International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 20 (2008)

© EuroJournals Publishing, Inc. 2008
http://www.eurojournals.com/finance.htm

External Debt Sustainability of Turkey: A Nonlinear Approach

Veli Yilanci
Department of Econometrics, Istanbul University, 34452, Istanbul, Turkey
E-mail: yilanci@istanbul.edu.tr
Tel: +90 212 4400000 x 11661; Fax: +90 212 4400159

Burcu Özcan
Department of Economics, Istanbul University, 34452, Istanbul, Turkey
E-mail: bozcan@istanbul.edu.tr

Abstract

The objective of this paper is to investigate the sustainability of external debt of

Turkey by using a method which allows testing nonlinearity and nonstationarity
simultaneously. We use the time series data of the ratio of Turkey’s net external debt stock
to GDP over the period 1990:Q1-2007:Q2. First we test the linearity of the ratio against to
the threshold autoregressive alternative by using the Wald test. Since our findings suggest
that the ratio has threshold effects, we test stationarity of external debt with the suit tests
and we conclude that it is a unit root process. These results provide evidence that Turkish
external debt is not sustainable.

Keywords: External Debt, Sustainability, Threshold Autoregressive Model, Unit Root.

JEL Classification Codes: C22;C52;F34

I. Introduction
External debt burden of developing countries continues to be one of the key barriers to economic and
social progress. Therefore, fiscal policies, sustainability and solvency have become important research
areas.
In the closed economy, domestic debt was the only choice for financing of economy, but in the
open economy, countries and their economic structures depend on each other so external debt has
started to substitute domestic debt with the liberalization.
External debt or borrowing refers to taking monetary aids from a foreign country or institution.
It can be explained in many ways. According to Evgin (2000) external borrowing refers to the taking
fiscal or real income of a government or government’s institution from external sources. In other
words, obtaining external credits of resident people or institutions in a country from resident people or
institutions in abroad. Uçak (2006) explains external debt as transfer flows which are taken from
foreign resources and during their repayments have attenuator or booster effects on national income
and are emanated from international relationships.
The issue of external debt sustainability has gained importance in 1980s. Because these years
were defined as the “foreign debt crisis years” due to many developing countries experienced of
foreign debt crisis while industrialized countries like USA and Germany experienced constant current
account deficits (Özkan, 2006).
International Research Journal of Finance and Economics - Issue 20 (2008) 92

Foreign debt sustainability refers to a country’s ability to meet its foreign debt obligations. If
the present value of a country’s net future foreign earnings equals the current value of its foreign debt,
its foreign debt is considered sustainable. In other words, foreign debt is considered sustainable if the
country’s intertemporal budget constraint is satisfied (Mohammadi et al. 2007). Debt and external debt
sustainability is measured by some ratios or indicators too. For example, the ratio of total external debt
to GDP is an important indicator. To achieve sustainability of debt the ratio of total external debt to
GDP must be stabilized (Keating and Keating, 2003).
Whether external debt is sustainable or unsustainable depends on critic levels of some ratios.
These ratios which are generally accepted for identifying of external debt sustainability by IMF and
World Bank are those: total debt to GNP, total debt to export, debt service to export and finally interest
service to export. When the country transcends determined levels (for the ratio of total debt to GNP is
%50, total debt to export is %275, debt service to export is %30 and interest service to export is %20)
in the three of four ratios it is accepted heavily indebted country (Evgin, 2000).
To the best of our knowledge there are just three studies investigate the sustainability of
external debt of Turkey. Utkulu (1999) examines the sustainability of external debt of Turkey with unit
root tests following the methodology of Trehan and Walsh(1991) and finds it as unsustainable. Önel
and Utkulu(2006) investigates it with intertemporal approach suggested by Hakkio and Rush(1991)
allowing for structural breaks and find it weakly sustainable. Mohammadi et al. (2007) find it strong
sustainable allowing for asymmetries in the adjustment process.
The objective of this study is to test for sustainability of Turkey’s external debt by using a
method which examines nonlinearity and nonstationarity simultaneously.
This paper organized as follows; in Section II we sum up the Turkey’s external debt’s
development over the period 1990Q1-2007Q3. Section III explains the econometric methodology.
Section IV presents empirical results and finally Section V provides a conclusion.

II. The Development Process of Turkey’s External Debt

Turkey needs external debt for its development process like other developing countries. Its external
debt had increased much and reached at very dangerous levels in some years, but especially at the last
years, domestic debts’ share in total debt stock increased. So, whether it’s external debt is sustainable
or not is a matter for discussion.
In this study, Turkey’s external debt structure is analyzed for the period of 1990Q1-2007Q3.
Since Turkey’s economic policy has essentially changed between 1980 and 1990 years and this
political change has affected Turkey’s external debt at very large scale, therefore we give a short
comment about the period of between these years in the next subsection.

II.A. The Period of Between 1990 and 2000

With the January 24 Program in 1980, Turkey has initiated liberal policies, opened its economy to the
world and started to follow export-led growth policy by giving incentives for export. The export-led
growth policy was quite successful at the early stages of its implementation. The ratio of total exports
to GDP increased from 4.1 to 13.3 percent during the period of 1980-1988. The ratio of total import
increased but it was smaller than export. So, external deficit to GDP fell from 7 percent in 1980 to 1
percent in 1988 (Ertuğrul and Selçuk, 2001).
According to Kocaoğlu(2005) Turkey’s external debt kept on increasing and international
markets credits’ share increased in the years between 1980 and 1990. Turkey’s external debt stock
increased ten times in this period. It reached 17.2 billion dollar in 1982, then 25.6 billion dollar in 1985
and, 40.3 billion dollar in 1990 and finally 49 billion dollar in 1990.
After 1989, external debt burden and so the ratio of external debt to GDP started to decrease.
Treasury office initiated the principle of limitation of external debts by external debt servicing. This
initiation had positive effects on external debt servicing and external credibility, but negative effects on
93 International Research Journal of Finance and Economics - Issue 20 (2008)

internal balance. Stability of internal balance problem was born because similar cautions were not
taken for internal balance (Tandırcıoğlu, 2000).
In the following years, Turkish economy has suffered from high inflation, high budget deficits,
rapid depreciation of the domestic currency and persistent current account deficits. To be a solution of
these problems, government initiated a number of policies. In 1989, liberalization of capital account
has achieved. In 1994, a stabilization program which aimed decreasing of inflation has been initiated.
In 1992, 1998, and in 2001, the International Monetary Fund- monitored austerity programs were
followed (Muhammedi et al., 2007).
This period (1990-2000) affected Turkish economy badly and left permanent marks on the
economy. Turkish economy experienced two serious crises in 1994 and 1998-1999 (Russian crisis).
Also, two earthquakes which were seen in 1999 had negative effects on Turkey’s economy.
In this period, public sector borrowing requirement increased and reached at the peak level in
the 1993 year. In addition to consolidated budget deficits, local administrations, circulating capital
institutions, public economic enterprises and founds started to take external borrowing for their
deficits. Finally, Turkey has been coerced on paying of its debts since 1994. By the reason of debt
accumulations from old years, inability of paying of debt services of new debts and of taking external
debts as the sufficient quantity, Turkey came into hard times. Domestic debts were used for closing the
budget deficits due to insufficient external debts. In the 1990s, except the inability of taking external
debt in the 1994 year, Turkey’s external debts kept on increasing. While its external debt level was 66
billion dollar in 1994, the level exceeded 100 billion dollar in 1999 year (Özkan, 2006).

II.B. The Period of Between 2000- 2007(Q3)

In this period, some cautions were taken to achieve sustainable growth based on IMF stabilization

• Achieving of budget discipline and fiscal discipline on public sector.

program from 2000 to 2002 year. These are as the following (Kocaoğlu, 2005):

• Determining of exchange rate with crawling peg which was determined in advance.
• Implementing of structural reforms and precipitating of privatizations.
After this stabilization program, increasing of tax incomes, substitution of domestic debt by
external debt, treasury office’s domestic debt demand decreased, too. This brought about interest rates
decreases and important problems were born about financial sector. Also, rises of import expenditures
had bad effects on economy. All of above factors brought about financial markets’ crisis in November
2000. By the reason of developments which were seen in “National Security Council Convention” on
February 20, 2001, political confidence in markets got lost. So, a new crisis started (Kocaoğlu, 2005).
The 2000-2001 financial crises were unprecedented in intent. Public debt’s growth rate and
level became the primary sources of macroeconomic vulnerability. Also, public net debt to GNP ratio
was around %90 in 2001. After these crises, the reform agenda based on the National Convergence
Program to the EU and on the Stand-By Arrangement with IMF has aimed to address the debt problem
(Önel and Utkulu, 2006).
After these crises “Transition to the Strong Economy Program” (TSEP) which was supported
by IMF and World Bank was initiated on May 15, 2001. TSEP included the conventional IMF
measures: such as monetary contraction, flexible exchange rate management, reductions in wage
remuneration and cuts in public spending. This program aimed at reducing the ratio of net stock of
domestic debt/GDP to %40.9 and that of foreign debt/GDP to %40.3 (Voyvoda and Yeldan, 2005).
While the ratio of external debt to GNP is %50 in 1994, following years this ratio kept on
increasing and reached to %80 in 2001. The ratio of total external debt to GNP exceeded %275
(maximum risky level which is identified by World Bank) from 1994 to 2004 According to this ratio,
Turkey was very indebted country between these years). After this year, this ratio started to decrease
under this critic level. The ratio of external debt service to export was always above the % 30 critic
levels between these years; even it exceeded %80 in 2000 and 2001 years of recession. It has showed
to decrease since 2003. The ratio of net international reserves to external debts decreased again in the
2000 and 2001 recession years and it showed important rise in 2005 (Özkan, 2006).
International Research Journal of Finance and Economics - Issue 20 (2008) 94

Table 1: Total Public Sector Net Debt Stock in the Period of between 2000 and 2007(Q3) (Million TRY)

Years 2000 2001 2002 2003 2004 2005 2006 2007Q1 2007Q2 2007Q3
Total public sector net debt stock 71.681 159.575 215.68 250.841 274.456 269.748 259.463 262.662 249.036 252.483
Net External debt stock 23.762 66.235 88.359 78.316 74.897 42.051 30.458 22.479 18.533 14.919
Net Domestic Debt Stock 47.919 93.341 127.321 172.526 199.559 227.697 229.005 240.183 230.503 237.564
Source: www.treasury.gov.tr (Turkish Treasury, Public Sector Net Debt Stock Statistics, 2007)

Table 1 shows that Turkey’s total public sector net debt stocks increased from 71.681 million
TRY to 252.483 TRY. Especially, in the years of 2001, 2002, 2003 and 2004, its external debt stock
reached at the very high level, after 2004 it started to decrease. External debt stock of Turkey was only
14.919 million TRY in 2007 (Q3). Turkey’s domestic debt stocks increased from 47.919 TRY to
237.564 TRY in this period. The share of domestic debt stock in the public sector debt stock increased,
too. After 2004, it exceeded 200.000 million TRY. Finally, we propose that in the period of 2000 and
2007 (Q3), while the share of domestic debt stock in the public sector debt stock increased, external
debt stock decreased.

III. Econometric Methodology

In this study we use a two-regime threshold autoregressive (TAR(k)) model with an autoregressive unit

ΔB = θ ′ x 1 + θ ′x 1
root as suggested by Caner & Hansen (2001);
+e

( )′ for t = 1,...,T , e is an i.i.d. error and 1

t 1 t −1 {Zt −1 < λ} 2 t −1 {Zt −1 ≥ λ} t (1)

where xt −1 = Bt −1 rt′ ΔBt −1 ,..., ΔBt − k t (.) is the Heaviside indicator

⎧1 if Z t −1 < λ
function that takes the form

1(.) = ⎨
⎩0 if Z t −1 ≥ λ
(2)

Here λ is an unknown threshold and takes on values in the interval λ ∈ ∧ = [ λ1 , λ2 ] . λ1 and λ2

are chosen so that P ( Z t ≤ λ1 ) = π 1 > 0 and P ( Z t ≤ λ1 ) = π 2 < 1 . Caner and Hansen (2001) observe that
it is typical to treat π 1 and π 2 symmetrically so that π 2 = 1 − π 1 , which imposes the restriction that no
regime has less than π 1 % of the total sample. Andrews (1993) suggests that setting π 1 = .15 and
π 2 = .85 is reasonable for the analysis. The particular specification for the threshold variable Z t −1 is
not essential to the analysis. However what is necessary for the analysis is that Z t −1 is predetermined,
strictly stationary, and ergodic with a continuous distribution function.
In Eq. (1), rt is a vector of deterministic components including an intercept and possibly a
linear time trend. If the series yt is trended it would seem natural to set rt = (1 t )′ , if not a natural
option is to set rt = 1 .

⎛ ρ1 ⎞ ⎛ ρ2 ⎞
It is convenient to show the components of parameter vectors as

⎜ ⎟ ⎜ ⎟
θ1 = ⎜ β1 ⎟ , θ 2 = ⎜ β 2 ⎟
⎜α ⎟ ⎜α ⎟
(3)
⎝ 1⎠ ⎝ 2⎠
where ( ρ1 , ρ 2 ) are the slope coefficients on Bt −1 , ( β1 , β 2 ) are the slope coefficients on the
deterministic components rt and (α1 , α 2 ) are the slope coefficients on ( ΔBt −1 ,..., ΔBt − k ) in the two
regime.
95 International Research Journal of Finance and Economics - Issue 20 (2008)

For each threshold value λ ∈ ∧ , Eq.(1) is estimated by least squares(LS), since the equation is a

ΔB = θˆ ( λ )′ x 1 + θˆ ( λ )′ x 1 + e (λ )
regression equation (although nonlinear in parameters):
t −1 {Zt −1 < λ} t −1 {Zt −1 ≥ λ} (4)
The LS estimates of the threshold λ and the corresponding parameter vectors are found by
t 1 2 t

λˆ = arg min σˆ 2 ( λ )
minimizing residual sum of squares:
(5)
λ∈∧

where σˆ 2 ( λ ) = T −1 ∑ eˆt ( λ ) . We can obtain the LS estimates of the other parameters by plugging in
T

( ) ( )
2

the point estimate λ̂ , to have θˆ1 = θˆ1 λˆ and θˆ2 = θˆ2 λˆ .

1

In Eq (1), there are two important issues; threshold effect and stationarity property. The

H 0 : θ1 = θ 2
threshold effect disappears under the null hypothesis of linearity:
(6)

WT = T (σˆ 02 / σˆ 2 − 1)
This null is tested against the alternative of a threshold model using standard Wald statistic:
(7)
where σ̂ 2 is the residual variance from estimated model, and σ̂ 02 is the residual variance from OLS
estimation of the null linear model.
The stationarity of the process Bt can be established in two ways. First when there is a unit root
in both regimes. Here, the null hypothesis is of the form H 0 : ρ1 = ρ 2 = 0 against the alternative
H1 : ρ1 < 0, ρ 2 < 0 If the null can not be rejected, it can be concluded that Bt is not stationary in both
regimes i.e. we have a stationary TAR if (1 + p1 )(1 + p2 ) < 1 . This is tested making use of Wald statistic
R1t :
R1t = t121( ρˆ1 <0) = t221( ρˆ2 <0) (8)
where t1 and t2 are t ratios for ρ̂1 and ρ̂ 2 from the OLS regression of the TAR model. Two-sided
Wald test statistic, R2t , can be also used to test the null of unit root, against the alternative
H1 : ρ1 ≠ ρ 2 ≠ 0 . This statistic is R2T = t12 + t22 . Caner and Hansen (2001) suggest using one-sided Wald
statistic instead of two-sided version since the latter may have less power than the former.
Second, when there is a unit root in only one of the regimes, a case of partial unit root, the

⎧ ρ1 < 0 and ρ 2 = 0
alternative hypothesis is of the form:

H2 = ⎨
⎩ ρ1 = 0 and ρ 2 < 0.
(9)

state, p1 < 0 shows that in the first regime, the process is mean reverting whereas in the other, the
In this case, the process is non-stationary but it is different from the classic unit root. In the first

behavior is not different from I (1) . This partial unit root case is tested by using the individual t -
statistics for ρ̂1 and ρ̂ 2 .

IV. Empirical Results

We use the time series data of the ratio of Turkey’s net external debt stock to GDP (RNGDP from now
on). This data set comprises quarterly observations over the period 1990:Q1-2007:Q2, and come from
Republic of Turkey Prime Ministry Undersecretariat of Treasury and International Financial Statistics
International Research Journal of Finance and Economics - Issue 20 (2008) 96

respectively. All our results are based on π 1 = .15 and π 2 = .85 as suggested by Andrews (1993) while
all bootstrap tests based on 10000 replications.
We begin by selecting the appropriate lag order k and delay parameter m . We use the
minimization of the Akaike Information Criteria (AIC), and also Schwarz Information Criteria (SIC)

criterias suggest k = 4, m = 1 model, we select it as the appropriate model. Hence, we choose

following Franses and Van Dijk (2000). In Table 1, we report the results of both statistics. Since both

Z t −1 = yt −1 − yt − 2 as the threshold variable.

Table 2: Results of Information Criterias

AIC 1 2 3 4
1 3.47 3.42 3.4 3.24
2 3.4 3.44 3.35
3 3.38 3.29
4 3.38
SIC 1 2 3 4
1 3.34 3.24 3.17 2.96
2 3.22 3.22 3.08
3 3.15 3.02
4 3.11

Next, we test the linearity of RNGDP against to the threshold autoregressive alternative by
using the Wald test. In Table 2, we report the threshold test and the unit root test results along with the
bootstrap critical values, and boostrap p -values. Since Wald Statistic WT (53.2), is bigger than the
critical value(26.3), we can reject the null hypothesis of linearity in favor of the TAR model. This
result shows that Turkey external debt dynamics have undergone significant regime shifts. Since we
determine that we need to test the RNGDP using the TAR model, we now test the stationarity of the
RNGDP by using threshold unit root tests. The results of both the one-sided R1 and two-sided R2
Wald tests show that RNGDP is a threshold non-stationary process since bootstrap p-values of both
tests bigger than the 0.05 critical value.

Table 3: Threshold and Unit Root Tests

Wald Statistic 5% Critical Value Bootstrap-p value

Bootstrap threshold test 53.2 26.3 0.001
R2 7.14 15.7 0.330

R1 7.14 15.2 0.287

To investigate stationarity of the regimes individually, we examine the individual t statistics, t1

and t2 . We report the t statistics along with the bootstrap critical values and bootstrap p -values in
Table 2. For our model, the t1 statistic(0.0437) is smaller than the bootstrap critical value(3.31) at the
5% level of significance. Moreover, the t2 statistic is insignificant at the same level of significance
since it is (2.67) smaller than the bootstrap critical value (3.24). So, according to the t statistics results,
we conclude that both regimes are characterized by unit root individually.
97 International Research Journal of Finance and Economics - Issue 20 (2008)
Table 4: Individual Unit Root Tests

t-statistics 5% Critical Values Bootstrap-p value

t1 0.0437 3.31 0.757

t2 2.67 3.24 0.111

For our preferred specification of m = 1 , we report LS estimates of TAR model in Table 4. The
point estimate of the threshold λ̂ is 3.00. This value implies that the TAR splits the regression into two
regimes depending on whether the threshold variable Z t −1 = yt −1 − yt − 2 lies above or below 3.00. The
first regime occurs when zt −1 < 3.00 , which happens when the RNGDP rate has fallen, remained

approximately %73.8 of the observations. The second regime is when zt −1 > 3.00 which occurs when
constant, or has risen by less than 3.00 points over a 1-month period. First regime contains

the RNGDP rate has risen by more than 3.00 points over a 1-month period. This regime has %26.2 of
the observations.

Table 5: Least Squares Estimates of TAR model

mˆ = 1 λˆ = 3.00
Z t −1 < λˆ Z t −1 ≥ λˆ
Regressor Estimate s.e. Estimate s.e.
Intercept 0.197 0.677 6.790 2.380
Y(t-1) -0.001 0.045 -0.209 0.078
DY(t-1) 0.507 0.240 0.688 0.372
DY(t-2) -0.416 0.164 -0.861 0.167
DY(t-3) 0.418 0.170 0.178 0.158
DY(t-4) 0.943 0.116 -0.924 0.280

Figure 1 shows the deviations of the threshold variable from the estimated threshold point over
the sample period. In this figure values above the axis identify the upper regime and below the axis
identify the lower regime. Figure 1 presents that major fluctuations happen especially after 1998 in
which year Turkish economy has been under effect of the Russian crisis. After this year, fluctuations
have become permanent because of the 1999 earthquake and the 2000-2001 financial crises.

Figure 1: Identification of the threshold regimes

International Research Journal of Finance and Economics - Issue 20 (2008) 98

V. Conclusion
In this paper, we have investigated the long run sustainability of Turkey’s external debt stock during
the period spanning from 1990:Q1 to 2007:Q3 by using a method suggested by Caner and Hansen
(2001) which allows for the joint testing of nonlinearity and nonstatinonarity. First, we find that the
external debt- GDP ratio is a nonlinear series. Second, when we examine the stationarity of the ratio
with the suit unit root test, we conclude that the series is characterized by a unit root process.
Using this method we provide evidence that external debt-GDP ratio is a TAR process with a
unit root. If the ratio shows an increase of more than %3 between the previous quarter and the 2nd
quarter before, significant fiscal stabilizations would occur. Finally, this result shows the external debt
of Turkey is unsustainable.

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