Abstract

Two key aspects of Turkey’s economic performance emerge from the analysis presented in this paper. First, recovery from the 2000–01 crisis has been remarkable, led by sound macroeconomic policies and supported by an impressive array of structural reforms. Inflation has fallen to its lowest level in a generation, while the recovery in output has outperformed all expectations. Interest rates have fallen substantially and the Turkish lira has become a store of value. The successful redenomination of the lira has been a welcome consequence of the stabilization effort.

Two key aspects of Turkey’s economic performance emerge from the analysis presented in this paper. First, recovery from the 2000–01 crisis has been remarkable, led by sound macroeconomic policies and supported by an impressive array of structural reforms. Inflation has fallen to its lowest level in a generation, while the recovery in output has outperformed all expectations. Interest rates have fallen substantially and the Turkish lira has become a store of value. The successful redenomination of the lira has been a welcome consequence of the stabilization effort.

Second, despite this success, significant vulnerabilities remain, the key sources of which are the high levels and vulnerable structure of government and external debt. The financing outlook thus remains challenging, as short public debt maturities add to domestic rollover risk and the government faces high external debt repayments in the years ahead. A sudden shift in investor sentiment could pressure exchange and interest rates, in turn undermining disinflation and weakening bank and government balance sheets. The high current account deficit, financed largely by short-term inflows, adds to this concern. Another worry is the high unemployment rate. Despite the high rate of labor force growth and robust economic growth, employment generation has not yet been strong enough to significantly reduce unemployment.

Political developments have facilitated the reforms needed to underpin the stabilization effort. The severity of the 2000–01 crisis generated the political momentum to put in place sound macroeconomic policies and enact critical structural reforms. In addition, the formation of Turkey’s first single-party majority government since the 1980s has provided a helpful backdrop for reform. Prospects for an ongoing, positive economic performance have benefited from political support for the creation of independent and strong institutions, strides made to improve transparency (especially in the fiscal area), and the wide range of legislative reforms in economic areas.

The analyses in this paper suggest several elements of a forward-looking reform agenda to sustain Turkey’s improved economic performance and address the vulnerabilities that remain:

  • Primary surplus. Sustained high primary surpluses have clearly been the key to the success of economic policies over the last few years. Sustained surpluses would facilitate higher growth and support ongoing disinflation efforts. This would also reduce Turkey’s public debt burden to safer levels and help contain the current account deficit. On the financing side, shifting to longer-term local currency instruments should help lower the government’s own balance sheet vulnerabilities.

  • Structural fiscal reforms. Although successful to date, Turkey’s fiscal adjustment efforts face the risk of unraveling unless they are supported by deeper structural reforms. These reforms should include controlling expenditures through such means as comprehensive Social Security and civil service reform. Improved tax administration and a streamlined tax system are needed to address tax evasion and broaden Turkey’s narrow tax base.

  • Monetary policy. The Central Bank’s impressive disinflation record has been one of Turkey’s major achievements in recent years. Continued disinflation would lay the foundation for sustained higher growth and, over time, should help reduce dollarization, a key balance sheet concern. In addition to sustained fiscal consolidation, credibility of the Central Bank itself is essential. The bank’s recent moves toward formal inflation targeting should help, but safeguarding the institution’s independence is also critical. On the external side, the Central Bank has also announced an ambitious reserve accumulation target that should help address Turkey’s external balance sheet vulnerabilities.

  • Banking reforms. Despite major achievements, further critical reforms of the banking sector are needed. Most importantly, the supervisory and legal framework needs to be brought closer to European Union standards, asset recovery accelerated, and state banks restructured further in preparation for eventual privatization. The formulation of a new Banking Law is encouraging in this regard. Fiscal policy could also help by further reducing intermediation taxes, which are high by international standards.

  • Business environment. To improve Turkey’s business environment and reduce unemployment, red tape needs to be cut further, privatization accelerated, and the high costs of complying with statutory employment protection legislation reduced.

Fulfilling this reform agenda could provide further support for Turkey’s move from crisis resolution to EU accession. Turkey has already come a long way from the 2000–01 crisis. The European Council decision to begin EU accession negotiations with Turkey was in many respects an endorsement and recognition of the country’s progress not just in the political arena, but also in the economic sphere. The challenge now is to sustain and advance these gains. This paper has identified at least some of the economic reforms needed to fulfill Turkey’s aspirations for economic convergence with the European Union. Recent economic success bodes well for the country’s future, but as always there are no guarantees that those successes will be sustained. Continuing sound macroeconomic policies and advancing structural reforms are ultimately the only secure way to provide employment and improve the living standards of Turkey’s young and growing population.

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