Currency substitution and credit expansion interaction in 2000--2001 Turkish financial crises

The main objective of this dissertation is to investigate the dynamics of credit expansion and its link with economic volatility in Turkey. First, we introduced currency substitution as a factor, which becomes intertwined with liquidity preference in the case of a financially liberalized country. Next, we argued that financial reforms, which accompany financial liberalization, brought about currency substitution within the domestic banking system directing inactive money balances into foreign exchange deposits in the domestic banking system. Consequently, changes in liquidity preference lead to quantity rather than price changes in the form of shifts in the composition of total bank deposits between active and inactive balances. However, since we now observe shifts between two different currencies the shifts from active to inactive balances involve currency substitution as well. We claim that changes in liquidity preference, being intertwined with currency substitution under the circumstances described, act as a built-in macroeconomic destabilizer, as domestic banks' reserve requirements are higher for foreign exchange denominated accounts than for those denominated in home currency.; When inactive balances rise in volume in the banking system at a time of rising liquidity preference and economic slow down, the outcome is to reduce banks' liquidity through redistributing deposits within the system from low to high reserve accounts. On the contrary, banks' liquidity volume increases during times of rising economic activity and falling liquidity preference when the relative size of active balances in home currency accounts rises as compared to inactive balances that essentially comprise foreign exchange deposits.; We provided statistical evidence to support our claim by performing a cointegration analysis between total volume of credits of the Turkish commercial banking system and currency substitution indicator. We found that there is a negative relationship between the two over the concerned period. In other words, the existence of currency substitution and the very existence of higher reserve requirement ratio for foreign exchange denominated deposits helped increase economic volatility.; We further observed statistically that there is a negative relationship between the Gross Domestic Product and currency substitution indicator. The outcome is compatible with the earlier finding concerning the relationship between the credit expansion and currency substitution.