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The overall macroeconomic situation, which sets the broad incentive structure for the operations of banks, has affected the financial sector. As a result of predictable depreciation of the currency, banks borrow at cheaper rates abroad and lend it at high rates domestically, expecting to earn more in net interest income than they lose from currency depreciation. As a result of the moral hazard created by extensive government guarantees and the lack of effective prudential regulation and supervision, the banks take on substantial risks in their interest rate exposures due to maturity mismatches, in unhedged foreign currency positions, and in potential loan losses. Such risks and the existence of large confidence-sensitive claims by nonresidents make the banking sector vulnerable to business cycles and shifts in market sentiment. Although the state banks have much less exposure in market risks, their operations are distorted by their heavy involvement in quasi-fiscal activities and the failure of the government to reimburse the banks for the subsequent "duty losses". Their losses are a major source of liquidity risk to the banking system.

The rest of the paper is organized in three main parts. First, we analyze capital flows data and the determinants of capital flows and their impact on the real sectors of the economy. Seconcl, we consider macroeconomic management issues relating to capital flows. Thirdly, we review the interactions of capital flows with the financial sector. Section II presents the basic capital inflows and outflows data and, discusses the main characteristics of these flows and provides a decomposition of the capital account. In section III the setting for capital account liberalization and the initial conditions with regard to the key macroeconomic aggregates are presented, followed by some econometric evidence on the determinants of capital flows. Section IV discusses the effects of capital flows on consumption and investment. Section V turns to macroeconomic management issues, including the exchange rate, monetary and fiscal policies, that relate to capital flows and point out macroeconomic vulnerabilities. Section VI turns to the financial sector and analyzes banking intermediation of capital flows and issues surrounding the process. Section VII concludes.

# **II. The Characteristics of Capital Flows**

# **11.1 The Record**

Despite the unstable macroeconomic environment, capital inflows to Turkey increased steadily after 1990, 'with net capital inflows reaching more than four percent of GNP in 1996 and 1997. At the aggregate level, the volatility of capital inflows reflected the volatility in economic activity. Turkey's GNP grew by more than six percent each year in the 1990s, except in 1991 (the year of the Gulf Crisis which saw GNP growing by only 0.3%) and in 1994 (the year oif a severe currency crisis when GNP contracted by six percent). In parallel, total net capital inflows were also above two percent of GNP each year, except in 1991 and in 1994., when there was a net capital outflow.

In comparative terms, the relative level (in terms of GNP) of net capital inflows to Turkey has been higher than that to Brazil before the implementation of the Real Plan, close to the level of capital inflows to Indonesia, but lower than those to Mexico and Thailand. In