We would like to thank staff for the comprehensive and informative set of papers that provide an in-depth analysis of the Turkish economy and financial system. Our authorities appreciate the thorough and candid discussions with the Article IV mission.
The Turkish economy registered a notable recovery in the wake of the global economic crisis and expanded by 5.5 percent on average between 2010 and 20141. Unlike the economic plague described as jobless recovery, buoyant growth in Turkey translated into 5.7 million new jobs since total employment dipped in 2009. A widening external deficit and inflationary pressures, however, have emerged as side effects of the recovery, driven by strong credit expansion and domestic absorption.
The staff report characterizes the improvements in the external accounts as cyclical. However, the authorities view that the prudent policy mix was the driving force behind the rebalancing even in the most recent period, while acknowledging that cyclical factors have also provided some support. In fact, it should be noted that starting from the second half of 2011, the authorities responded in a timely manner and introduced a set of measures to limit domestic demand growth and contain a rapid increase in credit and a widening in the current account deficit. In response to tight fiscal policies, monetary policy response and macroprudential measures, credit growth remained within the authorities’ indicative limits and the current account deficit-to-GDP ratio declined by 3.6 percentage points to 6.1 percent in 2012. Furthermore, consumer price inflation plummeted to 6.2 percent in 2012 year-end, the lowest level in the last 25 years. In view of the reemergence of inflationary pressures and a widening current account deficit in 2013, additional macroprudential measures were put in place and monetary policy was tightened in late 2013 and early 2014.
The overall macroeconomic setting remains stable. The electoral cycle will end in the first half of 2015, and no elections are scheduled to take place between mid-2015 and 2019, which will provide a window of opportunity for major structural reforms. Notwithstanding external shocks, the Turkish economy is on track to grow at a sustainable pace. Denting the external imbalance, maintaining price stability and upholding the reform momentum remain the overarching objectives. Fiscal policy will be supportive of the rebalancing process and relieve the pressure on monetary policy while contributing to the growth momentum and domestic savings. Monetary policy is focused on price stability with financial stability under its radar. The authorities will pursue an ambitious reform agenda.
Recent Macroeconomic Developments
After the strong growth reading in the first quarter of 2014, economic activity lost some steam. Private expenditures waned in the second quarter as macroprudential measures kicked in late 2013 to early 2014 while public spending remained weak. A contraction in the agricultural sector and the negative contribution from the construction sector weighed on growth. In the first half of 2014, year-on-year growth remained moderate at around 3.3 percent, while net exports’ contribution to the headline figure was 2.7 percent.
Leading indicators—except for investment demand—point to a revival in economic activity amid relatively weak performance in the second quarter. In September, industrial production gained pace and grew by 9.3 percent in annual terms. Subdued growth, especially in the major trading partners, and geopolitical tensions may limit export growth. GDP growth is likely to be around 3.3 in 2014, a tad higher than staff’s expectations, with external demand contributing 2 percentage points.
Improvement in the real exchange rate, moderate credit expansion and demand rebalancing supported the adjustment in the current account deficit. September current account deficit data came in at US $2.2 billion, which brings down the 12 month rolling deficit from US $48.9 billion to US $46.7 billion. Total exports, mainly driven by demand from European countries, are expected to reach US $161 billion in 2014. Imports will be around US $244 billion and the current account deficit will plunge to 5.6 percent of GDP in 2014, which is almost 1 percentage point better than envisaged at the beginning of the year.
The rising trend in the share of FDI and long-term capital flows, which includes banking and the real sectors’ long-term net credit and bonds issued by banks and non-financial sectors, in the financing mix highlights the improvement in external deficit financing.
Inflation hovered above the target triggered mostly by high domestic food prices and FX pass-through. Negative supply-side shocks brought about by the adverse weather conditions put significant pressure on food prices and contributed to the divergence between international and domestic food prices. The strong FX pass-through and tax hikes on automobiles also fueled the headline rate.
After climbing to 14.4 percent in August 2014, annual food price inflation eased to 12.6 percent in October on the back of the deceleration in unprocessed food inflation. The food price inflation’s contribution to the headline figure was 3.1 percentage points in October. The deterioration in core inflation started to fade recently and the core inflation trend improved in the third quarter reflecting the impacts of the tight monetary policy stance and macroprudential measures. Yet, administrative price adjustments in natural gas and electricity tariffs in October and still high food prices delayed the improvement in the headline figure. The Central Bank of the Republic of Turkey (CBRT) expects year-end inflation to be around 8.9 percent.
Outlook: Medium-Term Program for 2015–2017
Built upon a cautious, realistic and consistent macroeconomic framework, the Medium-Term Program (MTP), unveiled in early October, aims at further strengthening macroeconomic fundamentals and addressing major challenges, which are underlined in staff’s analysis. Policies and structural reforms scheduled for implementation in the next three years are geared towards maintaining price stability, improving external imbalances and bolstering domestic savings.
The MTP’s objectives also include reorienting resources to more productive sectors, enhancing production capacity and technological advancements as well as improving export contribution to GDP growth and boosting productivity.
The authorities are more sanguine on the growth outlook, expected improvement in the external deficit and the inflation rate in the medium term.
Growth is projected to rise gradually to 4 percent next year and 5 percent in 2016 and 2017 on account of investments especially in the productive sectors, which will mostly be financed by increasing domestic savings, and productivity gains, particularly in the industrial sector. Private fixed investments will revive and grow by 8.7 percent on average during the MTP’s time frame. Estimated gains in total factor productivity, which held back growth in the last two years, will be one of the factors boosting growth going forward.
Having remained attentive to macroeconomic stability, the authorities will restrain the increase in private consumption beyond household disposable income growth. This will be mostly done through prudential measures. Private savings are expected to rise from 11.7 percent in 2014 to 13.1 percent in 2017, making an important contribution to the increase in the domestic savings ratio. With a tight fiscal policy stance in place, the public sector will also continue to contribute to domestic savings.
Against the background of higher domestic savings, favorable oil prices and measures to suppress the reliance on imports, the current account deficit will remain contained at around 5 percent of GDP, notwithstanding the surge in GDP growth. The recent fall in oil prices, if sustained, would help achieving a much sharper reduction in the current account deficit despite the sluggish growth trend in Turkey’s major export markets.
Following the exchange rate stabilization, the FX pass-through is expected to die out by the end of 2015 and open up room for a decline in the inflation rate. Inflation is expected to fall to 6.3 percent at the end of 2015 based on the assumption that domestic food prices normalize, oil prices remain stable and exchange rate effects gradually weaken. Going forward, a tight fiscal policy stance will be an essential factor contributing to the monetary guardian’s fight against inflation. In the medium term, inflation is forecast to converge to the target.
Macroeconomic Policies and Structural Reforms
Fiscal discipline remains intact. The authorities plan to limit current expenditure growth in an effort to rein in the public investment-savings deficit while capital spending will be reoriented to infrastructure spending and R&D investments. The total public sector primary surplus will increase by 1.4 percentage points to 1.8 percent of GDP in 2017 with the public sector overall balance yielding a surplus of 0.1 percent of GDP. Improvement in the primary surplus will decrease public debt to 28.5 percent of GDP in 2017.
As a cornerstone of Turkey’s macroeconomic policy setting, fiscal discipline will help to prop up domestic savings and provide the necessary space that may be required for structural reforms. Strong public balances will also support the CBRT’s mandate to maintain price stability. 2015 draft budget law is crafted to strike the right balance between strengthening infrastructure, improving quality of public services and maintaining fiscal discipline. The authorities are also focused on maximizing the contribution of public investments to growth, and improving the resource allocation and efficiency of public spending. Education and healthcare spending will continue to receive a major share of the budget, with education spending constituting 22.5 percent of tax revenues.
The new Income Tax Law, submitted to the Parliament, will broaden the tax base, make the tax system fairer and enforce voluntary tax compliance. New policies are in the pipeline that will modernize the tax procedures law and streamline stamp duty and other charges that will lower the cost of doing business. The authorities are also committed to effectively fight against the informal economy.
The FX market came under pressure due to heightened financial market woes in emerging markets and country-specific factors at the end of 2013. The CBRT provided FX liquidity through foreign exchange selling auctions and directly intervened in the FX market when the pricing mechanism was impaired. In an effort to contain the adverse implications of market jitters on price and macroeconomic stability, the CBRT hiked the one week repo rate by 550 basis points to 10 percent in January 2014. Furthermore, the monetary policy framework was simplified with Turkish Lira liquidity provided mostly at the one week repo rate. Frontloaded monetary tightening proved effective as risk premia recovered notably in the second quarter, which also reflects diminished domestic uncertainties.
Amid improvements in the global liquidity conditions and the external and domestic sentiment, and signs that the cumulative impact of the currency depreciation on inflation steadily declines, the CBRT initiated a series of measured rate cuts to roll back frontloaded tightening early this year. A first rate change in April 2014 slashed the late liquidity window lending rate to 13.5 percent. The CBRT cut the one-week repo rate by a cumulative 175 basis points between May–July 2014. In the meantime, with a recent tightening in its liquidity policy, the CBRT kept the yield curve flat, which confirms the tight monetary policy stance.
The CBRT remains vigilant to avoid a deterioration in inflation expectations that may affect pricing dynamics and hence the inflation outlook. There is a broad range of instruments in its toolkit including policy rates, macroprudential policies, a reserve requirement ratio and liquidity policy, which can be used to manage inflation expectations. Judgments based merely on the level of policy rates may not give an exact impression about the monetary policy stance. Liquidity policy and the effective cost of funding from the CBRT should also be taken into account in order to get a clear and complete picture of the monetary policy. Taking all tools in place into consideration, the authorities believe that financial conditions are tight and will quell the inflation rate.
The authorities concur with the staff’s assessment that reserve buffers need to be bolstered though the current pace of accumulation seems appropriate. The CBRT receives FX flows from export rediscount credits. Through export rediscount credits, which are extended to companies through intermediary banks in domestic currency and repaid by companies in FX, a total of US $12.9 billion will be added to the reserves in 2014.
Financial Sector Policies
The Turkish banking system remains robust and resilient with the average capital adequacy ratio well above regulatory standards, strong asset quality, and ample liquidity buffers. Regulatory and supervisory standards are compatible with international standards. Despite the recent volatility in the currency markets and interest rates increase, the non-performing loans ratio remained well anchored at about 2–3 percent. The average capital adequacy ratio is 15.9 percent and the capital structure is mainly composed of core equity. The stress test results of both the CBRT and the Banking Regulation and Supervision Authority (BRSA) indicate that, as a whole, the sector is resilient to idiosyncratic shocks.
In light of the strong pickup in consumer lending, the authorities put in place a set of prudential measures to limit the growth trend to more balanced levels and reorient resources to more productive sectors. Credit card spending with installments has been the major driving force of the total credit card balance growth in the last five years. Following the first round of changes in credit card limits and maturity limits on consumer loans in the last quarter of 2013, the number of installments on credit card spending was limited to 9 months in early 2014. Additionally, loan-to-value requirements for car loans were differentiated based on the value of cars. Higher funding costs were reflected in the consumer and commercial lending rates. Macroprudential measures pursued by the banking watchdog weighed especially on consumer credit demand. Consumer lending growth slowed down significantly from 27.8 percent in 2013 to 14.3 percent in mid-September on FX adjusted terms, whereas commercial loan growth remained robust.
The CBRT announced that the Turkish Lira component of required reserves will be remunerated, where the rate of remuneration will be based on the financial institutions’ core liability ratios. This will be instrumental in encouraging banks to manage balance sheets cautiously and thus strengthen financial stability. The remuneration rate will be the weighted average cost of the CBRT’s funding rate minus 700 basis points for all banks and financing companies for November-December 2014. Starting from 2015, for financial institutions with core liability ratios above the sector’s average remuneration rate will equal the weighted average cost of the CBRT funding minus 500 basis points. For those with ratios below the average rate will be weighted average cost of the CBRT funding minus 700 basis points.
New prudential measures are in the pipeline. There is ongoing work on collecting household income data that may be used as a basis to introduce caps on the level of household debt to income. In the meantime, the Turkish Parliament authorized the Ministry of Finance to introduce a partial tax deductibility on corporate debt. This prudential measure would basically lower the tax deductibility threshold on debt from 100 percent to 90 for companies with a total debt to assets ratio above 50 percent. The Ministry of Finance has not implemented this measure so far, but it remains in the authorities’ toolkit.
The direct and indirect FX risks which the Turkish banking system is exposed to are limited and manageable. The banking sector FX loans to the non-financial corporates (NFCs) are subject to strict underwriting rules and loans are highly collateralized. Historically, the NPL ratio for FX loans has been under 1 percent. Banks’ external FX funding rollover ratio remains above 100 percent and they have not experienced any difficulty to rollover their FX funding. Total FX bond issuances by Turkish banks abroad grew by 46.1 percent year-on-year in 2014 and reached US $23 billion with an average maturity longer than 5 years. Banks have substantial amounts of FX deposits at the CBRT kept as part of ROM and FX reserve requirements. Moreover, the CBRT stands ready to provide around US $10.8 billion to banks through its lender of last resort facility should they face FX rollover problems. Rates for US$ and euros stand at 7.5 and 6.5 percent, respectively. Even though this is a relatively costly facility, the CBRT may adjust its cost and limits available to the banks depending on the new conditions to provide additional relief.
The FX risk of NFCs is lower than implied by macroeconomic data. A micro-based study by the CBRT revealed that FX borrowing of many NFCs is naturally hedged. 63 percent of real sector companies do not have FX loans, while 68 percent of companies having FX loans generate export receipts, which eliminate FX risk. Anecdotal evidence also shows that some of the loans are covered by FX collateral. NFCs were able to rollover their external debt in the last four years as the external debt roll-over ratio remained above 100 percent.
The authorities are determined to step up the reform process, paving the way for a major leap forward in Turkey’s economy. To provide a clear and holistic framework and prioritize the implementation of reforms, 25 comprehensive transformation programs were mapped out in parallel with the 10th Development Plan, a roadmap that lays out the medium-term perspectives and policies required to reach the 2023 targets.
The first reform package, unveiled in November, includes nine transformation programs and 417 action plans. The primary goal is to improve the value added of exports and lower the dependency on imports in energy. Industry specific measures will be designed to increase productivity and competitiveness. In response to these policies, the export-import coverage ratio, which stood at 60 percent in 2013, is estimated to soar to 70 percent in 2018. Special emphasis is put on innovation, R&D and technology development. The government will support startup companies especially in the innovative fields along with investments in technology intensive production in several sectors.
Domestic resource utilization in energy production and energy efficiency is essential to lower the energy import bill, which constituted approximately 22 percent of total imports in 2013. The authorities will develop new financing models and incentives for energy efficiency investments, encourage capacity improvements in renewable energy and promote efficient use of domestic coal resources.
With the remaining transformation programs in the pipeline the authorities will address the weaknesses in the labor market, improve the business climate, and bolster competitiveness and productivity.
The 2014 figure is based on the Medium-Term Program forecasts.