Overview

Turkey has achieved encouraging results with its Fund-supported program of stabilization and reform, and with its strategy to qualify for starting accession negotiations with the European Union. Strengthened confidence in Turkey’s political stability and continued disciplined economic policies have helped lower the cost of credit and have stimulated investment and growth.

The economy is quite buoyant. Capacity utilization rates, indicators of industrial and agricultural production, and strong export and tourism revenues give reason to project output growth in the range of 6 percent to 7 percent this year. The significant decline in inflation is a great achievement that in no small measure results from strict fiscal policies and skillful monetary management. Annual consumer and wholesale price inflation have now reached 8.9 percent and 10.5 percent, respectively. Turkey’s performance under the Stand-By arrangement shows that tight fiscal discipline, disinflation and strong growth can be achieved simultaneously.

The current account deficit is growing significantly. It reached USD 8.8 billion during the first five months of this year, even though during that period there was a record inflow of USD 3.6 billion tourism receipts, a 51 percent increase over the same period last year. Needless to say that the authorities are closely monitoring these developments. The behavior of the exchange rate under the floating exchange rate regime should play a corrective role. But if needed, measures to restrain consumer demand will be taken to avoid a widening of the current account deficit beyond an amount that Turkey can safely finance.

Fiscal Stance and Structural Fiscal Policies

The buoyant economy and strict budget execution have yielded a favorable budget outcome so far this year. During the first 5 months, the primary surplus exceeded the target by 0.75 percent of GDP.

The authorities recognize the need to improve the quality of fiscal adjustment, lest every new budget requires taking significant corrective measures that are politically costly and an administrative burden. Without structural fiscal reforms, sustaining the present fiscal stance might prove difficult. The enactment of the Public Financial Management and Control Law and the indirect tax reform were very important steps in this direction.

The authorities have now intensified their efforts in some major areas: reform of direct taxation, administrative reform, and social security reform. The tax administration reform is expected to be passed by parliament by end-October. The authorities are determined to address the causes of the informal economy. One strategy is to widen the tax base, to increase tax compliance and lower the tax rate. This should improve the business climate and raise revenues. The Fund staff is actively discussing these tax issues with the authorities.

The authorities are also working on a comprehensive social security reform, which has been a major source of the deficit in fiscal accounts. This reform includes institutional arrangements, changes in the pension system to reduce the deficit in the medium term and reform of the health insurance scheme. This reform package will be discussed by Parliament in January 2005.

Monetary policy

The floating exchange rate regime has struck a good balance between reducing inflation and preserving competitiveness. It creates more room for monetary policy to pursue its inflation objective, and makes the economy less exposed to shocks. For low inflation to last, fiscal discipline must be preserved and incomes policy should be consistent with productivity growth.

The revised base money targets under the program will make it possible for the Central Bank to accommodate the increased demand for currency, due to the declining inflation and increasing real activity. The CBT will continue implementing its interest rate policy in such a manner as to achieve and maintain low inflation, while taking into account the external price changes, particularly high oil prices and the pass-through from currency depreciation.

Banking Sector Reform

Bank regulation and supervision will be further improved to ensure that private banks are solid and able to support growth in the economy. The authorities have prepared a draft Credit Institutions Law and are now consulting the banking community. This draft deals with, inter alia, bank licensing procedures, the monitoring of bank ownership, limiting connected lending, and the organization of on site inspections. It also better delineates the responsibilities of the Banking Regulatory and Supervisory Agency (BRSA) and the Savings Deposits Insurance Fund (SDIF). This framework law is expected to be approved by Parliament by November 2004. It will bring the Turkish banking sector more in line with EU standards.

The government has updated the restructuring strategy for the State Banks with the help of international consultants. Pamukbank, which has been intervened, will be integrated in the state-owned Halkbank. These two banks complement each other well, and the newly integrated bank will eventually be privatized. The Parliament has recently approved the legislation to allow this operation. At the same time, a detailed restructuring plan has also been formulated for the other state-owned bank, the Ziraat Bank.

The blanket guarantee of bank liabilities has been recently removed and a new limited guarantee scheme introduced. There have been no panic withdrawals or sudden changes in the composition and distribution of savings. The new guarantee scheme will cover almost 60 percent of the savings deposits by value and 90 percent of accounts under TL 50 billion (approximately USD 33.750). People have learned from experience that savings should not be placed where extraordinarily high interest rates are offered. The BRSA will closely monitor developments in the sector and take prompt action when needed. The State Banks have addressed the private banking community’s concerns by reducing their deposit interest rates below market average.

Recent court rulings declaring invalid earlier BRSA decisions to intervene Kentbank and Demirbank are unfortunate for the banking reform efforts in Turkey. However, the authorities are studying every legal option to contain the possible negative impact of these decisions. The new Credit Institutions Law will address the loopholes in the legal framework and strengthen the position of the independent supervisory agency.

The Savings and Deposits Insurance Fund (SDIF) has continued to implement its strategy for the sale of its asset portfolio. Another auction was launched earlier this week and will be finalized by end-August. Last week, the SDIF has published its updated valuation of its assets.

Debt Management and Sustainability

Prudent public debt management contributes to improved borrowing conditions. As rollover rates are declining during the remainder of the year, the Treasury will increase its cash account at the CBT as market conditions allow. This strategy will help create room for maneuver when market conditions are tight, as witnessed during market turbulence a few months ago. The Treasury will coordinate its debt management with the CBT.

The staff’s analysis of Turkey’s debt sustainability shows that the public debt to GNP ratio will continue to decline under the program’s assumptions for GNP growth, real interest and exchange rates, and primary fiscal surpluses. We know that the set of assumptions in the staff’s baseline scenario is conservative. And indeed, almost all key economic indicators are progressing better than expected, notably the growth rate which is a key determinant in this calculation.

Future Relations with the Fund

The government is determined to continue its economic transformation strategy building on the progress made so far. The authorities are in the process of formulating a new medium- term economic program which could secure the necessary public support. The new program is being designed with the aim of further reducing the debt to GNP ratio and borrowing costs, while creating a favorable environment for private sector-led sustainable growth. Social policies will be targeted to protect the most vulnerable segments of the society.

The new economic program will also contribute to Turkey’s pre accession program for the European Union. The authorities are eager to continue their close and successful cooperation with the Fund and are considering what format would be the best. The authorities have announced that their decisions will be taken by September.

The authorities are well aware of the need to reduce the Fund’s exposure to Turkey. At the same time, continued financial support from the Fund could strengthen the robustness of access to the financial markets and lower the cost of borrowing.

Transparency and Data Issues

The authorities regret that it was not possible to publish the sixth review staff report, which they believe contains highly market sensitive information and assessments, especially regarding the financial sector. However, the Staff Report on the seventh review has been published and the authorities intend to agree with the publication of the Article IV consultation and eighth review staff reports and the background papers in accordance with the Fund’s publication rules.