Turkey
2004 Article IV Consultation and Eighth Review Under the Stand-By Arrangement and Request for Waiver of Nonobservance of Performance Criterion—Staff Reports; Staff Supplement; Public Information Notice and Press Release of the Executive Board Discussion; and Statement by the Executive Director for Turkey
Author: International Monetary Fund
Publication Date:
19 May 2005
eISBN:
9781451838145
Language:
English
Keywords:
ISCR; CR; deficit; current account; June inflation datum; widening current account deficit; government debt ratio; net profit; Turkish lira; broad money; central bank; state bank
Download PDF (1.6 MB)

This paper examines Turkey’s 2004 Article IV Consultation and Eighth Review Under the Stand-By Arrangement and Request for Waiver of Nonobservance of Performance Criterion. Economic performance over the last three years has been impressive. For the medium term, the main challenge is to implement policies that achieve the goals of sustained growth and low inflation. The authorities need to take steps to encourage foreign direct investment, to make good on their plans for privatization, and to reform the judicial system to facilitate the functioning of Turkey’s market economy.

Abstract

This paper examines Turkey’s 2004 Article IV Consultation and Eighth Review Under the Stand-By Arrangement and Request for Waiver of Nonobservance of Performance Criterion. Economic performance over the last three years has been impressive. For the medium term, the main challenge is to implement policies that achieve the goals of sustained growth and low inflation. The authorities need to take steps to encourage foreign direct investment, to make good on their plans for privatization, and to reform the judicial system to facilitate the functioning of Turkey’s market economy.

I. Introduction

1. The 2004 Article IV consultation takes place at an opportune time. First, the current program is drawing to an end, and the authorities will soon decide whether they wish to request a successor arrangement. Second, later this year the European Union will formally assess Turkey’s compliance with the Copenhagen criteria and its eligibility to begin accession negotiations. Finally, recent tensions in financial markets have brought out a number of difficult short-term policy challenges that the authorities need to address—a reminder that, despite recent progress, Turkey is still highly vulnerable to shifts in sentiment towards emerging markets. The Article IV consultation therefore offers a well-timed opportunity to take stock of what has been achieved under the program, to set out reform priorities ahead (which could provide useful input for any new program), and to gauge Turkey’s challenges in commencing EU accession negotiations.

II. From Economic Crisis to Economic Recovery

A. The Economic Crisis

2. For Turkey, the 1990s was a decade of economic mismanagement. Although economic growth averaged 4 percent, it was extremely volatile. Inflation was variable and high, averaging close to 80 percent and peaking in 1994 at more than 100 percent. High inflation raised nominal interest rates, and with it the public sector borrowing requirement, which increased from 10 percent of GNP in 1991 to more than 20 percent in 1999. High deficits and inflation uncertainty pushed up real interest rates and slowed growth, and doubled the public debt ratio to 60 percent of GNP.

3. The collapse of the 2000 exchange rate based disinflation program magnified these weaknesses. Although the crawling peg had reduced inflation and interest rates significantly, competitiveness deteriorated. With domestic demand booming and fiscal policy failing to tighten, the current account deficit worsened. Vulnerabilities in the financial sector increased, as poorly supervised banks bet on the success of the program by borrowing overnight and in foreign currency, and investing in longer-term TL paper, anticipating further reductions in interest rates. When the exchange rate came under pressure in late 2000 and again in early 2001, interest rates increased, highlighting these weaknesses in the financial system. When the exchange rate was finally allowed to float in February 2001, it lost more than half of its value. This pushed inflation back up to 70 percent by the end of the year, and increased the government’s net debt ratio to more than 90 percent of GNP (75 percent using centered GNP). Parts of the banking system faced huge losses both because of the collapse of the exchange rate, and the high interest rates and borrowing costs that preceded it.

B. The Economic Recovery Strategy

4. With the devaluation of the exchange rate and the sharp rise in interest rates, the outlook for disinflation, debt sustainability, and renewed growth appeared bleak. Although the possibility of debt restructuring loomed, it was quickly ruled out.

5. The reforms launched in May 2001, and extended into the current program in early 2002, were a strong attempt to address Turkey’s underlying vulnerabilities. With debt restructuring ruled out, the first priority was to ensure debt rollover and debt sustainability. Notwithstanding the severe recession, this meant committing to high and sustained primary surpluses. For 2001, the target was 5½ percent of GNP; this was increased to 6½ percent of GNP in 2002 and beyond. The exchange rate was allowed to float, its role as nominal anchor abandoned. Instead, to reduce inflation the central bank was freed from any obligation to finance the deficit, and given operational independence to reach its new primary objective of achieving and maintaining price stability. To do this, the staff advocated the early introduction of formal inflation targeting, though this was perhaps premature given the high inflation rate and fiscal dominance problems. However, given Turkey’s severe balance of payments and government financing problems, these efforts at macroeconomic stabilization would not have had the chance to succeed without substantial outside financial assistance. This was supplied by the Fund.

6. The program also strongly emphasized structural reform, largely to signal a break from the failed economic policies of the past. To reduce a key source of vulnerability and quasi-fiscal activity, the banking system was restructured and recapitalized (first the state banks, then the private banks), at a cost of US$47 billion (more than 30 percent of GNP). A wide range of other structural reforms was also introduced, from privatization to governance reform, in an attempt to change the way the economy functioned and to demonstrate this to markets.

C. Macroeconomic Performance under the Program

7. The program strategy has delivered a dramatic improvement in financial market confidence (Figure 1). Though markets were volatile through much of 2001, the February 2002 augmentation and relaunching of the program helped assuage the financing concerns that had resurfaced after September 11, 2001. Despite interruptions from domestic political tensions (early elections in 2002) and outside shocks (the Iraq War), interest rates have declined substantially and debt maturities have lengthened, helping the government’s debt rollover. The program’s focus on generating large primary surpluses and on reducing inflation have been integral to this improvement. But outside factors—the availability of substantial financial assistance: first from the Fund, later (potentially) from the United States, and the extended period of low world interest rates—have also been important.

Figure 1.
Figure 1.

Turkey: Financial Indicators, 2001-2004

(in percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

Source: Data provided from the Turkish authorities.

8. Recovery has been rapid and powerful (Table 1). After contracting by nearly 10 percent in 2001, GDP grew by close to 8 percent in 2002 and 6 percent in 2003, well above program projections (Figures 2 and 3). Once political stability emerged and the authorities demonstrated their commitment to keep fiscal policy on track, real interest rates declined sharply in 2003, below program projections, setting the stage for a rapid increase in consumer credit. With consumer and investor confidence picking up too, the recovery has become increasingly led by domestic demand. The strength of the exchange rate has fuelled private consumption and consumer goods imports, and this year’s pension and minimum wage increases have added to this. Despite banks’ reluctance to lend to indebted corporates, improved profitability and higher capacity utilization have stimulated private investment.

Table 1.

Turkey: Selected Indicators, 2000-05

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Sources: Data provided by Turkish authorities; and IMF staff estimates.

Average of monthly nominal interest rate divided by 12-month ahead CPI inflation. With average maturity of newly issued debt less than one year, and with FRNs paying quarterly coupons, this measure overstates the effective real interest rate when inflation is declining.

On a commitment basis, excluding profit transfers from the CBT, interest receipts, and privatization proceeds

For 2003 and 2004, program projections.

Interest payments minus interest receipts plus profit transfers from the central bank.

Interest payments minus interest receipts plus CBT profits before transfers to the government..

Defined as the sum of quarterly GNP in the last two quarters of the year and in the first two quarters of the following year.

Change in reserve money in percent of GNP, where reserve money is defined as currency issued plus reserve requirements.

Figure 2.
Figure 2.

Turkey: Macroeconomic Indicators, 1999-2004

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

Source: Fund staff estimates and projections.
Figure 3.
Figure 3.

Turkey: Output and inflation, 2001-2004

(in percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

Source: State Institute of Statistics; and Central Bank of Turkey.
uA01fig01

Turkey: Real Interest Rate on Domestic Treasury

Turkish Lira Borrowing, 2002-04 1/

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

1/ 12-month ahead CPI used in real interest rate calculations.

9. Inflation too has outperformed expectations. The contribution of primary surpluses towards achieving debt sustainability, the CBT’s adherence to the base money program in 2002 and 2003, and the resulting improvement in financial market confidence and stabilization of the exchange rate, have led to a dramatic decline in inflation to levels not seen since the 1970s. Were it not for the recent exchange rate depreciation and the likely pass-through from higher world oil prices, inflation would have been on track to fall to single digits by end-year, below the CBT’s 12 percent target.

uA01fig02

Reserves Indicators

(In US$ billions)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

Source: Data provided by the Turkish authorities.

10. The strength of the recovery and the appreciation of the real exchange rate has pushed the current account deficit above the original program path (Table 2). Instead of stabilizing at around 1 percent of GNP, by 2003 the current account deficit had widened to close to 3 percent of GNP. Higher capital inflows—mainly the drawdown of residents’ foreign currency holdings—have more than compensated, allowing the CBT to accumulate reserves well above the projections made in 2002, but financing has been skewed toward short-term portfolio inflows. The CBT has responded to these developments by intervening to build up reserves.

Table 2.

Turkey: Balance of Payments, 2001–08 1/

(In billions of U.S. dollars)

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Sources: Data provided by the Turkish authorities; and Fund staff estimates and projections.

Including privatization receipts.

For 2004 includes reported data for January-March.

Nonbank external debt less the NFA of the banking system.

Interest plus medium- and long-term debt repayments as percent of current account receipts (excluding official transfers).

11. Although extreme poverty remains low, income inequality and unemployment are serious problems. In 2001, at the peak of the crisis, less than 2 percent of the population had per capita consumption under US$1 per day, little changed since 1994. However, inequality remains high, mainly reflecting extreme differences between regions, with the Southeast in particular much poorer than the rest of the country. The strong economic recovery has done little to reverse the increase in unemployment during the crisis (Chapter X of the Selected Issues paper). The official unemployment rate has risen from 6½ percent in 2000 to 10½ percent in 2003, and is especially high for educated youth, at almost 30 percent. Although the overall rate seems to be leveling off, this reflects declines in labor force participation—employment has actually fallen. With population growth in the 20-54 age group of around 2 percent per annum, generating a sustained recovery that lowers the unemployment rate will be a major challenge.

D. Remaining Vulnerabilities

12. Turkey’s economy is still vulnerable, and at the heart of this problem lies the magnitude of public debt, its short maturity, and currency composition (Table 3). Although the corporate sector has used the recovery to improve its financial health, its high leverage and unfavorable debt structure still leaves it vulnerable (Box 1). Banking sector balance sheets have improved, although much of this has come at the government’s expense. It has socialized many of the private sector’s risks, by taking on higher foreign currency and floating rate debt (Chapter III of the Selected Issues paper). Although the government has gradually lengthened maturities of new debt, average maturity remains low, so that rollover risk and vulnerability to increases in short-term interest rates are still concerns. And despite the shift to floating exchange rates, foreign currency risk is also a problem. Dollarization is extensive—around half the government debt and bank deposits are foreign currency denominated—and short-term external debt by remaining maturity exceeds gross international reserves.

Table 3.

Turkey: Indicators of External Vulnerability, 2000–05 1/

(In percent, unless otherwise noted)

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Sources: Data provided by the Turkish authorities; and IMF staff estimates and projections.

For 2004-05, program projections.

As of June 18, 2004, reserves stood at US$34.0 billion (at actual exchange rates).

By residual maturity.

Interest plus medium- and long-term debt repayments as percent of current account receipts (excl. off. transfers).

For 2004, as of May 2004.

For end-2001 Pamuk Bank is treated as a private bank, for 2002 as an SDIF bank.

Deflated by the CPI.

For 2004, as of June 18, 2004

For 2004, as of June 21, 2004.

uA01fig03

Maturity of Newly Auctioned Debt, 2001-04 (in months)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

uA01fig04

Composition of Public Debt, 2003 1/

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

1/ Consolidated “budget debt stock” (central government).

Corporate Sector Vulnerabilities—During and After the Crisis1

Turkish corporations were highly exposed to exchange rate and interest rate risk at the eve of the crisis. Similar to banks, corporations had significantly increased their foreign currency liabilities during 2000. Given that an increasing share of the domestic banks’ lending was going to the government, corporations relied heavily on borrowing from abroad. And a large share of their foreign currency debt, including that owed to domestic banks, had short maturities, even if it was not necessarily trade-related. In addition, corporations had signed (off-balance sheet) forward contracts with domestic banks, to which they were often closely linked, allowing these banks to meet the regulatory limits regarding their open foreign currency positions (banks reported a positive net forward position of US$9 billion by end-2000).

Foreign currency assets and liabilities of companies traded on the ISE

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Source: CBT, ISE (Istanbul stock exchange)

External debt of non-financial private sector

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Source: CBT, Balance of Payments data (International Investment Position)

The fall of the lira and the surge in interest rates created large financial losses in 2001, which the depreciation-induced export gains could not compensate.2 Corporations’ natural hedge (improved export competitiveness from a weaker exchange rate) showed some effect in 2001. However, the rise in exports was much less than would have been needed to offset the parallel collapse in the value of domestic sales. A lack of financing—as external credit was cut and domestic banks were in distress—is likely to have limited the full exploitation of export opportunities. Since the weak lira also implied a sharp fall in corporations’ domestic input costs, however, corporations managed to maintain positive operating profits during the 2001 crisis. Yet, the massive surge in financing expenses caused by a depreciated lira and rising interest rates turned these operating profits into net losses.

uA01fig05

Corporations’ gross sales

(in billions of US$)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

uA01fig06

Corporations’ operating and net profits

(in billions of US$)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

The financial health of corporations has much improved in tandem with the economic recovery. Profits swiftly recovered during 2002, and profitability ratios relative to capital, sales and financial obligations all improved, often showing stronger values than in 1999, before the crisis. Even with annual 2003 results not yet available for the larger sample, the further reduction in interest rates, the regained access to external credit, and the resolution of the banking crisis, should in principle have helped corporations to further strengthen their balance sheets. Yet, some 2003-data from larger companies traded on the ISE also indicates that the appreciation of the lira has lowered the margins of export-oriented companies.

Selected profitability ratios of Turkey’s corporate sector

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Profits in 2001 were negative, but the profitability ratios are reported as zero.

Source: CBT

Relatively high leverage ratios and the unfavorable structure of the debt continue to pose risks. Leverage ratios of Turkish corporations remain relatively high on average, leaving them with only a limited equity buffer against balance sheet shocks. Although it is estimated that between 10 to 20 percent of the funds recorded as debt on corporate balance sheet are funds provided by the owners and shareholders of the relevant company, it remains questionable to what extent such loans can provide an equity-like function in times of financial stress. Importantly, the short maturity of the debt financing and its extensive denomination in, or indexation to, foreign currencies implies that corporations still have considerable exposure to interest rate and foreign currency liquidity risk. Given that this composition of corporations’ debt is to a large extent simply the reflection of the banks’ need to create assets that balance their own foreign currency and interest rate exposures, the further strengthening of the domestic financial system will be key to moving such risks off the corporations’ balance sheets. This includes also a deepening of local capital markets and better access to equity financing.

Selected financial ratios of Turkey’s corporate sector

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Source: CBT
1 For an overview of Turkey’s sectoral balance sheets see Chapter III of the Selected Issues paper.2 The following analysis is based on annual aggregate corporate balance sheet data of over 8000 Turkish companies provided by the CBT (http://www.tcmb.gov.tr). End-2003 data will only be available later in 2004.

13. Recent financial market turbulence highlights these vulnerabilities. For much of 2003, the exchange rate appreciated and domestic interest rates and spreads on external borrowing declined sharply. But in May this year, the benchmark bond rate rose sharply, Eurobond spreads increased considerably, and the exchange rate depreciated by around 15 percent against the dollar. In part these shifts reflected changing expectations over the future path of US interest rates, and have been shared with other emerging markets. But in Turkey’s case the reaction has been more severe, reflecting the greater vulnerabilities in its economy, and also concerns over the widening current account deficit. Any exchange rate adjustment needed to boost net exports would also tend to exacerbate the debt burden.

III. Short-Term Macroeconomic Policy Challenges

14. The economy is on track to meet or exceed this year’s targets of 5 percent growth and 12 percent inflation, but faces problems of excess demand and a growing current account deficit (Figure 4). In the first few months of the year, growth of consumer credit, retail sales and imports have all been very strong (Figure 5). Indeed, it appears that domestic demand and growth have been running above the program targets, widening the current account deficit. In the staff’s view, current indicators pointed to growth well in excess of the target, the authorities thought any revision of the growth outlook for 2004 should await the first quarter outturn. (The first quarter national accounts released since the mission indicate that year-on-year growth in the first quarter was about 10 percent. An analysis of these data will be presented in the supplement to the staff report).

Figure 4.
Figure 4.

Turkey: External indicators, 2000-04

(in billions of U.S. dollars; unless otherwise indicated)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

Sources: State Institute of Statistics; and Central Bank of Turkey.
Figure 5.
Figure 5.

Turkey: Recent Credit Developments, 2000-04

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

Source: Central Bank of Turkey.

15. Though closely monitoring the risks to the current account, the authorities felt that subsequent developments had mitigated these somewhat. Recent real exchange rate depreciation would depress incomes and make imports more expensive. Higher secondary market interest rates had been passed on by banks to their borrowers, and there were signs that the growth in consumer credit was slowing. The government had also cautioned state banks to curtail consumer credit growth, and had reduced tax incentives for new car purchases. And although it had worsened the current account, the oil price increase would, if fully passed on, reduce domestic demand by lowering real incomes.

16. Even so, it was not clear whether these factors would suffice to contain domestic demand and stabilize the current account. While a slowdown was likely, it would take time to gauge whether it would be sufficient. Financial market conditions had already started to improve again, so the effects of the earlier correction might dissipate. The staff therefore urged the authorities to let the automatic fiscal stabilizers work and to save the recent demand-driven over performance of tax revenues, at least until the risks to the current account had clarified. It was also important to accept any exchange rate adjustment, even if this might have the short-run effect of raising prices. Historically, the current account had been a bell-weather of the need for policy correction and needed to be watched closely. The authorities accepted much of this, agreeing to let the stabilizers operate, but wishing to review the situation later in the year to see if some of the budget over performance could be spent on social priorities.

IV. Sustaining and Advancing Recent Gains: Medium-Term Policy Challenges

Discussions took place against a backdrop of consensus on the key medium-term challenge: generating sustained and rapid growth with low inflation. Rapid growth would provide the most promising avenue for achieving lasting remedies to Turkey’s social challenges, especially unemployment. The government had been extremely successful in achieving macroeconomic stabilization, with fiscal consolidation supporting low inflation and growth, and this augured well for the future. The record was more mixed as regards the composition of the adjustment and the pace of structural reforms. While rooted in social concerns, spending initiatives inconsistent with the aims of the program and delays in the implementation of reforms raised questions about the sustainability of fiscal consolidation and growth. Looking ahead, the government needed to build on its record of fiscal consolidation by demonstrating greater ownership of structural reforms. The political conditions for doing this had rarely been better. Unlike the coalition governments of the past, the single party government had the opportunity to introduce fundamental reforms (such as in social security or public expenditure) where short-term (political) costs may be high, but where long-term benefits to the country would be substantial.

A. Reassessing the Medium-Term Macroeconomic Framework

17. Historically, Turkey has gained much from economic liberalization but paid dearly for policy indiscipline. Since 1980, greater openness to trade and financial market liberalization have helped boost economic growth. However, this growth has been extremely uneven, and prone to interruption by economic and political crisis. The problem is that liberalization has gone hand in hand with increased fiscal, monetary and financial indiscipline that has effectively negated its beneficial effects. This has depressed economic growth and made it more volatile.

18. With continued liberalization and a refocusing on microeconomic reforms, Turkey has the potential for sustained rapid growth. Although the current program’s 5 percent medium-term growth path has seemed ambitious, it is not that far above the 4 percent historical average. Indeed, in the medium term Turkey has the potential for even higher growth. If the emergence of greater political stability can be used to contain demands for greater spending and translated instead into less discretionary fiscal policy, and if the recent reduction in inflation can be sustained, growth should pick up considerably (Box 2). The analysis in Chapter I of the Selected Issues paper indicates that growth could then be as much as 2 percentage points above its historical average of 4 percent. This stable environment would also be conducive to TFP-led growth, contrasting with the investment-led growth of the past, which has often run into current account constraints.

19. Despite this potential upside, the baseline scenario assumes a more conservative growth path (Table 4). For the medium term, growth is still assumed to be 5 percent, with inflation staying in single digits. Domestic demand is assumed to slow, lowering the current account deficit to more sustainable levels. Despite the reform program and passage in 2003 of the Foreign Direct Investment Law, FDI has averaged less than US$1 billion (½ percent of GNP) each year, very low compared with new member states and countries acceding to the EU. Without such long-term flows, a current account deficit above 3 ½-4 percent of GNP in Turkey is unlikely to be sustainable, and would likely result in an exchange rate correction (Box 3). However, the staff stressed that achieving the desired current account adjustment and sustained low inflation would depend on tight fiscal policy and wage restraint, and success in containing the growth in domestic demand. If the authorities were unable to implement policies that delivered such a slowdown, a more abrupt exchange rate adjustment might result instead, with adverse implications for inflation and debt.

Table 4.

Turkey: Medium-Term Scenario, 2000-09

(percentage change, unless otherwise indicated)

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Sources: SIS; SPO; CBT; and IMF staff projections.

Contribution to the growth of GDP.

Balance of payments basis.

Turkey’s Growth Record and its Determinants, 1960–20001/

Turkey’s relative economic growth performance has improved since the 1980s. Although during the last four decades real per-capita GDP expanded on average only slightly faster than in the rest of the world, this masks pronounced differences in growth performance during the two subperiods 1960–80 and 1981–2000. In the first two decades Turkey trailed the rest of the world but then surged ahead in the last two decades, when growth decelerated around the globe but not in Turkey. During 1981–2000, Turkey posted per-capita growth rates about one percentage point higher than in the rest of the world. And while Turkey did not escape the worldwide productivity slowdown, it was much less drastic than in the rest of the world. Notably, it managed to step up rates of capital accumulation when investment faltered elsewhere.

Growth Accounting, 1961-2000

(Annual percent changes)

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Note: The table covers 73 countries in our sample for which Bosworth & Collins (2003) provide physical and human capital stock data. GDP data are from the Penn World Tables (6.1), TFP is calculated as the residual, as described in the text.

Turkey’s changing growth record reflects the influence of conflicting forces. Econometric analysis of a cross-country dataset covering 92 economies helps identify the factors chiefly responsible for the difference in growth experience in 1981–2000 and 1960–80. The main determinants turn out to be (i) trade openness, (ii) fiscal volatility, (iii) inflation, and (iv) financial development. This specification is robust to the inclusion of other potential explanatory variables, such as external volatility, government size, or measures of political constraints.

Increased trade openness was the main engine of the post-1980 growth performance. Between the two subperiods trade as a share of GDP rose from 13 to 38 percent—a much larger change than elsewhere. According to the regression results, this added some 2.3 percentage points to growth during 1981–2000, mainly through stimulating investment. Indeed, had trade and financial liberalization been the only policy changes, Turkey would have posted growth rates similar to those in east-Asia.

Growing fiscal volatility and inflation, however, acted increasingly as a drag on growth. After 1980 fiscal policy became more discretionary, as measured by unexpected, cyclically-adjusted deviations from the past fiscal policy stance. Even though this development was not associated with larger government, it still knocked 0.5 percentage points off Turkey’s annual growth rate, mainly by discouraging investment. Rising inflation reduced growth by another 0.7 points, mainly by lowering productivity.

Turkey’s recent advances in combating inflation augur well for the growth outlook especially if fiscal discretion can also be scaled back. With inflation rates firmly heading toward single digits one key ingredient for better future growth is already falling into place. While there is some evidence that fiscal discretion might be positively correlated with deregulation, and indeed trade liberalization, a strengthening of institutions, more reliance on rules, and adherence to pre-set targets appear to offer the best way forward.

1/ This box summarizes the main findings of Chapter I of the Selected Issues Paper.
uA01fig07

Cumulative FDI Per Capita, 1996-03

(in U.S. dollars)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

Source: IMF, World Economic Outlook

B. Fiscal Policy: Safeguarding Debt Sustainability

Fiscal adjustment to date

20. There was strong agreement that the strategy of targeting a high primary surplus had been critical in reducing debt and stabilizing the economy. This had helped improve policy credibility, supported the CBT’s disinflation efforts, and delivered lower interest rates. By alleviating worries over debt sustainability, fiscal discipline had also helped re-establish consumer and investor confidence.

Turkey: Summary of Primary Surplus, 1999-2003

(In percent of GNP)

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Source: Fund staff estimates.

Competitiveness and the Current Account Balance

Turkish exports have performed well since the 2000 crisis, underpinned by a more competitive exchange rate, market diversification, productivity gains, and a reduction in real wages. However, the exchange rate appreciated as the economy recovered, imports accelerated and the current account deficit widened from a position of surplus to a projected deficit of nearly 4 percent GNP in 2004. This has ignited concerns that Turkey’s recovery is generating excessive external financing needs. In particular, the focus is on short-term debt financing and portfolio flows that may be curtailed by tighter international liquidity conditions, as well as longer-term considerations of debt sustainability.

uA01fig08

Turkey: export market share, 1997-2003

(1997-100)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

uA01fig09

Turkey: Share of International Tourist Arrivals

(percent)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

Short-term external financing has increased significantly, though not to levels seen before earlier crises. Short-term external debt rose 40 percent in 2003, though remains some 20 percent below its peak of $28 billion in 2000. While this undoubtedly poses a higher risk of a credit reversal and currency mismatch, the stock of trade credit is below 20 percent of annual import value, compared to more than 40 percent before the 1994 and 2000 crises. Similarly, banks’ foreign exchange credits are well below historical peaks and, more importantly, their on balance sheet open foreign currency positions have been maintained in the range of zero to US$2 billion and within prudential limits. Nonetheless, short-term external debt remains high by international standards in relation to gross official reserves, underlining the importance of continued reserve accumulation in coming years.

Over the longer term, the path of the current account deficit will need to be consistent with a level that will stabilize a prudent level of external debt to output. Starting from a debt stock of 60 percent of GNP, and 5 percent GNP growth, Turkey’s debt ratio will continue to fall gradually as long as the current account deficit stays below 4 percent of GNP. But to stabilize at more prudent debt/GNP levels of 40 percent or lower, the current account will need to fall below 3 percent of GNP. An increase in non-debt creating inflows would allow higher deficits. Rapid productivity growth consistent with EU convergence will also help lower the ratio of debt/GNP through the channel of real exchange rate appreciation.

What exchange rate adjustment would be needed to move Turkey to the long-run debt stabilizing current account deficit? Using estimates of trade responsiveness to exchange rate changes, we can calculate the “equilibrium” exchange rate that will deliver a debt stabilizing current account deficit when the Turkish economy and trade partners operate at full output potential. While this assessment is sensitive to the target current account balance, estimates of potential output gaps and assumed trade price and output elasticity’s it provides some indication of exchange rate divergence relative to the desired long-run equilibrium. Staff estimates show that the equilibrium real exchange rate has appreciated significantly since 2000, indicating that the Turkish economy has become more competitive, i.e. any given current account deficit can be sustained at a more appreciated real exchange rate than before. In addition, market forces have appreciated the actual exchange rate some 10 percent above the long run equilibrium rate. This divergence can be explained by factors such as a positive market assessment of future productivity gains associated with EU accession negotiations, higher real interest rates and the risk preferences of investors.

uA01fig10

Turkey: Actual and Equilibrium Real Effective Exchange Rate, 2000-2004

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

21. While fiscal consolidation had been impressive, the quality of adjustment raised concerns. Staff analysis presented to the authorities showed that the fiscal effort since 2001 had been high and more enduring than previous episodes of adjustment in Turkey (Chapters VI and VII of the Selected Issues paper). However, the quality of the fiscal adjustment under the program had been mixed. Adjustment at the state enterprise level had been supported by increasing prices, lowering costs, and explicit targets for reducing employment. However, current spending at the central government level had risen, financed by tax increases and cuts in capital expenditure. This raised questions about the sustainability of the fiscal adjustment, especially as the international experience suggested that adjustments based on lasting reductions in expenditure were more likely to be sustainable (Chapter VII of the Selected Issues paper).

22. Short-term policy choices had at times also aggravated the quality of the adjustment. Unplanned spending initiatives outside the budget cycle, such as the pensions and minimum wage increases earlier this year, had undermined the budget process and required compensatory or corrective measures. And while corrective steps helped put the primary surplus targets back on track, they had often come at the expense of the quality of the fiscal adjustment. Investment, for example, had borne the brunt of budget cuts. Frequent ad hoc policy changes (proposals for selective tax reductions, incentives and tax amnesties) had also undermined the credibility of the budget process.

23. The authorities thought that the achievement in 2003 of the highest primary surplus on record had substantially enhanced policy credibility. They stressed that the markets no longer doubted the government’s determination to deliver on fiscal consolidation. Strong fiscal policy had also gained increasing acceptability in the population at large as it was credited with helping to restore growth and reduce inflation. However, the authorities emphasized that sustaining the fiscal adjustment necessitated paying sufficient attention to social concerns. The increases in pensions and the minimum wage had been necessary to restore them to their pre-crisis levels and maintain social consensus for reform. However, they agreed that such decisions should and would be considered and acted upon within the budgetary framework.

24. There has also been progress on structural fiscal reforms. A major improvement in fiscal management had been the approval after much delay of the Public Financial Management and Control Law which established a clear delineation of responsibilities in the preparation and formulation of the budget, introduced a medium-term budget framework, and established new systems for control and auditing of government operations. Tax administration reform had recently gained momentum; this should help with efficiency of collection and begin to tackle the unregistered economy. Indirect taxes had also been reformed: simplifying and reducing the number of taxes, and consolidating excises and VAT. However, the reform of direct taxes had fallen short of the original objectives.

Structural challenges to sustained fiscal consolidation in the medium term

25. Looking ahead, the authorities saw an overhaul of the taxation system to reduce distortions and fight tax evasion as a top priority. Although Turkey’s tax rates did not stand out as too high compared with the EU and the OECD, they were very high compared to other emerging markets. The personal income tax system was too complicated, with multiple rates and deductions. High social security taxes imposed a large cost on employment. The headline corporate income tax rate in Turkey was high, particularly compared to EU accession countries, and yet the effective yield was much lower because of generous investment tax credits and exemptions. The authorities were also concerned that VAT avoidance was high. Staff estimates indicated that the VAT yield was not out of line with international experience but collections accounted for about 70 percent of the calculated potential VAT.

Cross Country Tax Rate Comparison

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Source: OECD, FAD databases and TA reports; VAT rates as of 2001; Turkey’s are as of 2004.

Including, employers, employees and unemployment insurance contribution.

Excluding the 10 percent temporary surcharge.

PIT on wage earners is 15-40 percent.

26. However, the authorities acknowledged that any tax reform needed to take account of an expected structural decline in revenues. As interest rates come down, the yield of intermediation taxes and the withholding tax on interest income (more than 1 percent of GNP) will fall. Indeed, because of their distortionary nature, the government has rightly declared its intention to phase them out. Also dividends, turnover taxes, and profits from SEEs, which currently contribute some 1 percent of GNP to the primary surplus, will diminish as these firms are privatized. Of course, in the long run this should be at least in part offset by higher private sector tax receipts, but in the interim it would lower revenues. Finally, the government’s plans for greater fiscal decentralization posed a significant challenge to maintaining fiscal discipline. If not handled carefully, this could seriously worsen public finances in the medium term.

27. Public expenditure reform is also needed. Non-discretionary spending accounts for some three-quarters of central government budget spending, with social security transfers and wages making up two-thirds of primary spending. Despite an attempt at reform in 1999, central government social security transfers had continued to grow and were now close to 5 percent of GNP, in part because the principles of the 1999 reform, such as no ad hoc increases in benefits, had not been observed. Arguably, the program could have focused on social security reform earlier and more forcefully, but the authorities saw this as a sensitive area of reform which needed strong political will and consensus, which was only now being formed. The authorities also agreed that wage outlays were high by international comparison; however, they thought this could only be addressed gradually. In contrast, they thought that the real decline in public investment over the last three years needed to be reversed in the medium term.

Turkey: Indicators of Government Employment and Wages

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Source: FAD guidance note on civil service reform; most data are for the second half of the 1990s, whereas in Turkey it refers to 2003.

In the case of Turkey the ratio is to GNP

Includes 15 OECD and 12 EU countries.

Avenues to sustained debt reduction

28. There was agreement on the need to elaborate a medium-term debt reduction strategy and an agenda of reforms intended to make consolidation sustainable. Structural reforms were needed to improve the underlying expenditure composition of the budget, improve tax collection, bring the unregistered economy within the tax base and eventually reduce the tax burden. These were essential to ensure that the adjustment of the last few years could be maintained in the medium-term. A medium-term debt reduction objective and strategy was needed to guide fiscal policy.

29. On the structural front, a large agenda needed to be tackled. Health and pension reform were clearly urgently needed given the widening social security deficit. There was also agreement on the importance of pressing ahead with tax administration reform to improve compliance and the efficiency of tax collection, with staff urging civil service reforms as an avenue to lower the tax burden. To reduce tax distortions, and pre-empt pressures to create new ones, the staff and the authorities agreed that work should begin on a major reform of tax policy, but careful attention had to be paid to maintaining the revenue base of the budget (technical assistance in this area has already been initiated). There was agreement that this agenda needed to be prioritized. The staff saw social security and tax administration reforms as priorities. Expenditure reform also needed to begin in the context of the 2005 budget, and the legal framework for decentralization carefully developed at an early stage. While broadly agreeing with this prioritization, the authorities also thought that tax policy reform needed to be tackled upfront but perhaps in a staged manner.

30. With public indebtedness at the core of Turkey’s vulnerability, debt reduction was seen as the necessary focal point of medium term fiscal strategy, but it needed to be articulated with care. Given the sensitivity of debt and fiscal variables to financial market conditions, legislative adoption of conventional rules such as a balanced budget rule, a borrowing rule, or a debt rule did not seem feasible at this stage. Instead, to guide fiscal policy over the next few years and ensure debt sustainability, the staff and the authorities saw merit in adopting a multi-year debt reduction plan to build government consensus, manage expectations, and guide policy. One option discussed was targeting a specific reduction in the debt (say 12–15 percentage points in the debt to GNP ratio over a four-year period) with an explicit commitment to adjust policies every year to achieve the targeted debt reduction. With a view to strengthening growth and limiting vulnerabilities to financing shocks, the medium-term aim should be to lower gross debt substantially, for example, to the average level of the recent EU accession countries (40 percent of GNP). If debt diverged from the target path, the primary surplus would be adjusted to achieve the targeted reduction in debt.

uA01fig11

Gross Public Debt, 2003

(in percent of GDP)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A001

Source: IMF, World Economic Outlook.

31. Staff noted that, for an unchanged pace of debt reduction, there did not seem to be room within such a framework for easing the primary surplus target. Recent market tensions and uncertainties over the current account deficit suggested that real interest rates and the exchange rate are subject to a great deal of uncertainty. Therefore, any debt reduction strategy, the staff thought, needed to build in substantial safety margins on the one instrument that the government does control: the primary surplus. Indeed, recent hints by some government members that the 6½ percent of GNP primary surplus target may be relaxed next year had already troubled the markets. A lower primary surplus should only be considered once greater credibility of fiscal policy has been established and real interest rates have been lowered on a sustained basis.

32. While not ruling out the 6½ percent target beyond 2004, the authorities thought there may be a trade-off between the quality and the size of fiscal adjustment. To meet the primary surplus target, government investment had declined in real terms and needed to be restored to ensure adequate infrastructure spending, particularly in health and education. Undertaking a major tax reform and ensuring continued decline in financial intermediation taxes would also be difficult, unless some decline in revenues was accommodated. After several years of fiscal consolidation there was also strong pressure from spending ministries for higher resources in priority areas.

33. The staff argued that a looser fiscal stance would slow debt reduction and could have a severe cost in the form of higher real interest rates. Indeed, surprising the markets by maintaining a stronger than expected fiscal stance was likely to be the most effective way of lowering real interest rates. Provided that the authorities were prepared to initiate expenditure policy reforms (FAD has provided TA to facilitate this), the staff presented a three year fiscal adjustment scenario that indicated it was possible to cope with the expected revenue decline, reverse the real fall in investment, and make room for a major tax policy reform within the constraints of the existing primary surplus targets (Table 5).

Table 5.

Turkey: Public Sector Primary Balances, 2000-07

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Source: Turkish authorities; and staff estimates.Note: from end-2003 the figures include special revenues and expenditures. From 2004 the authorities have moved to the GFS 2001 classification.

Excluding privatization proceeds, transfers from the CBT, and interest receipts.

Excluding recapitalization of state banks; including net lending to the private sector.

Added to the public sector balance for 2002. Not included in the 2001 primary surplus calculation.