In late 1979 Turkey found itself in the throes of a foreign exchange crisis, with widespread shortages, negative growth and three-digit inflation. A decade later, Turkey had a comfortable balance-of-payments position, substantial foreign exchange reserves and buoyant receipts of foreign exchange from tourism and other services. The economy has achieved a remarkable transformation from an inward to an outward orientation. Nevertheless, inflation remains high (around 70%), and the public sector budget is out of control.
In Discussion Paper No. 402, Research Fellow Dani Rodrik interprets the Turkish experience in the 1980s as one of tremendously successful external adjustment combined with severe internal imbalances. Solving a debt crisis of the sort that Turkey faced in the late 1970s requires two net transfers of resources: first from the domestic economy to foreign creditors and second from domestic residents to the public sector. Rodrik argues that the generous foreign capital inflows of the early 1980s, from a variety of official and multilateral sources, allowed a relatively painless reduction in inflation to take effect alongside a process of export-oriented growth.
Nevertheless, inflation rose once more in 1983-4, and again in 1987-8. Although there is evidence of a political cycle at work here, Rodrik finds that the inflation rate is determined by the government deficit and, most importantly, by the monetization of the economy as shown by the steady erosion of the base money/GNP ratio after 1983. This ratio declined considerably following the introduction of foreign exchange deposit accounts in early 1984, thus exacerbating the inflationary impact of a given deficit. By the end of 1986, foreign exchange deposits held by residents accounted for 16% of all financial assets. This is indicative of the ongoing process of dollarization (or `DM-ization'), which has caused the Turkish experience of inflation in the late 1980s increasingly to resemble that of the Latin American countries.
Rodrik argues that the early timing of its debt crisis, together with the geopolitical conjuncture, provided Turkey with an opportunity in the early 1980s that was not available to any other large country, and that if the outward-oriented reforms had taken hold by the mid-1980s the public sector could still have undertaken the necessary retrenchment at no great cost in terms of output. The curious mixture of financial liberalization and patronage politics pursued by the Özal government, which took power in 1983, was detrimental to monetary discipline, however, since liberalization reduced demand for base money while fiscal balances came under increasing strain on account of the external adjustment process.

Premature Liberalization, Incomplete Stabilization: The Özal Decade in Turkey
Dani Rodrik

Discussion Paper No. 402 (IM)