Turkey: Eighth Review Under the Stand-By Arrangement and Request for Waiver of Nonobservance of Performance Criterion

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.


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. Recent Developments

1. Turkish financial markets have steadied following a brief episode of market turbulence (Figure 1). Global market sentiment towards emerging markets worsened in early April, with high debt countries such as Turkey most affected. Domestic developments in Turkey added to investor concerns. These included a widening current account deficit and mixed signals from the government over the future course of fiscal policy. Following the market correction—the lira declined by 15 percent in a month and benchmark bond yields rose by 7 percentage points—conditions have stabilized.

Figure 1.
Figure 1.

Turkey: Financial indicators, 2003-04

(in percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A002

Source: Data provided from the Turkish authorities.

2. Despite this turbulence, demand for Turkish assets has held up well (Figure 2, Tables 14). The increase in Turkish lira deposits has continued apace, as has demand for government paper from mutual funds and the public. Dedollarization has also persisted, with foreign currency deposits declining in U.S. dollar terms. Foreign holdings of treasury bills—now about US$4½ billion—have also held up.

Figure 2.
Figure 2.

Turkey: Money and Credit, 2001-04

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A002

Source: Central Bank of Turkey.
Table 1.

Turkey: Quantitative Targets and Structural Conditionality Relevant for the Eighth Review

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PA=prior action, PC=structural performance criterion, and BM=structural benchmark.

Table 2.

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 2004 and 2005, 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.

Table 3.

Turkey: Monetary Aggregates, 2000-04

(In quadrillions of Turkish lira)

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Sources: Central Bank of Turkey and Fund staff projections.

Monetary authorities and deposit money banks; evaluated at current exchange rates.

Includes credit to local governments and state economic enterprises.

Evaluated as percent of nominal GNP over previous four quarters.

Table 4.

Turkey: Central Bank Balance Sheet, 2000-04 1/

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Sources: Central Bank of Turkey; Fund staff projections. Although program targets for base money and NDA are five day averages, all observations in this table are end of period.

Except for 2000, all foreign currency aggregates are valued at end-December 2001 exchange rates (program exchange rates).

Mainly Dresdner deposit liabilities.

Equals borrowing from IMF plus short-term foreign currency denominated liabilities.

Since the Treasury cannot create base money, equals negative of Treasury net foreign assets.


Yield Curve Developments, 2003-04

(in percent)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A002

3. Credit growth also remained strong, although the pace of increase has moderated in recent weeks (Figure 2). Consumer credit has grown especially rapidly, with consumer loans having increased threefold over the last year, albeit from a low base. However, in recent weeks higher real interest rates have helped moderate credit growth.

4. Macroeconomic developments have remained generally positive:

  • Economic growth appears strong. National accounts data for the first quarter released after the mission indicate year-on-year growth of more than 10 percent, driven by domestic demand. Recent adverse market developments have, however, begun to dampen market sentiment, as reflected in the latest business surveys.

  • Inflation has continued to decline despite the weaker lira. Exchange rate pass- through effects have so far been muted. Monthly wholesale prices declined by 1.1 percent in June. And, with a monthly CPI decline of 0.1 percent, annual inflation remained in single digits, its lowest level for more than 30 years.

5. The one black spot—the large current account deficit—has thus far been comfortably financed by capital inflows, although these are mainly short term (Figure 3):

  • Reflecting strong domestic demand growth, the current account deficit continued to widen. The deficit reached US$5 billion in the first quarter. While exports remain strong, and tourism receipts have rebounded, this has been overshadowed by a broad-based import surge, reflecting high fuel prices and rapid domestic demand growth.

  • In contrast, the capital account has remained strong, albeit tilted towards short- term flows. Portfolio inflows remained strong through April, banks drew down their foreign asset holdings abroad (reflecting dedollarization), and domestic banks’ short- term borrowing increased significantly.

  • Taken together, the overall external position ended up approximately in balance in the first half of the year. Central Bank of Turkey (CBT) foreign exchange purchases of US$5 billion helped to support the reserve position and ensured the program NIR floor was comfortably met.

Figure 3.
Figure 3.

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.A002

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

6. Meanwhile, political developments have remained supportive. The government’s resolve on Cyprus and other developments—including a revised penal code, and broadcasting in different languages and dialects—are viewed by markets as having enhanced Turkey’s EU prospects. Events in neighboring Iraq, however, have added to uncertainties in recent months.

II. Policy Discussions

A. Macroeconomic Framework

7. Both sides agreed to leave the existing framework broadly unchanged (¶5):1

  • The risks for the growth target of 5 percent are clearly on the upside (Box 1). With a strong first quarter GDP outturn, positive production and demand side indicators, and a large positive growth carryover from 2003, economic growth would likely exceed the 5 percent growth projection. While currency weakness and higher interest rates would likely curb growth in the coming months, they are unlikely to alter the economy’s general direction. And, although consumer confidence had fallen in recent surveys, positive responses still predominated.

  • The end-year inflation target remains achievable despite the weaker lira. Both sides agreed that price pressures would likely increase in coming months. The output gap has narrowed, reflecting rapid demand and credit growth, and exchange rate pass- through effects of the weaker lira remain incomplete. Bringing petroleum excise adjustments in line with the budget would also add to price pressures. However, given the existing cushion—the continuation of the inflation path through May would have seen inflation end up about 3 percentage points below the end-year target—the 12 percent CPI inflation target remains achievable.

  • The current account deficit is expected to widen to some 3½–4 percent of GNP in 2004. This mainly reflects rapid demand-fuelled import growth, twinned with high oil prices. Both sides agreed that the recent lira depreciation should, after a lag, bolster the current account balance. Buoyant tourism receipts would also help. It was agreed, however, that with growth likely to exceed its target and oil prices remaining high, there was a risk that the external accounts could show a further deterioration relative to baseline program projections over the rest of the year.

Turkey’s Economic Growth Performance in 2004: Developments and Prospects

Production and demand side indicators both point to strong growth performance so far this year. The industrial production index—the most reliable domestic output indicator in Turkey—increased by more than 14 percent in the first four months over the same period last year. Capacity utilization reached a record high in March, falling in April only because of public sector maintenance in the petroleum sector. On the demand side, surging car and retail sales—following large minimum wage and pension increases, a car tax rebate and booming consumer credit—signal continued strong domestic consumption growth. Imports continue to grow strongly, led by consumer goods but also reflecting strong capital goods imports. Tax revenues, which have so far outpaced program targets, particularly on VAT and motor vehicles taxes, lend further support to the growth story.


Consumer and credit card loans

(y-o-y growth, in percent)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A002

Looking ahead, recent financial market turbulence may temper domestic demand. Reflecting the increase in benchmark bond yields, consumer lending interest rates have risen, and credit growth has begun to decelerate. The impact of higher interest rates and a weaker lira was also seen in the most recent business survey data, which show signs of declining growth expectations.

Three-months forward looking business indicators (CBT business survey)

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“General course of business in your industry” (optimistic - pessimistic)

“New orders received from domestic market, excl. seasonal variations” (optimistic - pessimistic)

“Volume of output, excl. seasonal variations” (optimistic - pessimistic)

Annual growth is, however, well on track to meet the 5 percent target this year, even if growth slows in the second half. The robust growth thus far combined with the positive carry-over effect from 2003 make the annual growth target of 5 percent attainable even with a slowdown in the second half of 2004. By the same token, a quick recovery in confidence and a return to the trend of declining real interest rates would likely see annual growth rising well above the 5 percent program target.

B. Fiscal Policy and Reforms

Fiscal outturns have so far exceeded program targets. But part of this overperformance is expected to be unwound in coming months. Against the backdrop of strong domestic demand growth, discussions focused on compensating for past policy slippages and thereby on allowing automatic stabilizers to work fully. Progress continues to be made on structural reforms, including on social security and tax administration.

8. Fiscal performance has been strong. Fiscal outturns through May have exceeded program targets (Table 6). The performance criteria for the broader consolidated general government were exceeded by ½ percent of GNP in both March and April, with the overperformance about evenly divided between tax revenues and expenditures. Performance in May continued to be strong, with the primary surplus of the consolidated budget overperforming by ¾ percent of GNP.

Table 5.

Turkey: Balance of Payments, 2001–05

(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).

Table 6.

Turkey: Public Sector Primary Balances, 2000-04

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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.

9. With the overperformance likely to narrow, both sides agreed that caution was warranted. For a start, savings achieved through postponing spending were likely to be unwound as the fiscal year drew to a close. And, on the revenue side, any growth slowdown in the second half of the year would have a negative impact. For these reasons, both the authorities and staff agreed that there was no room to increase budget spending ceilings.


Consolidated Budget Primary Surplus January - May

(percent of annual surplus)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A002

Primary Surplus (program definition)

(In quadrillions of Turkish lira)

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April figures. SEE figures are provisional.

10. Staff noted that the fiscal record to date had been helped by strong growth, masking fiscal slippages. The write-over of “special revenues” were well behind target. (“Special revenues” are fees collected by off-budget institutions; these fees are used for off- budget spending by these institutions unless they are transferred to the central government.) This reflected spending pressures arising from the across-the-board spending cuts implemented in March to compensate for the earlier pension and wage increases. In addition, petroleum excises had also been cut to cushion the impact of rising international oil prices.

11. Against a backdrop of strong domestic demand growth, staff urged that past slippages be corrected and automatic stabilizers be allowed to operate freely (¶9). While the authorities argued for some flexibility on budget implementation, staff called for the unimpeded functioning of automatic stabilizers given the strength of demand. This would entail saving any revenue overperformance due to higher growth and keeping spending within budget limits. The authorities noted that the tax incentive scheme for new car purchases had been scaled back. And, to make up for past slippages, they decided to write over to the budget TL 1.2 quadrillion of special revenues and to adjust petroleum pump prices to bring excises in line with budget assumptions (structural benchmark, ¶9). Staff noted the risk that, without flexible pump prices, there was a danger that higher oil prices would hurt excise revenues. Looking ahead, the authorities agreed to adjust all excises to bring them in line with budget assumptions. They also argued that, should oil prices decline, they would not adjust pump prices, de facto achieving an increase in excises and providing a cushion. Finally, the authorities have also implemented an energy market reform, effective January 1, 2005 that completely liberalizes petroleum prices.

12. Looking further ahead, the 2005 budget call, to be issued by end-June, aims at maintaining fiscal discipline:

  • Staff argued unsuccessfully for a budget call announcement that would explicitly include the 6.5 percent primary surplus as a goal. Such a move would have helped reassure markets. The authorities noted that a decision on next year’s primary surplus target had not yet been taken.

  • Both sides agreed, however, on the need for non-interest current spending to decline in real terms. This would help compensate for the loss of temporary tax measures and reduced financial intermediation taxes, and would make room for an increase in investment.

13. To lay the basis for sustained medium-term fiscal consolidation, further progress is being made on the structural side (¶10):

  • With social security reform preparations now at an advanced stage, it is expected that draft legislation will be submitted to parliament by mid-December. The authorities explained that the planned administrative reform, aimed at combining and unifying the three existing pension systems, would be the most critical element in reducing the social security outlays in the long run. The main effects of this unification would be to reduce the generosity of the civil service pensions. Both sides agreed that parametric changes beyond current administrative reforms are also needed to put the social security deficit on a firmly declining path. The political sensitivity of such reforms called for continued careful preparations. With the technical work over, a White Paper was being prepared to explain the reform proposals; this was expected to be ready this summer. After consulting with interested parties, a final decision would be made by the Council of Ministers on the proposal for reform in September (new structural benchmark). Draft legislation would then be sent to parliament in December (new performance criterion), with the aim of securing parliamentary approval by early 2005.

  • Draft tax administration legislation has been completed in line with international best practice but its parliamentary passage has been delayed due to a heavy legislative agenda. The draft law, which is now expected to be submitted to parliament in July (delayed May benchmark) and passed by end-October (new performance criterion), will create a semi-autonomous tax administration, to be structured along functional lines, and reporting directly to the Minister of Finance. Local tax offices will be directly under the control of the new entity and tax policy responsibilities will be shifted elsewhere in the Ministry of Finance. The authorities and staff agreed that, while the transition would be difficult, the move would usher in improved tax administration and tax compliance. As a further step, staff suggested to consider unifying all tax auditing functions under the new entity after it had become fully operational.

  • Further expenditure reforms are being considered for next year’s budget. The authorities recently received technical assistance from the Fund on short-term expenditure reforms. While the authorities are considering including some of the recommendations in their 2005 budget, they felt that the budget call did not require such details, and that further time was needed to build consensus in certain critical areas. Staff urged the authorities to undertake the reforms as soon as possible, especially those measures designed to curb the public wage bill and address the special tax treatment of civil servants and pensioners.

  • Progress is being made on improving public sector governance. The civil servant code of conduct was approved by parliament in May 2004. The commission report on strengthening SEE governance was also completed in May. Following consideration of the report’s recommendations, and a consultative process with interested parties, the authorities intend to prepare draft legislation, which is expected to be sent to parliament by end-2004.

14. Both sides agreed that tax incentives should be avoided. While the authorities had broached the idea of possible investment tax incentives—to attract foreign investors and level the playing field with other countries in the region—staff argued against this, since it would represent a move away from the direct tax reforms of April 2003 and from the general strategy of simplifying the direct tax system, widening the tax base, and lowering overall tax rates. Further, ad hoc policy changes would also undermine policy credibility. In the end, the authorities decided to pursue the avenue of comprehensive, rather than piecemeal, tax policy reform. They initiated a study covering comprehensive direct tax reform; in this context, the authorities requested early technical assistance from the Fund.

15. To keep wider public sector balances under control, the authorities have taken steps to limit local government and SEE borrowing. The authorities intend to issue a circular requiring SEEs to provide prior notification to Treasury of their borrowing plans. In preparation for decentralization, the authorities are embarking on an important legislative agenda to define local authority responsibilities and financing arrangements.

  • The authorities indicated that they would set strict borrowing limits for local governments, a major improvement on current practice where there are no limits. The debt stock of municipalities and provinces will be limited to no more than their annual revenue, while for larger metropolitan municipalities the limit will be 1.5 times annual revenue. New domestic borrowing of all local governments will be limited to 10 percent of annual revenue. Staff agreed that the new limits and new data reporting requirements were indeed an improvement. However, the staff would have preferred a uniform debt limit equivalent to annual revenue. The authorities pointed out that the debt stock of most of the larger metropolitan municipalities already exceeded 1.5 times annual revenue and therefore borrowing would be strictly limited.

  • Staff recommended close monitoring of the larger municipalities with an eye to tightening the debt limits in the future if needed. The forthcoming public administration framework law (PAF) could transfer more expenditures to the local governments and therefore a stronger system could be needed in future to deal with debt and arrears problems. The authorities agreed that after the PAF is approved and in the context of new legislation setting out fiscal intergovernmental relations, the debt limits of the large municipalities could be tightened further.

  • The staff warned against any restructuring of local government arrears that could give the impression of an amnesty and create a negative incentive structure for local authority fiscal control in the future. The authorities explained that all local authority external debt arrears have been fiscalized already and are included in the public sector debt statistics. They had decided to create a commission that would restructure arrears on a case-by-case basis. Both sides agreed that arrears restructuring be guided by ability to pay, contain adequate safeguards, and be conducted in a transparent manner.

C. Monetary and Exchange Rate Policy

16. Both sides agreed on the need for continued caution in setting base money targets (¶11). Falling inflation and inflation expectations and strengthening real activity had increased demand for currency and TL deposits. The mission therefore agreed to revise the base money targets to accommodate the base money increase through May. But several factors had made the end-year inflation target more challenging (see above). And the recent increase in market interest rates and currency depreciation should help slow money demand (as well as helping to slow bank credit expansion and to contain the current account deficit). Base money targets for the rest of the year were therefore increased only in line with nominal activity. This would require continued caution in reducing overnight rates, which in any event were now below treasury bill rates. The staff also welcomed the central bank’s intention to announce steps aimed at increasing the transparency of its monetary policy operations.

17. The floating rate regime had illustrated its effectiveness during the recent episode of market turbulence. It was agreed that, while the CBT’s modest sales of foreign exchange had helped stabilize markets in May, discretionary intervention would remain strictly limited. Staff took issue with the frequent changes to foreign exchange purchase arrangements in recent months, as this had confused financial market participants, possibly adding to recent market volatility. The authorities argued that they needed to respond to changing market conditions, while acknowledging that fewer changes would be desirable.

18. The mission also argued that the buildup in international reserve should resume as soon as market conditions permit (¶12). While the CBT has built up its reserve position by intervening, including through auctions, Turkey’s external obligations remained large, and the CBT should restart its purchases of foreign exchange in a predictable and transparent manner once the balance of payments position allows. Staff also noted that Treasury should overborrow and deposit the proceeds at the CBT once market conditions settle. This would lower Treasury exposure to shifts in market sentiment (see below), but would have the indirect benefit of helping the CBT in its sterilization operations.

D. Financial Sector Reform (¶14)

19. Following a major review of the Banking Act, the authorities have prepared a new draft Credit Institutions law. The new legislation, which is expected to be passed by parliament by November (a new structural performance criterion), will bring the legal framework more closely in line with EU standards. Areas that received particular attention in the review included the scope of the legislation, “fit and proper” criteria, licensing process, related party lending, on-site supervision, legal protection for Bank Regulation and Supervision Agency (BRSA) and Savings Deposit Insurance Fund (SDIF) staffs and boards and the delineation of responsibilities between the two institutions. These are all covered in the draft law. The exclusive right of Sworn Bank Auditors to conduct on-site supervision will be reviewed to permit the BRSA to engage off-site personnel and outside experts as needed.

20. Responding to industry concerns, the original timetable for the new legislation has been extended. Given the fundamental reforms envisaged, the banking sector community had urged that more time be allowed for consultation. The authorities and staff agreed on the need to proceed carefully. The authorities now plan to submit the draft law to parliament by end-September 2004.

21. A comprehensive strategy has finally been developed for restructuring and privatizing state banks.

  • In a move welcomed by staff, a strategy has been formulated for the integration of the intervened Pamuk with state-owned Halk. The combined bank is expected to become fully operational by end-October. Integration of the two banks should lead to operational and financial synergies, including on IT, the customer base, and branch networks. Given these synergies, staff urged the authorities to aim at privatizing the new bank by end-2005. The authorities would not commit to a fixed timetable to doing this, preferring to wait until market conditions were supportive. Staff regretted that the resolution of Pamuk had taken more than two years to bring to closure.

  • A comprehensive restructuring plan for Ziraat is being developed with the assistance of international consultants.

  • The due diligence of Vakif has been further delayed. The authorities noted that the terms of reference has now been drafted, and that a consulting firm would be hired shortly. The assessment was expected to be completed by end-October.

22. Unfortunately, the SDIF asset sales strategy continues to proceed slowly:

  • The SDIF has relaunched last December’s failed auction, with winning bids to be selected by end-August, but its prospects remain uncertain. After the auction announcement, SDIF made a general discount offer to all its debtors, ending mid- July. The offer includes loans in the portfolio currently being auctioned. Staff noted that with high-quality borrowers more likely to accept the offer, the quality of the portfolio being auctioned and the price likely to be offered may deteriorate. Staff nevertheless stressed the importance of a successful auction, indicating that another failure would deter potential investors.

  • Staff urged the SDIF to sell its assets through regular auctions with successive loan portfolios being put up for sale until the sales process is complete. It was agreed that the reassessment of SDIF asset valuations should foster a better understanding of recovery rates and allow more realistic auction reservation prices. Staff indicated that bilateral deals with individual borrowers should take place only after seeking outside expert opinion, with the general terms of each deal being made public.

23. Another unwelcome development is recent court rulings on Demirbank and Kentbank. In April the courts made a ruling that BRSA’s intervention in Demir and Kent had been unlawful. This could have implications for future bank intervention strategy. However, the new Credit Institutions legislation will help address existing legal shortcomings.

24. Looking ahead, staff stressed that the removal of the blanket guarantee on bank liabilities, implemented on July 5, warranted careful monitoring. The BRSA indicated that the TL 50 billion guarantee would cover almost 99 percent of bank accounts (64 percent by value). They were also confident that the banking sector was ready and had presented a detailed assessment to the government, and issued a press release confirming the banking system’s ability to deal with the abolition of the guarantee. More generally, the authorities indicated their preparedness for the move and stressed that individual bank liquidity was being monitored closely. Staff urged the authorities to continue to pay close attention to monitoring individual banks, and to follow up on any disparities between deposit rates offered.

E. Other Structural Reforms

25. Despite recent setbacks, the authorities remain committed to privatization (¶17). A recent procurement law amendment had removed an important bottleneck, by facilitating the hiring of consultants. Preparations for the sale of Tϋrk Telekom are advancing, against a backdrop of strong foreign and domestic investor interest. Public offerings are also planned for PETKIM (petrochemicals) and Turkish Airlines by end-year, and financial consultants have already been appointed. Several smaller companies have already been sold, including the alcohol arm of TEKEL, with cash proceeds through June totaling US$475 million (against an end-June indicative target of US$500 million). Staff noted the judicial system as a major hurdle. With the privatization of TUPRAŞ in doubt, following a recent court ruling, the US$3 billion end-year privatization proceeds target might be difficult to achieve.

26. Responding to business concerns that follow up to the Investment Advisory Council (IAC) was moving slowly, the authorities have taken further steps to improve the business climate (¶15). These include the preparation of draft legislation on streamlining investor approval procedures, and for a new Investment Promotion Agency. The authorities committed to providing a progress report to the Prime Minister and IAC members by October.

III. Financing Issues

27. With comfortable rollover needs for the rest of this year, the staff urged the authorities to build up a cushion for a more challenging environment next year. Treasury had managed, until recently, to improve its borrowing terms with rollover rates of about 90 percent. Baseline projections of rollover requirements over the rest of the year are lower. Depending on market conditions, Treasury should use this opportunity to build its deposits at the CBT and prepare for tighter medium-term financing requirements (see the Article IV staff report).

28. To help address rollover concerns, the authorities have agreed to address remaining impediments to Treasury and CBT coordination (¶13). The authorities agreed to identify remaining practical obstacles to Treasury deposit buildup and to prepare an action plan, by end-September, for their removal (new structural benchmark). Staff noted that borrowing limits, appropriations for interest payments, payment terms on government deposits, and the taxation of CBT money market securities should all be covered in the plan.

29. Discussions continued on relations with the Fund after the program expires (Box 2).

  • The authorities have developed comprehensive medium-term macroeconomic scenarios covering the balance of payments, national accounts, and the budget, along with detailed alternative financing projections. Although financing requirements look tight (see the Article IV staff report), the authorities have not yet decided on what form of relationship they wish to pursue once the current program expires.

  • The authorities also expressed their intention to announce their post-program plans by September. Staff indicated that, should the authorities decide to opt for a successor arrangement, any request for a future program would have to be considered under exceptional access procedures and would depend not only on Turkey’s financing needs, but also on it large outstanding obligations to the Fund. Discussions would continue during the Ninth Review against the backdrop of the budget preparation process. While reasonably satisfied with the announcement timetable, staff nevertheless urged the authorities to announce their policy plans for 2005 promptly, including on the primary surplus. The authorities were not yet in a position to do this, however, and wanted to consider the options carefully before making an announcement.

IV. Program Modalities

A. Program Monitoring

30. Quantitative performance criteria. The attached Letter of Intent describes progress in implementing the program supported by the Stand-By Arrangement and requests completion of the Eighth Review.

  • The authorities request a waiver of nonobservance of the base money ceiling performance criterion for end-April. Given the small size of the deviation, staff supports the waiver request.

  • Annex B of the Letter of Intent outlines the updated program. The new performance criteria are unchanged from the indicative targets set in the Seventh Review, apart from the base money ceilings (see above).

Post-Program Considerations

This box lays out some key considerations should the authorities seek a successor arrangement.1/

A successor program could be either disbursing or precautionary. By seeking a precautionary arrangement, the authorities could benefit from continued market confidence while signaling that Fund resources were no longer necessary. The external outlook is, however, difficult without additional official financing. With large repayments falling due to the Fund, baseline program projections show a loss of reserves of one-third over 2004-06. While the possibility of extending expected repurchases falling due in 2006 helps, the baseline financing assumptions themselves are subject to downside risk.

Under either a precautionary arrangement or a disbursing stand-by, the aim should be to reduce Fund exposure. With the Fund so heavily exposed to Turkey, prudential considerations call for a reduction in Fund exposure over the program period. Directors have called for reduced exposure, and the authorities themselves have also signaled publicly that they would favor a continuation of net repayments to the Fund. At the same time, Turkey faces large financing needs. For the public sector, external medium- and long-term debt amortization is projected to reach US$26 billion in 2005-06, with more than half falling due to the Fund even after allowing for an extension of 2006 repurchases (see figure).


Gross Public External Debt Amortization

(US$ billions)

Citation: IMF Staff Country Reports 2005, 163; 10.5089/9781451838145.002.A002

An ambitious reform program is needed, however, if Turkey is to build on its recent achievements. Besides continuing with the program’s macroeconomic stabilization, including on the primary surplus and inflation, critical structural reforms are required in banking (state banks, intermediation taxes, legal reforms), fiscal (quality of adjustment, social security, streamlining of taxes, tax administration, expenditure policy), and monetary (the move to inflation targeting and coordination between Treasury and the CBT).

1 With Turkey’s high outstanding Fund access post-program monitoring (PPM) would be needed even if Turkey chose to graduate. Given its vulnerabilities, and high outstanding access, frequent (possibly quarterly rather than the usual bi-annual) PPM would appear to be appropriate.

31. Structural performance criteria. The performance criteria on banking and on social security reform legislation have now been specified. A new performance criterion is also proposed on the parliamentary passage of tax administration reform legislation.

32. The prior action for completion of the Eighth Review is:

  • Write over to the central government budget TL 1.2 quadrillion of special revenues.

B. Data Issues

33. The authorities are continuing their efforts to disclose in-kind foreign financed defense spending (whose exclusion from reported fiscal data for past test dates may have resulted in misreporting). The plan is to use estimates of this spending from reported debt stock movements to determine, by end-July, whether a noncomplying purchase may have taken place in the period January 2000 to June 2003.

V. Staff Appraisal

34. Despite recent market turbulence, Turkey’s macroeconomic outlook remains positive. Political conditions have remained supportive, and, on the economic side, both the float and strong fiscal outcomes have aided the adjustment process. With few signs of flagging activity, economic growth looks likely to exceed this year’s 5 percent program target. The 12 percent inflation target remains achievable, although recent currency weakness, high oil prices, rapid credit growth, a narrowing output gap, and prospective administered price increases make this task more demanding.

35. The immediate macroeconomic challenge is the widening current account deficit, which reflects rapid domestic demand growth. So far the financing of the deficit has not been a problem, although capital flows have been mainly short-term. Recent currency and interest rate movements, together with rebounding tourism revenues, should help narrow the trade and services deficit over time. Other steps have also been taken to address the deficit. State banks have reined in their lending. Lower car tax incentives and the operation of automatic fiscal stabilizers should also help dampen import demand. The situation warrants continued close monitoring, however, and additional corrective measures, including on the fiscal side, may need to be taken promptly.

36. Against this backdrop, the government needs to maintain strict fiscal discipline. Rapid growth had masked slippages in budget implementation, but the authorities have since taken remedial actions. Looking forward, the government needs to allow automatic fiscal stabilizers to function unimpeded, and save any revenue overperformance. With the current account widening, for example, the authorities’ focus on pump prices, rather than excises, is misplaced. The failure to adjust automatically to world oil prices amounts to a de facto tax cut when world oil prices are rising. The liberalization of pump prices should, therefore, be allowed to take effect next year as planned. It is also important to avoid new tax incentives and to keep a lid on spending. Finally, it is unfortunate that the budget call did not include an explicit commitment to a 6½ percent primary surplus target for next year. A clear commitment to maintaining this target would ease market concerns about financing needs and the pace of debt reduction.

37. The decentralization process entails many risks and needs to proceed carefully. The government’s intention to introduce explicit debt and borrowing limits for local authorities as well as new reporting systems is welcome. While the local authority debt and borrowing limits appear on the whole prudent, the larger debt ceiling for the major metropolitan municipalities could have been avoided by providing a transition period for those whose debt exceeded the new limits. An amnesty of local government arrears should also be avoided to ensure an appropriate incentive structure for the future. While the authorities’ intention to deal with arrears on a case-by-case basis is welcome, the process needs to be dealt with in a transparent manner.

38. On the structural side, the government is to be commended for working to improve the underpinnings of its fiscal policy. Notwithstanding some delays, its efforts to improve tax administration and the social security system are especially welcome in this respect.

39. This year’s monetary goals are challenging, but achievable. Although consumer price inflation is now in single digits, possible pass-through from the recent depreciation and high oil prices need to be contained. Accordingly, the central bank, which deserves continued credit for its conduct of monetary policy, should stick closely to its revised base money targets and to a prudent interest rate path. Incomes policy, including limiting the increases in the minimum wage and for government workers, would also need to be kept tight.

40. The floating exchange rate had worked well as a safety valve during the recent bout of market turbulence. While the float remains essential, Turkey’s external obligations are large. Foreign exchange reserves buildup should therefore resume as soon as market conditions allow, but in a predictable and transparent manner. Recent turbulence served as a reminder of the need for continued close coordination between the central bank and the Treasury in their operations.

41. The banking reform agenda is challenging but critical to the success of the program. State bank reform has been long-awaited. Another priority is to continue with the close monitoring of individual banks following the transition to the limited deposit guarantee in early July. It is also important to regain momentum on SDIF asset sales, including by setting realistic price expectations. Any bilateral loan restructuring deals should be handled professionally and transparently.

42. The authorities need to gain momentum in privatization and improve the business climate. With the recent setback on TUPRAŞ, the end-year privatization receipt target will be difficult to achieve. But recent steps, including the procurement law amendments and the preparation of large companies for sale, are welcome. Looking ahead, the authorities need to ensure that sales preparations are as thorough as possible and designed in ways that minimize the scope for court challenges. The follow-up work to the March inaugural Investment Advisory Council needs to be accelerated.

43. Against this background, the staff recommends the completion of the Eighth Review and approval of the authorities’ request for a waiver. Turkey has a good program implementation record, including for the current review, and deserves the support of the international community. The authorities have also taken some steps to address the risks to the external outlook, the clearest near-term risk. On this basis, the staff recommends the granting of the waiver on base money and the completion of the review.

Table 7.

Turkey: Banking System—Selected Indicators, 1999-2004

(in trillions of Turkish lira)

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

Data for December 2001 onward reflect the results of the audits conducted during the first half of 2002.