the economy, encourage exports and undertake fiscal and financial ·efonns. The initial results of the program were so impressive that Turkey could be :alled to be a 'success story'. Especially after the 1980 stabilization program, both the internal and external ransfer problem gained importance for the Turkish economy, like most debtor less leveloped countries. External transfers can take place only if there is an internal ransfer from private to public sector. This is because the private sector earns oreign exchange, but debt servicing has to be made by the public sector. Since :xtemaJ debt is predominantly the liability of the public sector, the creation of net

This is a revised version of the paper presented at Second Annual Conference on Global Economic Analysis, 20-22 June 1999, in Denmark. I am indebted to Merih Celasun and participants for their comments on which the revisions are based.

Copyright of Full Text rests with the original copyright owner and, except as pennitted under the Copyright Act 1968, copying this copyright material is prohibited without the pennission of the owner or its exclusive licensee or agent or by way of a licence from Copyright Agency Limited. For information about such licences contact Copyright Agency Limi'ed on (02) 93947600 (ph) or (02) 9394760' (fax)

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external transfers depends mainly on the ability of the public secror to raise these funds and the financial system to transfer them into financial instruments. This study analyses and evaluates interactions between the real (commodity production) and financial (monetary) sectors of the Turkish economy within the framework of a Financial Computable General Equilibrium (CGE) model. The model is calibrated to 1990, since the most recent available input-output table, the basis of Social Accounting Matrix for the Turkish economy, is for 1990. With the aid of the Financial CGE model, the channels of interaction between real and financial sectors, the internal and external transfers among the agents ofthe Turkish economy and the rest of the world and microeconomic and macroeconomic effects of different financial policies can easily be quantified and evaluated. The remainder ofthe paper comprises four sections. Section 2 briefly overviews objectives and phases of the Turkish adjustment experience. The discussion here concenlrates on the most important policy variables of the adjuslment process for the context of this sludy. A static Financial CGE model for Turkey is presented in Section 3. Section 4 reports the simulation experiments and their results under two alternative closure rules for the labourmarke!. A discussion on the major results and policy implications follows.

2. AN OVERVIEW OF THE TURKISH EXPERIENCE SINCE THE 1980'S The Turkish import substituting development strategy based on prolectionist policies since the 1950's was increasingly constrained lowards the end of the 1970's with accelerating inflation, worsening of balance of payments and a declining growth rate. A combination of internal and external factors contributed to the emergence of a debt crises in mid-1977 and Turkey became unable to service her foreign debt. The large price and incentive distortions and heavy dependence on imported inputs in production in the face of decreasing level of exports, can be identified as the most important internal facrors. These were aggravated by successive oil shocks (on average 70 per cenl of domestic oil and oil products are imported) and sudden termination offoreign lending by private creditors due to loss of confidence. In 1980, Turkey embarked a comprehensive stabilization-cum-liberalization program under the auspices ofthe IMF I . The program had both short-run and longrun objectives. These included: eliminating the disequilibria present in various markets; reducing inflation and attaining price stability~ attaining financial liberalization; reducing the role of the public sector in the economy and liberalizing foreign trade and payments as a necessary condition for a shift to an export-oriented development strategy and to auain a sustainable balance of payments position.

Ancanh and Rodrik (1990), Atiyas and Ersel (1994), Celasun and Rodrik (1989) and Ekinci (1996) can be cited among the literature evaluating Turkish stabilization and liberalization experience.

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2.1 Turkish External Transfer The Turkish stabilization program aimed to change the route of external financing.

It emphasized mainly export growth in servicing foreing debt instruments. In this way, Turkey faced a Iransfer problem. To increase the exportable surplus of the country, the relative prices of tradable goods were raised in the 1983-1987 period. The relative prices were manipulated by Iwo mechanisms, viz. real exchange rate depreciations and a downward pressure on real wages to depress domestic demand. High interest rates can also be cited as a factor that helped the reduction of demand. It can be argued that exchange rate has been one of the key policy tools in the Turkish adjustment process. After the initial steep devaluation of 28 per cent in 1980 and following mini devaluations by a daily adjusled crawling peg regime since 1981, an attempt has been made to shift resources to the tradeable sectors. However, not only the exchange rale policy, but also direct and indirect export incentives, favourable market conditions in the Middle East and existing excess

capacity, helped the export boom in 1980-1985 period. To facilitate this structural change, domestic demand was depressed by implicit incomes policy also. Under the transitional ntilitary rule established at the end of 1980, labour union activities were highly restricted; there occurred delays in wage adjustments and real reductions in salaries ofgovernment employees together with restrained increases in agricultural

support prices. Public sector real wages fell by 40-45 per cent during 1980-1988. These developments considered together with the priorily given to export promotion implied adverse effects on income distribution. In the period 1983 to 1989, liberalization of the external account was completed gradually. All reslrictions on capital movemements and borrowing by residents in international markets were

lifted. After this time, the banking sector became the main body for channelling foreign exchange to the Central Bank. Except in 1983 and 1990, Turkey made positive net transfers abroad for Ihe period 1980-1991. The amount oftransfers increased after 1985, where debt service payments increased substantially. During this period Turkey used 55 percent of her export revenue to service her external debt. The debt service/consolidated budget revenue ratio, another measure for external transfers. was around 25 percent before 1982, increasing to 41 per cent and 69 per cent in 1984 and 1988, respectively.

However, the ratio fell to 37 per cent in 1991. 2.2 Turkish Internal Transfer As mentioned above, Turkey faced the challenge of producing a positive net transfer abroad in the early 1980·s. To achieve this, the public sector had to extract the necessary funds from the private sector. Therefore, mechanisms to channel foreign exchange generated by the pri vate sector to the public sector were needed.

since the debt service mainly had to be made by the public seclor. As a part of the liberalization process, though the liberalization ofTurkish capital account had been completed in 1989, during 1980-1994 the public sector still had been the dominant figure· in external borrowing.

The World Bank (1989) argued that the most important channel of transfer occured through high interest rates and a fall in the proportion of credit allocated

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to the private sector by the banking system. Both caused generation of enough net private savings to finance the public sector and reduction in the current account deficit. However, the increase in the amount of net private savings occurs at the expense of private investments.

Before 1980, the Turkish financial system could be regarded as a typical example of a financially repressed economy. The organization and workings of the financial system was an important impediment in allocation financial savings into investments. Financial liberalization attempted basically to end financial repression

and disintermediation. It was believed that, as the Me Kinnon-Shaw (1973, 1974) hypothesis implies, this would increase savings and therefore investments which stimulates growth. The increasing need for financing the public sector deficit has played a crucial role in the development offinancial markets, with policies adopted for improvement of those markets. Since the public sector borrowing requirement was rising throughout the period, the public sector had to resort to both market and non-market mechanisms, i.e. treasury bonds and bills and inflation lax, respectively. In the mid1980s there occurred a policy change in the financing pattern of public sector borrowing requirement towards domestic borrowing. After the begining of weekly auctions of government borrowing instruments - treasury bills - in 1985, the share ofdomestic borrowing in financing public sector borrowing requirement increased.

Some measures were taken by the government to achieve the marketability of public sector securities, such as obligatory holdings of governmenl bonds bearing market interest rate as a fixed share of liquidity requirements of banks and tax exemption on interest income received.

During the same period an attempt was made to control the Central Bank advances to the public sector, which had been identified as the most important

source ofmoney growth. In 1989, Central Bank credits to the Treasury were limited to 15 per cenl of bugdetary appropriations. Despite of the high inflation rates observed in 1980-1990 period, the revenue from inflation lax fell, due to erosion of the monetary base, which may be explained by an increase in foreign exchange

deposits. Apparently, inflation tax seemed not to be a sustainable source of financing large fiscal deficits. However, according to World Bank (1989) estimates, 40 per cent of the real net private savings transferred to the public sector were from

inflation lax during 1980-1990. Since inflation tax in a way is.regarded as forced savings, this phenomenon can be interpreted as reluctance of the private sector to finance public deficit. Therefore, inflation tax cannot be relied on as a sustainable source of financing large fiscal deficits.

3. FINANCIAL CGE MODEL FOR TURKEY The Financial Computable General Equilibrium Model reported here is a static model which incorporates both real and financial variables. Real and financial submodels are interrelated through various channels such as flow of funds, interest

rates and monetary policy. The price level behavior which is an integral componenl of financial CGEs, is explicitly modelled. This. in tbe face of a disturbance, allows simultaneous adjustments to occur in both the real and financial spheres of the

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model to achieve equilibrium. The product and financial markets are cleared through a WaJrasian adjustment mechanism based on endogenous changes in prices. interest rates and exchange rate. 3.1 The Real Side of Ihe Model The real side of the model follows the standard neoclassical specification of COE models where three productive sectors (agriculture. industry and services) and institutions (public and private sectors and the rest of the world) are identified. Sectoral domestic output is determined by a Cobb-Douglas production function with three labour categories (agricultural. formal and informal labour) and capital as arguments. Agricultural labour appears only in agriculture. While formal labour covers all workers in formal employee status under social security arrangements, informal labour roughly represents self-employed, small scale enterprise and family workers. In the base run formulation oflhe model, it is assumed that the level oflabour employment can vary among sectors although the total number ofworkers in the economy is fixed. In the agricultural and informal labour markets, full employment is assumed where wage rates adjust to clear the market. On the other hand, in two sets of simulation experiments, either the nominal or real wage is assumed to be fixed forthe formal labour market. Therefore. the level ofemployment in the formal labour category becomes the adjusting variable with the assumption that there is no restriction on labour supply in the analyses. Domestic and imported goods are treated as imperfect substitutes, which is a widely used assumption in CGE literature. Hence, a composite commodity is defined, as a CES aggregation of imports and domestic production. following Armingtonian lines. On the export side, product differentiation is assumed through a Constant Elasticity of Transformation (CET) function. The level of endogenous domestic interest payments (DOM/NTP) is a fixed share of public sector borrowing requirement (PSBR) which is determined in the

financial side 2 , i.e. DOM/NTP = a PSBR

(3.1)

Private disposable income can be found by subtracting public disposable income from Gross National Product (GNP). In the private sector three income groups are identified: an agricultural income group covering agricultural labour. an urban labour income group covering formal and infoITIlal labour and an urban capitalist income group. The first two income groups' disposable incomes are detennined by adding corresponding factor incomes and government transfers and subtracting direct taxes. Urban capitalists' income is found as a residual. This treatment of income flows foHows the convention adopted in Turkish official development plans and annual programs.

As a convention. exogenous variables are denoted with Roman capital letters with a bar and parameters with lower case or Greek letters (with some exceptions). The complete model equations are available from the author upon request.

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Total private consumption is determined by deducting private savings from private disposable income. Like public consumption, endogenous private sectoral consumption is determined by a simple linear demand system with unitary expenditure elasticity. The level of private savings is determined by multiplying the level of disposable incomes for each household group by the respective average propensity to save. Although investment demand is modelled, it is assumed that sectoral capital stock is fixed and new investments do not add to capital stock in the current period. In this model tolal private investment by sector of destination (DKP,) is also modelled explicitly, as:

DKP, I

K. = BDKP, • (PRJ (PK,' K. • «1 + RBLN) I (I +

EXPINF))) ' ' 'P, (3.2)

In the formula above K" BDKP" PR" PK" RBLN, EXPINF and edkp, are sectoral capital stocks, trend level of private investments, endogenous sectoral profit rates, rate of capital rent by sector, interest rate on bank loans, expected inflation and interest elasticity of private investments, respectively.Therefore, sectoral private investments are a positive function of profit rates and a negative function of expected real interest rate on bank loans as in the traditional Tobin

(1969) q formulation. The parameter edkp, is assumed to be relatively low to indicate the reluctance of firms in financing their investments through bank loans. The sectoral profits PR, are determined as:

PRi = PH; • X, - E i FAClNC,.k - GFY,

(3.3)

where PNi ,X,. FA CINC',k and GFY, are value added price by sector, domestic sales by sector, factor income of each income group and public factor income by sector, respectively. The inventory investment is assumed to be endogenously determined as fixed shares of sectoral outputs.

The introduction of financial variables (specifically money) in the model allows the exchange rate to be determined as a nominal variable apart from being the ratio of domestic and world prices. In this way, not only the current account but also the capital account and therefore overall balance of payments system can be

included in the model. Foreign savings (FORSA V) is defined as total net accumulation of financial assets by various agents in the economy. Le.

FORSAV= - (RES'b + NOFA +RESb + BLNrow + CBLNrow + FCC.b) + FORB. + FORa) + DDrow + TDmw + ODF/+ ROWLNB (3.4) In the above formulation, RES" are changes in reserves at the Central Bank; RESbare changes in depository bank reserves; NOFA is the change in net other foreign assets; BLNrow and CBLNrow are changes in depository and Central Bank . loans to the rest the world, respectively; FCC•• is the change in foreign currency holdings ofincome groups; FORBgandFORB,are foreign borrowing hy government and firms,respectively; DD row and TD row are changes in demand and time deposits

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held at depository banks; ODFJ and ROWLNB are changes in other deposits held at other financial institutions and loans to banks extended by rest of the world, respectively. In this way, foreign exchange market equilibrium is obtained by endogeneous movement of the nominal exchange rate. 3.2 Financial Side of the Model In the financial side, portfolio choice of income groups and financial activity by private sector firms and the public sector are identified. These agents' financial decisions are reconciled through a financial system, composed of the Central Bank and depository banks. The Central Bank and other banks determine the level of money supply and amounl of credits in the system. Formally, seven groups of financial decision-making agents - namely the Central Bank of the Republic of Turkey, depository banks, the non-financial public sector, firms, income groups, other financial institutions in the financial system and rest of the world - are identified. Domestic and foreign currency, demand, time, foreign exchange and other deposits, the Central Bank loans and bank loans are financial assets of the financial system. Also government bonds and private finns' shares are presented as means of financing. Following Robinson (1991), the financial side of the model is formulated in terms of flows rather than stocks. As Robinson observed, shallow stock markets, limited use of government instruments and restrictions in foreign exchange markets save agents from having to restructure their portfolios completely every period. Therefore, portfolio allocations are made at the margin. In the model, the allocation of financial instruments refer to current period's savings by all agents, 3.2.1 Specification of 'The Central Bank of the Republic of Turkey' The Central Bank (CBRT), acts as the banker to the public sector and financial system, Loans made to the public sector are a fixed fraction of the public sector borrowing requirement PSBR, which can be treated as a policy variable in simulation experiments. On the other hand, loans to other institutions are sensitive to the interest rate charged by the Bank. The required reserve ratio (m), which is the most widely used tool to control the money supply, is differentiated for demand, time and foreign exchange deposits, in the model. Also the Central Bank requires from banks that a ntinimum fraction sbb of required reserves should be kept in the form of government bonds by the banks to finance the public deficit. However, banks can buy more than the required amount depending on the interest rate on bonds. Therefore. required reserves of the banks can be fonnulated as: RR = (l-sbb) • (rrrdd' DDS + rrrtd • TDS + mfxd • FXDS)

(3.5)

In the above formulation, RR are required reserves; DDS. TDS and FXDS are demand. time and foreign exchange deposits, respectively; and rrrdd. rrrtd and rnfxd are respective required reserve ratios on those deposits.

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[n financial CGEs, the treatment of aggregate price index (PlNDEXl deserves special attention. Besides, being the numeraire in the model around which prices are nonnalized, an explicit treatment of its behavior is necessary. The behavioral

equation for PlNDEX is inferred from the study by Celasun (1980)3. [t is assumed that the level of price index changes at the rate of inflation, PDOT. In determination of PDOT the rate of change in money supply (M2Y) over real income, the rate of change in the value of nominal exchange rate and expected

inflation are the crucial elements. Therefore PDOT is formulated as:

PDOT= CI + C2 * «MSS/ LMSS) -I) + C3 C4 * «ER/ LER) -I) + C5 * EXPINF

* «RGDP/ LRGDP) -1) + (3.6)

where MSS/ LMSS, RGDP/ LRGDF, ERJ LER and EXPINF are rates of growth of money supply, real GOP, exchange rate and expected inflation, respectively. 3.2.2 Specification of 'The Depository Banks' Both private and public banks colleCI deposits and provide funds to financial agents. The quantity of available loans by the banks (QL) is the difference between the amounts offunds they collect and dispose. The sources of funds they collect are: lhe financial surplus of banks', tolal demand, time, foreign exchange and other deposits, Central Bank loans to banks, foreign loans kept in the banks. cash in bank vaults and other fixed liabilities. Banks dispose these funds for: government bonds, firm shares bought by lhe banks; Ihe amount of required, excess and foreign reserves; and the part of government domestic borrowing financed by banks. BOlh the Central Bank loans to banks, and firm shares bought by the banks, are increasing functions of interest rate on Central Bank loans and interest rate on finn shares, respectively. In addition to government. banks provide credits to firms, income

groups, olher financial institutions and the rest of lhe world. The interest rate on bank loans RBLN is determined endogenously from the inverse supply function: QL

=QL * (1+RBLN) ~b

(3.7)

QL and ~b are trend level of bond supply and interest elasticity of bank loans supply. Similarly, interest rates on demand, time and foreign exchange deposits are

determined endogenously within the model. Demand deposits and time deposits are demanded by all agents in the economy as increasing functions of respective interest rates. while foreign exchange deposits are assumed to be held only by finns and income groups. Banks' incomes and therefore savings are determined

endogenously while banks' investments are fixed. The part of income accruing to

Celasun (1980) anempted

[0

explain the inflation experience of 1964-1979 period

econometrically. The findings indicate that excess monetary growth is a predominant variable in conjunction with inflationary expectations. Inclusion of domestic price of imports (accounting for import related cost~push factors) as an independent variable improves the explanatory power of the model.

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banks which is endogenous in this model is the net interest receipts from holding and issuing financial assets. The level of bank retained earnings (i.e. savings) is

found as a fixed fraction of after-tax income. 3.2.3 Specification of 'The Non-financial Public Sector' In the financial side of the model, distinctly from real part, the public sector excluding financial State Economic Enterprises, namely public depository banks (i.e. non-financial public sector NFPS) is modelled. Deducting public depository banks' savings and investment from public savings and investments yields the

deficit ofNFPS. Following the Turkish convention, total borrowing requirement of NFPS, PSBR is defined as:

PSBR = GRDEF+ DD;. + TD, + SRF + CAPTRA

(3.8)

where DDgand TDgcorresponds to changes in cash and bank, SRF stock revaluation fund and CAPTRA capital transfers. To finance PSBR either the Central Bank loans or domestic borrowing or external sources are used. NFPS domestic borrowing is composed of loans from the banking system and government bonds sold to financial agents.

The interest rate on government bonds (RGRBND) is detennined in the model

as: RGRBD + I = (GRBNDSIGNP)(l/og)

(3.9)

with tg being the interest elasticity of government bond supply. Government bond demands are detennined by all financial agents as increasing functions of RGRBND. 3.2.4 Specification of 'The Firms' In the financial sector, finns are aggregated as private sector companies without

distinguishing the sector of production. The total amount of firms' required financing is equal to the difference between the value of total private investment (less private banks' investment) and less firms' savings. Finns' savings are by definition the retained earnings and depreciation of firms' income after allowing for taxes. Besides issuance of shares, firms' required borrowing has to be financed by

bank loans and foreign borrowing. The rest is financed by share issue. Firms' shares are demanded by government, income groups and other financial institutions as an increasing function of return on those shares. The yield on firms' shares is

detennined endogenously. 3.2.5 Specification of 'The Income Groups' As observed in the real part of the model, interest rates have no role in the determination of level of savings. However, allocation of financial wealth among the available assets is interest sensitive. Income groups' .financial wealth is defined as private savings less housing investment. The allocation of financial wealth

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follows a branching decision structure4 . At the first stage currency demand is determined. Currency demand formulation includes the level ofrespective incomes for each income group and expected level of interest rate on time deposits as

arguments. At the second stage, the residual, financial wealth FWhh (i.e. the amount left after allowing for currency holdings) is allocated among the available menu of assets according to a CES type portfolio allocation'. The income groups are assumed to maximize utility from expected total earnings on the assets they hold. Because the various assets and return on them are not perfect substitutes due to risk and liquidity concerns, a certain degree of substitution is assumed to exist. REThh is defined as hamlOrne mean return on all assets, with respective expected returns on each asset (EXPTRFA) each household has, distribution parameters, Af'hh and substitution elasticities, 'Vas arguments. RET"" = 4, (Af'hh)'l' * EXPTRFA'l'1

(3.10)

In determination of expected returns, expected inflation is formulated with adaptive expectations as a weighted average of present and previous year's inflation rates. In this model it is assumed that both firms and income groups can hold foreign exchange deposits. Additionally, income groups can allocate their financial wealth into foreign exchange. In calculation of expected returns on foreign denominated assets, the level of expected devaluation must be specified. For convenience, it is assumed that households do not expect any real devaluation, therefore expected devaluation is equal to expected inflation. In this way. the model excludes the holding of interest parity condition.Therefore, income groups' demand for each type of financial asset can be formulated as:

HFA f'"" = SHARE"""

* FWhh

(3.11)

i.e. as a share of financial wealth where rates themselves are determined by expected rates of return on each asset and expected hannonic mean return. (3.12)

3.2,6 Specification of 'Other Financial Institutions'

In the model other financial institutions are assumed to have a rather passive role, since in the Turkish financial system the dominant role of banking system since the 1970's is explicit. The other financial institutions hold demand and time deposits and demand both Central Bank and other bank loans as other agents in the economy, Their demand for those assets are increasing functions of interest rates.

Tobin (1969) pursued the same multi-level portfolio allocation in his study. For a similar treatment, see Rosenweigh et aJ. (1990).

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3.2.7 Specification of 'Rest of the World' As seen in the balance of payments equation, 'rest of the world' has demand and time deposits which are small percentages oftotal deposits held at the banks. They also give credits to other financial institutions and depository banks. 3.3 MODEL CLOSURE The Financial GCE model is closed by assuming that there is equilibrium in all asset markets. As discussed in length by Lewis (1985). financial CGE models normally preclude the necessity of imposing saving-investment balance as an identity over the model. In financial CGEs it is possible to model saving and investment behaviour of agents explicitly in the financial side. Therefore, saving-!nvestment balance appear to be an equilibrium condition rather than an identity. In the present model, private fixed investment takes the main burden of adjustment to attain internal balance. In the foreign exchange market, an excess supply resulting from transactions in current and capital account will cause an increase in Central Bank reserves. Iffixed exchange rate is assumed, the Central Bank reserves will clear the foreign exchange market. Ifexchange rate is freely floating, then change in reserves should be fixed. generally set to zero. Then exchange rate is allowed to adjust until excess demand or excess supply is eliminated. 3.4 DATA REQUIREMENTS OF THE MODEL It is generally accepted thai the Social Accounting Malrix (SAM) provides the most comprehensive basis for the creation of a plausible model. SAMs mainly contain information about the national accounts of a country at a specific time period. In construction of a financial CGE, it is necessary to expand the capital account of the SAM according to the requirements of the model which implies integration of balance sheets and flow of funds information into the SAM. In tms way the links between real and financial sides of the economy and the role of financial intermediaries in stimulating savings and allocation of them will be quantified explicitly. In Financial Social Accounting Matrices' , FSAMs in Capital Account. each financial agents' savings, additions to loanable funds market and their disposition in terms of financial assets can all be observed explicitly. Sectoral investment by each financial agent and their financing through issuance ofliabilities are displayed. also. This information is provided by flow of funds accounts inlo FSAMs. In the model a deterministic approach is used for calibration. The model is calibrated to 1990 when the Turkish economy was considered to be in macroequilibrium. The model is solved using the GAMS language.

The name is due to Fargeix and Sadoulet (1990) while the stock counterpart was named as Financial Accounting Matrix by Easterly (1990)

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POLICY EXPERIMENTS

In order to examine the effects of various policy measures on the real sphere and see the changes in the financial structure of the economy, three experiments under

two different closure rules in labour market have been designed. All of the three simulation exercises have been conducted under two different assumptions about

labour market. In the first set, A, 'nominal formal labour wage', and in the second set, B, 'real formal labour wage' are assumed to be fixed. As discussed in Section

3.1, in the formal labour category government employees and other workers in formal employee status covered by social security arrangements are included. Therefore, determination of wages for this category depends on policies of government and labour unions to a large extent. The role of incomes policy as an unchallenged component of the adjustment process in the Turkish experience has been mentioned above, and two alternative routes are explored in this paper. Specifically the following simulation experiments have been conducted: Experiment I: 25 per cent increase in the share of the Central Bank advances to the public sector in financing public sector borrowing requirement (PSBR). • Experiment 2: 50 per cent increase in total nominal public investment expenditure. • Experiment 3: 20 per cent nominal devaluation of the exchange rale. Contrary to the first two, the third experiment assumes fixed exchange rate in the model, and the reserves at the Central Bank becomes the adjusting variable. Although this is not a realistic assumption given the policy settings of the economy, the possible impact of devaluations in the adjustment process cannot be ignored, and thus it is thought to be worthwhile to conduct this experiment. In this section, only the response of macroeconomic and selected sectoral

variables will be examined. Also, the stock values for financial instruments together with interest rate changes and aggregate flow offunds for the economy for each experiment will be presented, in Tables I to 3. It is observed that for most of the cases, the response of variables for the same

experiments under different labour market closures follow the same route. Therefore, the same experiments undertwo different adjustment mechanisms will be evaluated together7 .

4.1 Increase in the Share of the Central Bank Advances in Financing PSBR under 'Fixed Nominal Formal Labour Wage' (AI) and under 'Fixed Real Formal Labour Wage' (B1) As discussed above, in the mid-1980's there occured a policy change in financing pattern of public sector borrowing requirement towards domestic borrowing. This

was strengthened by the monetary program implemented in 1990. One of the The detailed description of sectoral responses of prices. output and final demand together with the changes in the holdings of financial instruments by each agent can be provided by the author upon request.

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objectives of this program was to restrain the growth of the Central Bank' s balance sheet by controlling domestic credit expansion. This experiment is designed as a counterfactual exercise against the tight monetary policy applied with the implementation ofthis monetary program. The encountered results mainly highlight the impact of inflation on real and financial sectors of the economy. The effect of this experiment on the economy is different in Al and B I. There is an expansion in the economy when nominal fonnal wages are fixed, but a moderate contraction in case of fixed real fonnal wages, while in both experiments the domestic demand components of absorption (namely consumption and fixed investments) decline. From Table 2. it can be observed that the non-financial public sector deficit as a percentage of GNP falls. mainly due to the fall in public investments. As the pace of monetization of fiscal deficit rises. the liabilities of the non-financial public sector to the Central Bank and banking sector rise while the liabilities to private sector (domestic borrowing) and foreign sector (foreign borrowing) decrease. Consequently, the burden on government bond finance declines. causing falls in the supply and interest rate on government bonds, a result which is widely discussed in Yeldan (1997). As expected, the increase in the share of Central Bank credits extended to government has an inflationary effect through monetary base. The inflation rate

TABLE 1 REAL MACROECONOMIC INDICATORS ('Yo CHANGE FROM BASE RUN) Variable

Rew GOP Fixed investments Public Private Consumption Public Private Urban Employment Ponnal Infonnal Urban Real wage Ponnal Infonnal Real Exchange Rate ITUg)

Al

A2

A3

BI

B2

B3

0.173

0.618

1.225

·0.058

0.117

-0.445

-1.720

6.398 46.038

-15.565 -5.647 -19.971

-1.889 -1.028

6.156 45.456

-14.530 -6.353

2.272

11.284

18.162

0.861 3.539 1.507

1.282 5.048 0.730

-0.792 -2.132

-11.211

0.374 0.536 0.350

1.283 3.097

0.909

1.926

1.667

0.587 0.777 0.559

0.866 0.000

3.627 0.000

6.600 0.000

0.405 0.000

0.841 0.000

-2.654 0.000

1.148 0.303

2.489 0.145

8.279

0.000 0.224

0.000

0.830

0.329

0.000 0.619

2.300

5.300

11.000

2.400

5.500

11.300

4.255

AI: Increased Central Bank advances for financing PSBR under fixed nominal formal labor wage B I: Increased Central Bank advances for financing PSBR under fixed real formal labor wage

A2: Increased nominal public investments under fixed nominal formal labor wage B2:"Increased nominal public investments under fixed real fo-rmaJlabor wage A3: Devaluation of nominal exchange rate under fixed nominal formal labor wage B3: Devaluation of nominal exchange rate under fixed real Connal labor wage

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YoU I No.2. September 200 I

increases to 0.619 and 0.621 in Al and B 1 respectively, where the base run value is 0.6. In both experiments, the increase in public sector disposable income results in an increase in public sector savings as a percentage of GNP, while total savings fall. Table 2 reveals that the increase in external transfer is achieved hy increased internal transfer through both by the rise in private sector financial surplus and fall in public sector financial deficit. It is observed that while the share of current account deficit in GNP falls compared to base run in AI, there is surplus in current account in B I. From the figures in Table 2, it is clear that the burden of increased external transfer falls mainly on depository banks and private sector. The increase in financial surplus of the private sector occurs indirectly through increased liabilities of the banking sector due to increased interest rates on deposits. The interest rate on bank loans in these experiments increase by 3.3 percent and

3.1 per cent respectively, above the actual rate of 0.94 per cent in the base run, due to the squeeze in the amount of available credits in the banking sector held. Consequently, the interest rate on demand, time and foreign exchange deposits rise

(Table 3). Mainly due to high costofborrowing, total (real) private investments and the real value of nominally fixed public investments decline. The higher level of expected inflation though slight, contributes to this decline. The fall in private investments results in a decline of borrowing requirements by firms. The decline

amounts to 2.48 and 2.35 per cents for Al and B I, respectively below their base run value. The response of gross output expansion to the change in the financing pattern

of PSBR is moderate. For AI, output expands in agriculture and industry, while for B1output expansion is observed only in industry sector. In both experiments, there occurs a fall in seIVices sector output, while sectoral exports rise in both cases.

4.2 Increase in Total Nominal Public Investment under 'Fixed Nominal Formal Labour Wage' (AI) and under Fixed 'Real Formal Labour Wage' (BI) The experiments A2 and B2 aim to capture the effects of an expansionary fiscal policy, namely rising public sector investments on the economy. It is well accepted that in generation of exportable surplus for external transfer, the investment

program of the Turkish economy plays an important role. In the 1980-1991 period, because ofthe choice of a growth oriented development strategy, fixed investments increased as a percentage of GNP in the Turkish economy. As expected, the effect of increased investments is expansionary. The increase

in real GOP is less in B2 (0.117 %) than in A2 (0.618 %). As indicated in Table 1, though private fixed investments decline due to crowding-out, aggregate fixed investment increases in both experiments, as does aggregate private consumption.

Government disposable income falls as a percentage of GNP in both experiments compared to the base year value of 13.4%. This can be attributed mainly to the increase in domestic interest payments. The fall in public disposable income causes public sector savings to decrease while overall savings in the economy as a

percentage of GNP rise from 0.252 per cent to 0.264 per cent in A2 and 0.265 per cent in B2.

Economic Analysis & Policy

Vo!.31 No.2. September 200 I

153

In both experiments, PSBR increases approximately by the same percentage as the rise in government investments. Therefore naturally, the liabilities of the nonfinancial public sector to other agents, increase also. Additionally, it is observed that the composition of government domestic borrowing changes. The nonfinancial public sector depends more heavily on bond issuing rather than bank loans, since the cost of borrowing increases. Because the largest portion of government bonds issued are held by banks (85 percent in 1990), the rise in interest rate on them will result in increasing command of bonds on available funds in the banking system. Therefore, the quantity of bonds available shrinks by 12.85 per cent and 1.90 per cent in real terms in A2 and B2 respectively, compared to base year value, causing a significant increase in interest rate on bank loans (Table 3). Additionally, it can be claimed that higher interest earnings on government bonds is the main cause of increase in financial surplus of the banking sector (Table 2). Financial crowding-out in the system is naturally reflected as crowding-out of real private investments. [n an sectors, around 8 per cent to 26 per cent falls are observed in A2 and B2, due mainly to a rise in the cost of borrowed funds. As a consequence of the fall in investments, firms' borrowing requirements also fall together with foreign borrowing, amount of bank credits and issuance of equities by finns. The increasing claim of government bonds on available funds causes a large increase in the interest rate on bank loans (RBLN) resulting in sharp falls in credit demands of other financial agents. The increase in RBLN causes parallel increases in interest rates on bank deposits, and therefore increases the volume of deposit holdings by agents. As a result the monetary base rises, resulting in 64 per cent inflation rate in both experiments as compared to 60 per cent in the base run. In this set of experiment trade balance improve about 1.5 per cent over its base year value causing a real appreciation as shown on Table 1. The net capital inflow in this experiment causes the adjustment of the exchange rate. It can be observed that the fall in external transfers and increase in public sector deficit is reflected as higher internal transfers from the private and banking sectors. Sectoral output production expands in agriculture and services sectors while output production falls in industry in both experiments. The reason of the fall in industrial output can be attributed to the decline in exports due to appreciation.

4.3 Nominal Exchange Rate Devaluation under 'Fixed Nominal Formal LabourWage' (AI) and under 'Fixed Real Formal Labour Wage' (Bl) Though the exchange rate policy of the Turkish economy had been effective in maintaining a path of real depreciation till 1989, year 1990 witnessed a real appreciation of domestic currency (annual percentage change in real effective exchange rate is 16.6) due to high interest and capital flows. Therefore, the experiment of 20 per cent nominal devaluation can be thought as a countenactual simulation analysis. In this experiment, nominal devaluation yields different responses under two different labour market closures. In A3, while real GDP increases by 1.225 per cent, a slight contraction (0.445 per cent) takes place in B3. In both of the experiments, private investment falls in real terms, because of the increase in cost of borrowing together with the decline in the real value of nominally

154

VoUl No.2. September 2001

Economic Analysis & Policy

TABLE 2 AGGREGATE FLOW OF FUNDS (% OF GNP)

CBRT BANK NFPS PRlV ROW ODFI LASSETO DEF/SUR'

CBRT BANK NFPS PRiV ROW ODFI LASSET DEFISUR

CBRT BANK NFPS PRiV ROW ODFI LASSET DEF/SUR

CBRT BANK NFPS PRIV ROW ODFl LASSET DEFISUR

!lASE

ODFIf ELIABlLIT.

CBRT3

BANKb

NFpsc

PRlVd

ROWe

0.0000 0.0006 0.0144 0.0000 0.0054 -0,0036 0.0169 0,0000

0.0057 0.0000 0.0357 0.0757 -0,0021 0.0015 0.1165 0,0083

0.0000 0.0099 0.0000 0.0024 0,0000 0.0156 0,0279 -0,0554

0.0114 0,0895 0.0002 0,0000 0,0000 0,0416 0,1427 0,0152

0.0000 0,0079 0,0070 0,0115 0,0000 0,0089 0,0353 0,0320

CBRT

BANK

NFPS

PRIV

ROW

0,0000 0,0006 0.0148 0.0000 0,0054 -0,0036 0,0172 0,0000

0,0046 0,0000 0.0355 ,0.0739 -0,0022 0,0014 0,1133 0,0045

0.0000 0,0103 0,0000 0.0023 0.0000 0.0057 0,0183 -0,0500

0,0127 0,0952 0.0002 0,0000 0,0000 0,0360 0,1441 0,0204

0,0000 0,0023 0,0057 0,0111 0,0000 0,0091 0,0283 0,0251

-0.0002 0,0004 0,0121 0,0364 0,0000 0,0000 0,0487 0,0000

CBRT

BA.NK

NFPS

PRIV

ROW

ODFI

0,0000 0,0006 0,0206 0,0000 0,0053 -0.0069 0,0196 0,0000

0,0075 0,0000 0,0376 0,0670 -0,0023 0,0013 0,1112 0,0701

0,0000 0,0076 0,0000 0,0020 0,0000 -0,0053 0,0043 -0,0920

0,0000 0,0205 0.0100 0.0098 0,0000 0.0083 0.0487 0,0457

-0.0003 -0.0447 0,0280 0,0547 0,0000 0,0000 0,0377 0,0000

CBRT

BANK

NFPS

ROW

ODFl

0.0000 0.0006 0,0243 0.0000 0.0045 -0.0034 0,0260 0,0000

0.0080 0.0000 0.0373 0.0600 -0,0023 0.0011 0.1040 0,0104

0.0000 0.0112 0.0000 0.0016 0.0000 0.0493 0,0621 -0,0570

0,0000 -0.0321 0.0118 0,0084 0,0000 0,0115 -0.0004 -0,0026

0.0038 0.0004 0,0454 0,0485 0.0000 0,0000 0,0981 0,0000

A.l

A2

A.l

0,0124 0.0570 0.0002 0.0000 0.0000 0.0402 0.1098 -0,0238

PRIV

0.0143 0,1136 0.0002 0,0000 0,0000 0,0396 0,1678 0,0493

-0,0003 0,0004 0,0260 0,0379 0,0000 0,0000 0,0640 0,0000

0.0169 0,1083 0.0833 0.1276 0.0033 0,0640

ODFI ELIABILIT.

0.0172 0,1088 0.0682 0,1238 0,0033 0.0487

ELIABlLT,

0.0196 0.0410 0.0964 0.1335 0.0030 0.0377

UL\BILT.

0,0260 0,0937 0,1191 0,1185 0,0022 0.0981

Economic Analysis & Policy

Vol.3 I No.2. September 200 I

ISS

TABLE 2 (contd.)

CBRT BANK NFPS PRIY ROW ODFI D\SSET DEF/SUR

CBRT BANK NFPS PRIY ROW ODFI D\SSET DEF/SUR

CBRT BANK NFPS PRIV ROW ODFI l:ASSET DEF/SUR

• ,b

1U

CBRT

BANK

NFPS

PRIV

ROW

ODFI

!UABILT.

0.0000 0.0006 0.0187

0.0047 0.‫סס‬OO

0.0000 0.0111

0.0145 0.0825

0.‫סס‬OO

O.OOOZ

0.0017 0.0000 0.0054 0.0182 ·0,0465

0.0017 0.0004 0.0023 0.0493

0.0049 -0.0034 0.0209 0,0000

0.0364 0.0613 -0.0023 0.0011 0.1012 0,0338

0.0001 0.0408 0.1380 0,0172

0.0000 -0.0271 0.0071 0.0084 0.0000 0.0098 -0.0019 -0,0046

0.0209 0.0674 0.0647 0.1207 0.0027 0.0538

CBRT

BANK

NFPS

0.‫סס‬OO

0.0076

0.‫סס‬OO

0.0006 0.0206 0.0000 0.0053 -0.0035 0.0230

0.‫סס‬OO

0,‫סס‬OO

0.0376 0.0673 -0.0022 0.0013 0.1116 0,0157

0.0075 0.0000 0.0020 0.0000 -0.0054 0.0041 ·0,0923

CBRT

BANK

NFPS

0.0000 0.0006 0.0173 0.0000 0.0074 -0.0034 0.0219

0.0053 0.‫סס‬OO

0.0000 0.0110

0.0371 0.0626 -0.0023 0.0012 0.1039 0,007

0.‫סס‬OO

0.0141 0.1104 0.0002

0.0017 0.0000 0.0147 0.0275 -0,051

10.0001 0.0444 0.1691 0,045

0.‫סס‬OO

°

1U

ll.l

0.‫סס‬OO

0.‫סס‬OO

0.0000 0.0538

O?OOOO

PRIV

ROW

ODFI

llIABILT.

0.0124 0.0659 0.0002 0.0000

0.‫סס‬OO

0.0214 0.0100 0.0099

0.0030 0.0004 0.0280 0.0550 0.0000

0.0230 0.0959 0.0965 0.1343 0.0031 0.0865

0.‫סס‬OO

0.‫סס‬OO

0.0857 0.1643 0,0300

0.0083 0.0497 0,0467

PRIV

0.‫סס‬OO

0.‫סס‬OO

0.0865 0,‫סס‬OO

ROW

ODFI

llIABILT.

0.‫סס‬OO

0.0026 0.000 0.0150 0.0506 0.0000 0.0000 0.0686 0

0.0219 0.0974 0,078 0.1238 0.0052 0.0686

-0.0250 0.0084 0.0089 0.0000 0.0117 0.0040 -0,001

CBRT: The Centrnl Bank of the Republic of Turkey BANK: The Depository Banks NFPS: Non·financial Public Sector d PRIV: Private sector including both finns and income groups e ROW: Rest of the world f OFl: Other financial institutions 1: ASSET: Total Assets g h 1: LIABILT.: Total Uabiliities i DEF/SUR: Financial Deficit/Surplus AI: Increased Central Bank advances for financing PSBR under fixed nominal fonnallabour wage 81: Increased Centrnl Bank advances for financing PSBR under fixed real fonnallabour wage A2: Increased nominal public investments under fixed nominal formal labour wage BZ: Increased nominal public investments under fixed real fonnallabour wage A3: Devaluation of nominal exchange rnte ullder fixed nominal fonnalli1bour wage B3: Devaluation of nominal exchange rate under fixed real fonnallabour wage

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VoUI No.2, September 200 I

Economic Analysis & Policy

fixed public investments. Though the same trend is observed for consumption in B3, this cannot be claimed for A3. In A3, contrary to public consumption, both aggregate and private consumption rise. In A3, urban fonnal employment increases by 6.6 per cent over its base run value. In tum, formal urban employment drops in B3 because of real wage rigidity and output contraction in services. As a result of decrease in private investments, finns' borrowing requirements fall. This fall is followed by decreases in issuance of firm shares and in return on those shares. It should also be noted that foreign borrowing by firms declines. Due to devaluation, the current account yields a surplus because of the higher sensitivity of exports. Although, public sector foreign borrowing increases in both experiments, net capital inflow to the economy falls resulting in reserve loss in both experiments. The high rates of inflation may be cited as one of the reasons of decrease in net capital inflow. To satisfy the export demand, industrial output expands together with production in other sectors in A3. However, in B3 where real fonnal wages are fixed. production in service sector decreases approximately by

TABLE 3 SELECTED FINANCIAL VARIABLES Variables

BI

B2

B3

1.000 1.000 1.000 1.000

1.006 0.984 1.000 1.002

1.060 1.038 1.005 1.028

1.061 1.020 1.007 1.045

0.790 0.939

1.000 1.000

0.976 0.994

0.889 0.969

0.824 0.950

0.163 0.776 0.145 1.270

0.124 0.574 0.108 0.940

1.125 1.593 0.111 0.971

1.141

0.670 0.126 1.097

1.155 0.737 0.138 1.207

A2

A3

BlISe

1.006 0.984 1.000 1.003

1.060 1.037 1.005 1.029

1.079 1.043 1.0lO 1.060

1.000 1.000

0.975 0.993

0.885 0.968

0.124 0.574

0.125 0.594 0.111 0.973

0.142 0.675 0.127 1.104

BlISe

AI

1.000 1.000 1.000 1.000

A. Ralios to Base Run Stocks

Monetary Base (MBS) MI. (MIS) M2. (M2S) M2Y(M2YS) Change il1:

Finns' shares supply (FSHRS) QUWltity of loans (QL) B. Interest Rates On: Demand deposits (ROD) Time deposits (RTD) Foreign exchange deposits Bank loans (RBLN)

0.108 0.940

C. Monetary Ratios 1.476 1.450 1.474 1.457 1.507 1.474 1.475 1.507 MIS/MBS 3.220 3.245 3.182 3.2823 3.264 3.185 3.264 3.264 M2S/MBS 0.059 0.057 0.058 0.057 0.658 0.059 0.058 0.058 MBS/GNP 0.087 0.083 0.085 0.083 0.087 0.087 0.087 0.085 MIS/GNP 0.184 0.188 0.189 0.187 0.188 0.185 0.189 0.187 M2S/GNP 0.237 0.241 0.242 0.243 0.241 0.237 0.243 0.241 M2YS/GNP AI: Increased Central B;:mk adv;:mces for financing PSBR under fixed nominal fortlUlllabour wage B I: Increased Central Bank advances for financing PSBR under fixed real fOfTffilllabour wage A2: Increased nominal public investments under fixed nominal fOnl1allabour wage B2: [ncren.sed nominal public investments under fixed real fonnallabouc wage A3: Devaluation of nominal exch;:mge rate under fixed nominal fOnl1allabour wage B3: Devaluation of nominal exchange rate under fixed real fortlUlllabour wage

Economic Analysis & Policy

Vol.31 No.2. September 2001

157

2 per cent compared to its base value, resulting in a slight contraction in industrial output. From Table 2 it is observed that to finance the increased external transfers and the increase in non-financial public sector deficit, especially in A3, private sector savings are activated to a large extent. As a result, liabilities of the private sector to both banking sector and rest of the world fall.

5. DISCUSSION In this study a financial CGE has been used to investigate the impacts of changes in the financing pattern of the public sector deficit, spending of public sector and finally devaluations, under two alternative regimes for the labour market. In the first set, nominal formal wage and in the second real formal wage, is kept constant. It can be argued that when Central Bank resources are used more heavily in financing the public sector deficit, the impact on the economy is expansionary under the first closure rule, while it is slighlly contractionary in the second. However, an upward trend can be observed for financial variables under both closure rules. These results are valid also for the devaluation simulations. With regards to the second group of simulations, the economy expands under both closure rules. All simulation results indicate that the share of internal and external transfers in GNP among agents in the economy are affected by policy changes at different degrees. In summary. one of the main general conclusions to be drawn is that in case of fixed real wages the adverse effects of policy changes on the economy are much larger compared to the case of fixed nominal wages. Therefore, with real wage rigidity, the adjustment becomes more costly for all sectors in the economy. This phenomenon can be interpreted in such a way that to cushion the adverse effects of exogenous shocks, wage treatment by authorities should be considered extremely important. With the formulation of the financial CGE, the interaction of financial and real variables can be captured explicitly. The above results reveal that in deciding about sectoral production, export and investments, policy makers also have to consider financial variables such as inflation rate, exchange rate and interest rates.

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158

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YoU I No.2. September 200 I

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