Fiscal Policy and External Performance
The Turkish Experience*

In 1980 Turkey embarked on a far-reaching stabilization and liberalization program, which contributed to export-led growth and a significant movement toward both domestic and external equilibrium. Later, as fiscal policy was partly reoriented from a restrictive to an expansionary stance while adhering to a flexible exchange rate policy, inflationary pressures intensified but the external current account did not deteriorate. Counterfactual simulations, performed with a computational general equilibrium model, suggest that Turkey would have experienced a significantly lower inflation rate, with only a small reduction in growth, if it had adopted a less expansionary fiscal stance.

Abstract

In 1980 Turkey embarked on a far-reaching stabilization and liberalization program, which contributed to export-led growth and a significant movement toward both domestic and external equilibrium. Later, as fiscal policy was partly reoriented from a restrictive to an expansionary stance while adhering to a flexible exchange rate policy, inflationary pressures intensified but the external current account did not deteriorate. Counterfactual simulations, performed with a computational general equilibrium model, suggest that Turkey would have experienced a significantly lower inflation rate, with only a small reduction in growth, if it had adopted a less expansionary fiscal stance.

I. Introduction

At the beginning of the decade, Turkey emerged from a severe balance of payments crisis and five decades of virtual economic isolation, through a comprehensive stabilization and liberalization program. 1/ The program has led to both a substantial reduction in the external imbalance and satisfactory economic growth. The external current account deficit was equivalent to 1 1/2 percent of GNP in 1987, as against almost 6 percent of GNP in 1980. Real GNP growth averaged 4 percent yearly during 1981-83, rose to 5 1/2 percent in 1984-85, and accelerated to nearly 8 percent—a rate that was hardly sustainable—in 1986-87. As compared with the initial years of the program, when growth had been underpinned largely by an extraordinary export performance, the recent expansion involved a marked increase in real domestic demand growth. The adjustment effort met with less success in restoring internal balance. Following a deceleration from triple digits in 1980 to about 25 percent in 1982, the annual rate of inflation rebounded to 50 percent in 1984, fell back again to 25 percent at the end of 1986, and soared above 70 percent in the middle of 1988.

As background for the analysis of the role of fiscal policy in these developments, Section II summarizes some theoretical considerations—drawing largely on the Mundell-Fleming model—of relevance to the Turkish experience. Section III provides an overview of economic policies and performance in Turkey over two phases separated by a shift in fiscal stance in 1984. Section IV discusses simulations of the macroeconomic impact of alternative combinations of fiscal and exchange rate policies during 1984-87, performed with a computational dynamic general equilibrium model.

II. Conceptual Setting

Among the macroeconomic consequences of fiscal policy, the effects on output and employment have been the focus of attention of Keynesian analysis under excess supply conditions. On the other hand, increasing preoccupation with the effects on the price level and on the external balance has given prominence to the monetary approach. Rooted in this double tradition, contemporary analysis of the effects of fiscal policy, especially on the balance of payments, rests for the most part on the well-known Mundell-Fleming model. 2/

The model traces the impact of fiscal and monetary policies under different exchange rate regimes. In a small open economy, with flexible exchange rates, an increase in the government budget deficit financed with debt results in a temporary rise in the domestic interest rate which attracts capital from abroad; as a consequence, the exchange rate appreciates with a Loss in competitiveness and a deterioration in the external current account. The latter offsets the initial demand expansion, while crowding out leaves output unaffected. If the increased public sector deficit is financed with money creation, changes in the exchange rate and the current account are ambiguous, while the levels of income, output and employment rise. However, with less than full capital mobility, as in Turkey, the exchange rate will tend to depreciate and the current account not to deteriorate. By contrast, under a fixed exchange rate, with money determined endogenously, an expansionary fiscal stance leads to a rise in domestic activity and a worsening of the current account. Of course, the deterioration of the external position, whether under fixed or flexible exchange rates, cannot be incurred over the long run.

The basic model has been extended in a number of directions, including allowance for: price flexibility, imperfect capital mobility, rational expectations, various forms of unemployment, disequilibrium conditions, and interactions in a multi-country context. 3/ Among these extensions, it has been shown that a money-financed (and in certain cases debt-financed) increase in government expenditure tends to result, inter alia, in a rise in the domestic price level, especially under flexible exchange rates.

A less explored case, where the nominal exchange rate is adjusted continuously to the inflation differential at home and abroad, deserves particular attention as it may have some relevance to recent developments in Turkey. With flexible prices and all variables deflated by the price level, such a real exchange rule can be viewed much like a fixed exchange rate regime cast in real terms. The real exchange rule has been characterized as a policy of full monetary accommodation, since any shock to the price level is validated by a nominal exchange rate change and capital movements in the balance of payments, which, in turn, are reflected in the money supply. Under the circumstances, and particularly with sticky prices or inflationary expectations, maintenance of external competitiveness may entail loss of control over inflation. 4/ Furthermore, although an unchanged real exchange rate, even when accompanied by an expansionary fiscal stance, can prevent a deterioration in the current account in the near term, the fundamental disequilibrium ensuing from a continued fiscal expansion cannot be bottled up indefinitely and over time it will be reflected in a widening external deficit.

In general, theoretical analysis is limited in coping with the macroeconomic repercussions of fiscal, monetary and exchange rate policies undertaken in the presence of structural reform measures, such as trade and financial liberalization. It is, however, in this broader context that the Turkish experience must be examined.

III. Policies and Outcome

1. Structural reform

Since 1980, the Turkish economy underwent for the most part an outward- and market-oriented transformation, underpinned by a set of far-reaching structural measures: broad-based price liberalization, including flexible determination of exchange and interest rates; changes in wage determination; foreign trade liberalization; exchange and payments liberalization; financial sector reform; streamlining of state economic enterprises (SEEs); tax reform; and fiscal decentralization. Commodity and factor price liberalization was undertaken to bring about a more efficient allocation of real and financial resources in the economy. Increased openness, through external trade and payments liberalization, comprised an integral part of this process. Tax reform was intended to assist in the improvement of allocative efficiency and to strengthen incentives to save and to work. The overhaul of SEE operations would be conducive to greater managerial efficiency in a more competitive environment. Fiscal decentralization would contribute to social infrastructure and regional development.

In 1980, the government freed private sector prices and sharply adjusted the prices of basic commodities and services supplied by SEEs and state monopolies. Except for a few items whose prices continued to be subsidized, SEEs were instructed to set prices on the basis of cost developments—a policy that has been broadly followed since then, with the exception of a temporary slowdown in administered price adjustments in the course of 1983 and 1987, prior to general elections. Subsidies on agricultural products and inputs were reduced considerably.

After several small increments, interest rates on time deposits were decontrolled in mid-1980, allowing commercial banks to determine them through a gentlemen’s agreement. Since December 1983, the central bank has periodically reviewed and set ceilings on domestic bank deposit rates—with one-year deposit rates fully decontrolled during the second half of 1987—taking into account fluctuations in the rate of inflation and the expected yield on foreign currency deposits, which were determined freely. On the lending side, banks were allowed to set nonpreferential interest rates. Except for parts of 1983-84 and of 1987-88, key time deposits and lending rates have been positive in real terms. In particular, real nonpreferential lending rates rose considerably in recent years reflecting high bank intermediation costs and a heavy tax burden.

In September 1980, the authorities introduced an incomes policy that was followed through 1985. Centrally determined wage increases, based on yearly inflation targets, were mandatory for the public sector. Since 1986, for most of the industrial labor force (including an increasing portion of the SEE labor force), wages have been set through collective bargaining.

Following a sharp devaluation in January 1980, the central bank began to adjust the exchange rate with increasing frequency to at least compensate for differences in inflation rates at home and in major industrial partner countries; since May 1981, adjustments in the nominal rate have taken place daily. Actually, over the period 1981-87, the Turkish lira was depreciated steadily in real terms, although subject occasionally to significant short-run fluctuations.

The highly restrictive import regime (consisting of nontariff barriers, tariffs, and advance deposit requirements) was relaxed significantly in 1980-81. In 1984, most imports were freed from licensing, and by the end of 1985, quantitative restrictions had been removed, many tariff rates were reduced, and deposit requirement rates were cut to very low rates. Since then, the authorities raised deposit requirement rates temporarily and imposed various import levies—with most of the revenue earmarked for newly-created extrabudgetary funds. Export subsidies, which had been intensified in the initial phase of the adjustment program, were trimmed and export restrictions were abolished in 1984; but some subsidies were again raised in 1987.

Early in the program, multiple exchange rates and several other restrictive practices were terminated. In January 1984, the exchange and payments system was further liberalized; in particular, residents were permitted to open foreign currency deposits with commercial banks; banks were allowed to engage in foreign exchange operations within certain limits; and restrictions on foreign travel and invisible transactions were eased and simplified.

Major banking reform legislation was introduced in 1985, with provisions on capital requirements, accounting and reporting standards, and a deposit insurance scheme. In addition, indirect instruments of monetary control were strengthened: the reserve and liquidity requirement system has been simplified and made more effective since 1983, and weekly auctions of government paper were introduced in 1985, interbank money market transactions in 1986 and open market operations in 1987. In recent years, there was a significant diversification of financial instruments (commercial paper and bonds issued by private enterprises; a wider range of government paper, including bonds and income-sharing certificates issued by specialized extrabudgetary funds). 5/

Besides obtaining authorization for regular price adjustments, SEEs were subject to a hiring freeze and a slowdown of wages in the initial years of the program. More fundamentally, in 1983 the legal basis for SEE reform was established, requiring enterprises to be run along commercial lines. By the end of 1984, enterprises had lost almost all tax, tariff and credit preferences. 6/

Following an upward adjustment of personal income tax brackets in 1981 to compensate for the effect of inflation, marginal tax rates were reduced each year during 1982-86. The corporation income tax was unified in 1981 and was extended to SEEs in the following year. In 1984, withholding tax rates on financial income and transactions were reduced substantially. In January 1985, Turkey substituted a value-added tax (VAT) for a number of indirect taxes. Since 1984, wage earners have been granted a rebate for domestic indirect taxes against their income tax liability, in proportion to certain expenditures.

In 1984 the authorities created a number of extrabudgetary funds for special-purpose expenditure and lending (mostly for housing, transport, tourism and education projects) financed with earmarked indirect taxes, operating revenue, and sale of income-sharing certificates. Local governments were encouraged to expand urban and rural infrastructure in part with revenue shared with the central government. Also, extrabudgetary funds and local governments had gained access to external borrowing, to finance large-scale investment projects. Overall, the importance of decentralized government entities has grown markedly in recent years. 7/

2. Fiscal policy

At the risk of oversimplification, the period since 1980 can be split into two subperiods. In the first subperiod, spanning through 1983, fiscal policy—supported by monetary and incomes policies—was aimed principally at reining in the growth of domestic demand, while structural measures underlay an export-led rise in output, to restore domestic and external balance. Since 1984, however, the internal stabilization goal seems to have given way to high growth, as well as social and regional development objectives—as set out in the Fifth Five-Year Development Plan—to be pursued mainly through fiscal instruments.

Between 1980 and 1982, the fiscal stance was tightened markedly; the general government deficit, in proportion to GNP, was more than halved to 1.6 percent. Subsequently, poor revenue performance, partly compensated for with expenditure cuts, led to a rise in the deficit, reaching 4.5 percent of GNP by 1984. The introduction of the VAT, followed by a one-time revenue boost from reduced income tax collection lags, contributed to a fall in the deficit to 2.5 percent of GNP in 1985-86. However, as part of the revenue gain wore off and outlays continued to rise rapidly, the deficit-to-GNP ratio doubled in 1987. After adjustment for cyclical variations, the economy experienced a cumulative contractionary impulse of 4.2 percent of GNP during 1980-83. In the years 1984-87, the general government injected an expansionary fiscal impulse totaling 4.8 percent of GNP, net of a withdrawal of stimulus equivalent to 2 percentage points in 1985. 8/

Since the outset of the adjustment program the revenue performance by and large has been less than satisfactory. Revenue failed to respond in the short term to supply-side cuts in marginal tax rates; in fact, the direct tax ratio dropped by some 6 percent of GNP during 1981-85, followed by a rebound of almost 2 percentage points in 1986 due to the phase-in of advanced income tax payments by businesses. The fall in indirect tax receipts, owing largely to cuts in tax rates on financial transactions in 1984, was more than reversed in the following year by the introduction of the VAT and various import levies. All told, in 1987, the ratio of general government revenue to GNP stood at 25 percent, which is slightly below the ratio that prevailed at the end of the 1970s.

Given lackluster tax buoyancy, the stabilization burden fell chiefly on government spending. The proportion of expenditure and net lending to GNP fell 5.5 percentage points in 1980-82, fluctuated around 24 percent in 1983-85, and jumped to nearly 30 percent in 1986-87. Budgetary restraint in the early years was achieved through a hiring freeze, real wage cuts, and sharp reductions in transfers to SEEs. By contrast, other transfers (mainly tax rebates to wage earners and exporters), interest payments (reflecting since 1985 near-market yields on auctioned government paper and income-sharing certificates), capital expenditures and net lending (mainly by the extrabudgetary funds and local governments), increased strongly in real terms.

The SEEs made an important contribution to the initial stabilization effort. As a result of price adjustments and some austerity measures, their operating surplus rose steadily from nothing in 1980 to almost 4 percent of GNP in 1985, and the net inflow from the budget (transfers less direct taxes), which totaled 4.5 percent of GNP in 1980, turned into a small net outflow from 1985 onward. The SEEs’ borrowing requirement was halved from 5.2 percent of GNP in 1980. An apparent relaxation in employment policy and stepped-up investment outlays in subsequent years, and more recently, insufficient price adjustments, led to an erosion in the enterprises’ operating surplus to an estimated 1.6 percent of GNP and a rebound in their borrowing requirement to 4.3 percent of GNP by 1987.

Reflecting the above developments, the public sector borrowing requirement (PSBR) declined by more than 3 percentage points, to 5.4 percent of GNP, between 1980 and 1983; thereafter, albeit subject to some swings, it rose at an accelerated pace to reach 9.3 percent of GNP in 1987. The shift in fiscal stance in 1983-84 was broadly paralleled by monetary policy. The initial reduction in the PSBR permitted a significant slowdown in reserve money creation and interest rates became highly positive in real terms. Lacking effective safeguards against unsound financial practices and protection of bank deposits, monetary tightness culminated in a financial crisis in 1982. The crisis prompted some monetary accommodation, including cuts in time deposit rates. Subsequent efforts to reimpose monetary restraint were complicated by the rise in the PSBR, capital inflows from abroad, and currency substitution—reflected in a marked slowdown of the real growth of M2 relative to that of M2X (defined to include resident foreign exchange deposits), following the decontrol of foreign exchange deposits in 1984 and spurred by the rise in inflationary expectations.

3. Outcome

As shown in Table 1, Turkey experienced an extraordinary recovery in the years 1981-83. The economy moved rapidly toward a sustainable growth path, significantly correcting both domestic and external imbalances. During 1984-87, further progress was made in narrowing the external current account deficit and in particular the trade deficit. Indeed, the most successful aspect of the recovery was the growth and diversification of exports. Merchandise exports more than tripled in terms of both volume and share in GNP. 9/ However, the continued external adjustment—interrupted briefly by some weakening in 1986—was not matched by a similar process internally. The pickup in output growth, based largely on a surge in domestic demand, was accompanied by a revival of inflationary pressures. Whereas domestic developments seem to have reflected the greater ease of financial and incomes policies, the external outcome did not. Before attempting to explain this distinction in terms of specific policy measures, it is necessary to identify outside factors and structural measures that may have had a bearing on the comparability of the two subperiods.

Table 1.

Turkey: Selected Economic Indicators, 1980-87

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Source: Undersecretariat of the Treasury and Foreign Trade, State Institute of Statistics, State Planning Organization, Central Bank of Turkey, and authors’ calculations.

Trade-weighted and adjusted for changes in relative consumer prices of major partner countries. An increase indicates appreciation.

Average broad money stock divided by GNP deflator. M2X consists of M2 plus resident foreign exchange deposits with commercial banks.

After-tax interest yield on six-month deposits denominated in Turkish lira.

All accounts shown are on a commitment basis.

Inclusive of net lending by the general government.

General government is defined as the consolidated budget, extrabudgetary funds and revolving funds of the central government, plus local governments. Prior to 1982, fiscal year ending in February of the following year; for 1982, underlying official data (March through December) has been multiplied by 1.2; from 1983 onward, calendar year data.

Calculated for the general government, as explained in the footnote of page 6.

Excluding net inflows to resident official sector, but including Dresdner Bank deposits.

It might be tempting to argue that whereas in the first subperiod Turkey’s current account position was hurt by a deterioration in the terms of trade of some 5 percent a year on average, in the second subperiod it benefited from a nearly 4 percent average annual terms of trade gain. However, the effect of the turnaround in the terms of trade on the current account was to a large extent tempered by the adverse consequence of the concomitant contraction in oil-exporting countries’ demand—brought about by the oil price decline underlying the terms of trade improvement—reflected in a fall of Turkish exports in 1986 for the first time since the beginning of the decade. More importantly, the substantial passthrough of the decline in oil import prices helped contain the rate of inflation below the rate that would have prevailed under unchanged oil prices, but by the same token, it contributed to a surge in real domestic demand growth.

Besides the structural measures that impinged directly on demand management—tax overhaul, fiscal decentralization, SEE reform, and phase-out of incomes policy—trade and payments liberalization, as well as financial sector reform, may partly account for some differences between the two subperiods. The removal of nontariff import and export barriers 10/ and decontrol of foreign exchange deposits resulted in more open current and capital accounts since 1984, as compared with previous years. In addition, several financial innovations enhanced the potential for debt-financing of the public sector deficit; a larger portion of the PSBR was financed by commercial banks and—in very modest amounts—by the nonbank public, with appreciably less recourse to direct central bank financing than previously.

Nevertheless, none of these measures seems to have strengthened significantly the relationship between the budget deficit and the trade deficit. 11/ At most, increased substitution between foreign and domestic goods, and between foreign and domestic financial assets, and greater availability of government debt instruments, may have brought Turkey closer to some of the basic assumptions of the Mundell-Fleming construct in recent years. Accordingly, the reduction in the trade deficit between 1981-83 and 1984-87, at a time when the budget deficit widened, is attributable principally to continued direct or indirect monetization of the budget deficit and exchange rate flexibility.

In principle, the exchange rate regime adopted in the 1980s can be characterized as a real exchange rate rule. However, in practice, the 6.6 percent average annual real effective depreciation—probably underestimated in the second subperiod—12/ subject to considerable variance from year to year, 13/ seems to have taken Turkey closer to the flexible exchange rate case of the Mundell-Fleming model. Given greater capital mobility in the second than in the first subperiod—reflected to an extent in the rise in induced net capital inflows—the exchange rate depreciation in the second subperiod was probably lower than it would have been without the liberalization of the capital account that had taken place in 1984. Clearly, the exchange rate had become increasingly the key to sustaining the external stabilization effort, but not without considerable cost in terms of reviving inflationary pressures.

IV. Policy Simulations

For a broad assessment of the quantitative impact of an alternative set of policies on economic performance during 1984-87, several counter-factual simulations were conducted on the basis of a computational dynamic general equilibrium model of the Turkish economy. 14/ The model distinguishes among three products: manufacturing and agricultural goods, which are tradable, and nontradables. Producers choose their output level and mix by maximizing revenue, given a quadratic production function, while households choose their expenditure basket by maximizing utility, expressed as a simple loglinear function of consumption of each product, subject to an overall budget constraint. Excess demand (supply) for either tradable good is directly reflected in a trade deficit (surplus); for nontradables, excess demand (supply) results in a drawdown (buildup) of inventories. Prices of tradables are a function of foreign prices, together with the exchange rate, import taxes and export subsidies; prices of nontradables are determined by wages (which adjust partially with a lag to changes in the price level) and excess demand for nontradables. The model incorporates simple government and monetary sectors. Government expenditure is exogenous, while revenue is a function of national income. Excess money supply, derived in part from a standard money demand function, influences the level of private sector expenditures, and thereby, both prices and the balance of payments. The parameters of production and consumption functions were estimated using nonlinear techniques. Other parameter values were drawn from earlier work on the Turkish economy, or where necessary, from work on other comparable countries.

The model was used to simulate the impact of three specific policy experiments, expressed in reference to those actually adopted during 1984-87: a reduction in public sector expenditure of one percent of GNP per year (simulation 1); a one percentage point reduction in the annual rate of real exchange rate depreciation (simulation 2); and a package, comprised of cuts in both public sector outlays and the rate of depreciation, designed to maintain the current account at its baseline level (simulation 3). Real after-tax interest rates are assumed to remain constant in each of the three simulations. The results, shown as deviations from the baseline solution, are summarized in Table 2.

Table 2.

Turkey: Policy Simulation Results, 1984–87

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Source: authors’ calculations.

Under simulation 1, the cut in the PSBR, assisted by a concurrent fall in private sector demand (as excess liquidity in the economy is reduced) leads to a reduction in the current account deficit equivalent to 1 percent of GNP per year. The effect on inflation is very small because of the unchanged rate of real depreciation. Also, the effect on output growth is negligible, as the external contribution substitutes for the fall in domestic demand.

Under simulation 2, as a result of the cut in the rate of real depreciation, the inflation rate falls by 2.6 percentage points, while the relative price of nontradables increases, stimulating excess supply in that market. At the same time, the current account deficit deteriorates by 0.6 percent of GNP, as output of tradables falls and their consumption rises.

Simulation 3 measures the impact of fiscal policy aimed at containing the PSBR at its average 1981-83 level, while the current account is constrained to remain at its 1984-87 actual level, both in proportion to GNP. The fall in the PSBR allows a slowdown in the rate of real depreciation by 2.4 percent a year, contributing to a 6.5 percentage point reduction in the average inflation rate. GNP growth falls by 0.6 percent, largely due to the impact of the slower real depreciation on manufacturing output, combined with weaker demand for nontradables.

While broadly consistent with the basic Mundell-Fleming framework, the simulation model is in certain respects more versatile (e.g., it allows for flexible prices), but in others, less general (e.g., it precludes capital mobility). Overall, the simulation results need to be interpreted keeping in mind the properties of the model and its applicability to the Turkish economy. In this regard, it may be noted that the first two simulations are simply meant to provide a sensitivity analysis. Simulation 1 is predicated on a fixed real exchange rate, whereby the fiscal correction produces an equivalent improvement in the current account; similarly, simulation 2 is restricted to an exogenous change in the real exchange rate. By contrast, simulation 3 is a more realistic experiment in that it combines exchange rate flexibility with a more moderate fiscal stance.

V. Concluding Observations

In general terms, the Turkish experience of the 1980s highlights two phases in the conduct of fiscal policy: broadly restrictive until 1983, and expansionary thereafter. As throughout this period the public sector deficit has been largely monetized and the exchange rate remained fairly flexible, the impact of the shift in fiscal stance on external performance was limited. However, real GNP growth accelerated and the inflation rate picked up significantly—the latter despite the decline in the price of oil. Admittedly, developments in Turkey have been far more complex than depicted here, in particular when viewed against the backdrop of economy-wide structural changes. Nonetheless, they illustrate the case of a small open economy where a significant rise in the public sector deficit accompanied by real exchange rate depreciation and increasing real wage stickiness, can fuel a surge in inflationary pressures. In essence, protection of the balance of payments through real depreciation, without tackling the root cause of the problem, namely, the fiscal imbalance, is not a viable option over the medium term.

Policy simulations with a computational general equilibrium model suggest that an unchanged PSBR during 1981-87, equivalent to over 5 1/2 percent of GNP (still a rather high level, in view of the lack of a sufficiently developed domestic financial market), combined with a lower than actual rate of real depreciation, would have contributed, on balance, to an improvement in economic performance. It was found that during 1984-87, Turkey would have experienced a reduction of about 6 1/2 percentage points in the annual rate of inflation and an unchanged decline in the external current account deficit, at a cost of less than 1 percentage point cut in annual real GNP growth, in comparison with actual rates. Needless to say, these results are experimental in nature and are to be viewed with caution given the inherent limitations of the model—which cannot capture fully the important structural changes that have taken place over the last decade—and of the underlying data. However, they do convey an overall sense of the policy tradeoffs faced by Turkey in its quest for a number of valid economic and social goals, within a rather short time horizon and constrained by a limited number of instruments.

Fiscal Policy and External Performance: The Turkish Experience
Author: International Monetary Fund