Turkey
Request for Stand-By Arrangement and Extension of Repurchase Expectations: Staff Report; Staff Supplements; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Turkey
Author: International Monetary Fund
Publication Date:
17 Nov 2005
eISBN:
9781451838152
Language:
English
Keywords:
ISCR; CR; Turkey; SDR; deficit; Stand-By Arrangement; repurchase expectation; central bank; exchange rate; current account; foreign currency; net profit
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This paper discusses Turkey’s Request for Stand-By Arrangement (SBA) and Extension of Repurchase Expectations. Turkey’s economic program has delivered impressive results. Output has grown rapidly, inflation has fallen to its lowest level in a generation, and government debt has declined markedly. However, significant vulnerabilities remain. The authorities have prepared a three-year economic program for which they are seeking the support of the IMF. Implemented successfully, the program should help Turkey converge toward the economies of the European Union and exit successfully from IMF financial support.

Abstract

This paper discusses Turkey’s Request for Stand-By Arrangement (SBA) and Extension of Repurchase Expectations. Turkey’s economic program has delivered impressive results. Output has grown rapidly, inflation has fallen to its lowest level in a generation, and government debt has declined markedly. However, significant vulnerabilities remain. The authorities have prepared a three-year economic program for which they are seeking the support of the IMF. Implemented successfully, the program should help Turkey converge toward the economies of the European Union and exit successfully from IMF financial support.

I. Introduction: Sustaining and Advancing Recent Gains

Over the last four years, Turkey’s economic program has delivered impressive results. Output has grown rapidly, inflation has fallen to its lowest level in a generation, and government debt has declined markedly. However, significant vulnerabilities remain, important structural reforms need to be advanced to help sustain the recent gains, and Turkey has large financing needs over the next few years. The authorities have thus prepared a three-year economic program for which they are seeking the support of the Fund. Implemented successfully, the program should help Turkey converge towards the economies of the European Union and exit successfully from Fund financial support.

1. In response to the economic crisis of 2000–01, the Turkish government launched an ambitious program of economic and structural reform. To address concerns over debt sustainability and debt rollover, it made a new commitment to prudent fiscal policy, with the primary surplus over the last four years averaging almost 6 percent of GNP and reaching nearly 7 percent of GNP in 2004. To help reduce inflation under the new floating exchange rate regime, the central bank was granted independence to pursue a new and clear objective—price stability—and freed from any responsibility to finance the government deficit. To overcome the worst of the financial crisis, the banking system was strengthened: state banks were re-capitalized, the weakest private banks were intervened, and open foreign exchange positions closed. The 2004 Article IV Consultation (Country Report No.05/163) discusses this strategy, the results it achieved, and draw lessons for future policy implementation.

2. Over the last four years, these reforms have delivered a decisive break with Turkey’s history of high and variable inflation, and low and volatile growth (Table 1). Despite interruptions from political tensions and external shocks, interest rates have fallen significantly and the lira has remained strong. Inflation is now well below 10 percent, its lowest in thirty years, while output has recovered strongly from the 2001 recession, with annual growth rates averaging almost 8 percent over the last three years. Once at risk of becoming unsustainable, government net debt has fallen to less than 65 percent of GNP. Implementation of the program has played a key role in achieving these results. However, the exceptional financial assistance provided by the Fund (which addressed debt rollover concerns in 2001 and 2002), the prospect of additional financing (in case of fallout from Iraq), and low world interest rates have been important too.

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.

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

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

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

In billions of new Turkish lira from 2005 onwards.

3. Despite the strong economic performance under the program, significant vulnerabilities still need to be addressed (Box 1, Table 2). Although government debt has declined, it is still high, with short maturities creating rollover risk. While macroeconomic conditions are now much stronger, the high current account deficit is adding to short-term external debt and poses a significant risk for the economy. A sudden shift in investor sentiment could cause a sharp correction in exchange rates and interest rates, which would undermine disinflation, weaken balance sheets and add to the public debt burden. Though declining substantially, real interest rates are still high and dollarization widespread. The financing outlook is also challenging. Over the next three years, the government must make more than US$40 billion in external debt repayments, more than half of this to the Fund. Without further financial support, gross reserves would fall sharply. Finally, despite strong growth, unemployment remains high and foreign direct investment very low.

Table 2.

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.

By residual maturity.

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

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

Deflated by the CPI.

Turkey: Vulnerabilities

While the economy has become more resilient under the program, vulnerabilities remain. The restoration of macroeconomic stability and the move to a floating exchange rate regime have created the conditions for a much less crisis-prone economy. However, several sources of risk remain: although lowered since the crisis, public debt remains high, dollarization pervasive, and the economy’s rapid growth under an open capital account creates additional exposure to potentially volatile foreign capital flows. This could in turn pose challenges for the stability of a relatively underdeveloped financial sector.

High public debt and roll over requirements, and interest rate and exchange rate exposure remain key vulnerabilities. The envisaged debt reduction under the program, although ambitious, will leave the net public debt-to-GDP ratio over 50 percent, still very high for an emerging market country. The high share of foreign currency and floating rate debt, and the still short average maturity of fixed rate lira debt, imply strong roll-over pressures and high exposure to sudden changes in exchange rate and interest rates. This exposure is reflected in the sudden rise of the public debt ratio that occurs under certain scenarios in the public debt sustainability assessment (Appendix III, Annex A). Even with skilled debt management it will take time to improve the public debt structure and thus reduce this exposure.

uA01fig01

Turkey: Composition of Public debt

(end 2004)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

The accumulation of external debt by the private sector and strong foreign capital inflows create additional vulnerabilities. With a private-demand led widening of the current account deficit, more than 40 percent of Turkey’s external debt is now owed by the private sector, of which 43 percent is at short maturity. EU-accession prospects could further stimulate private external financing. Although financing could take the form of FDI, this will take some time and meanwhile much of it is likely to remain debt-creating. The surge of foreign demand for local bonds and equities following the EU summit on December 17 also gave an indication of how strong capital inflows driven by positive investor sentiment can cause rapid currency appreciation and a boost in domestic asset prices. Conversely, a sudden shift in sentiment and a reversal of these flows could trigger a similarly sharp drop in asset prices. The associated exchange rate adjustment would abruptly raise the financial burden for those with foreign debt and create liquidity pressure for those whose external credits are not being rolled over.

uA01fig02

Turkey: Short-term external debt of private sector

(in millions of US dollars)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

High domestic liability dollarization adds to exchange rate related risks. Turkey is still among the most dollarized economies and, despite significantly improved inflation expectations, reversing this currency substitution has been limited. Foreign currency deposits still comprise a large share of banks’ domestic funding, which banks match by extending foreign currency loans to corporations and by buying foreign currency linked government paper (making it for the government to switch out of these instruments). A sudden exchange rate adjustment would create similar pressure for domestic foreign currency debt as it does for foreign debt.

Exchange and interest rate developments depend on future global liquidity conditions, which are beyond the control of domestic policies. Faster-than-expected interest rate increases in the U.S. or the Euro area could have a large impact on capital flows to emerging markets. This would negatively affect the Turkish currency and domestic interest rates, a key risk.

uA01fig03

Foreign currency share in total debt

(end-2002; taking into account foreign-currency denominated domestic debt)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

A continuing rapid expansion of domestic bank lending could pose additional challenges to financial sector stability. Despite its rapid recovery, bank lending is still low as a share of GDP, implying a vast potential for further credit growth. Indeed, new credit instruments are now being aggressively marketed as banks compete for market share: the sharp rise in credit card loans in 2004 is one example, and the planned introduction of a mortgage loan market in 2005 could be another. Fast expansion of such activities could create new vulnerabilities, even if regulations are in place.

Empirical evidence confirms that Turkey’s vulnerability has decreased, but also shows that it remains above the average of emerging markets. Using the safety ratios proposed by Manasse and Roubini (2005), it can be seen that while comfortably meeting several of the thresholds, Turkey remains slightly above some of the important ones, related to external debt (see also Appendix III, Annex B).

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4. A considerable structural reform agenda needs to be implemented to sustain the improved performance. While the primary surplus has risen under the program, sustaining this performance will not be easy. The social security system runs a deficit of 4½ percent of GNP; tax evasion is widespread, due to the large unregistered economy; and, with a narrow tax base, revenues depend too much on distortionary indirect taxes. Reform in all these areas is needed to underpin debt sustainability. Although the banking system has been strengthened, further reforms are needed. The legal framework for banking supervision and asset resolution needs to be overhauled, and state bank reform reinvigorated. Steps are also needed to improve the business environment, foster employment, and spur foreign direct investment.

II. A Favorable Economic Backdrop to the New Program

Unlike in 1999 and 2002, the new economic program is being put in place in a favorable economic setting. Turkish financial markets have become much more resilient and macroeconomic indicators are strong. EU accession prospects also add a new positive dimension, serving as a catalyst for reform (Box 2). However, the large current account deficit continues to pose a risk despite signs that its deterioration is moderating, and Turkey remains vulnerable to swings in international investor sentiment towards emerging markets.

5. Financial market conditions have continued to improve and confidence is strong (Figure 1). Financial market conditions improved significantly during 2004 and the EU’s decision in mid-December to begin accession negotiations has helped consolidate and advance these gains. Both policy interest rates and domestic bond yields have fallen below 20 percent, the lowest since the onset of the crisis. The lira remains strong and has more than regained the ground it lost during the April-May 2004 emerging market tensions. A surge in foreign investments into domestic bonds and stocks has driven up asset prices and enabled the central bank to increase reserves. Even so, recent financial market pressures continue to highlight Turkey’s vulnerability to global economic developments (e.g. tightening of liquidity) and domestic factors (such as earlier uncertainty about IMF relations and EU accession).

Figure 1.
Figure 1.

Turkey: Financial indicators, 2002–05

(in percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

Source: Data provided by the Turkish authorities.
uA01fig04

Real GDP and GNP

(y-o-y growth rate)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

uA01fig05

Quarterly real growth, seasonally adjusted

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

Turkey’s EU Accession Negotiations

On December 17, 2004 the European Council pledged to open EU accession negotiations with Turkey by October 3, 2005. Recognizing the decisive progress made by Turkey in its far reaching reforms, the Council found that Turkey sufficiently fulfills the Copenhagen political criteria to open accession negotiations, provided that it brings into force six specific pieces of legislation identified in the Commission’s 2004 report. During the Council meeting the Turkish Government also confirmed that it was ready to sign, prior to the actual start of accession negotiations, an extension of the Ankara Agreement to the ten new EU members, including the Republic of Cyprus, which Turkey does not recognize. The negotiations aim at achieving full EU membership for Turkey, but the so-called framework for negotiations also sets out that (i) the process is open-ended and its outcome cannot be guaranteed beforehand; (ii) negotiations could be suspended in case of a serious and persistent breach of EU founding principles (liberty, democracy, respect for human rights and fundamental freedoms and the rule of law); and (iii) long transition periods or permanent safeguard clauses may have to be considered, e.g. for areas such as the freedom of movement of persons. A target date for Turkey’s accession has not been set, as was the case for the ten 2004 enlargement countries, and is generally assumed to be at least a decade away.

Turkey-EU relations have a long history. Turkey’s membership perspective arose as early as 1963 with the EEC-Turkey Association Agreement. In 1995, a customs union was formed, and in 1999, Turkey became a candidate country for EU accession at the Helsinki summit. The 2002 European Council pledged to open accession negotiations without delay if the December 2004 Council decided, on the basis of a report to be prepared by the Commission, that Turkey fulfilled the Copenhagen political criteria. The Commission report of October 6, 2004 came to a positive assessment regarding human rights, democracy, the rule of law, and protection of minorities, subject to certain legislation under preparation entering into force.

Accession talks will bring economic issues increasingly into focus. While compliance with political criteria has dominated EU-Turkey discussions so far, Turkey will now have to demonstrate that it has a functioning market economy and the capacity to withstand competitive pressures and market forces within the Union. This requires maintaining macroeconomic stabilization policies, so as to reduce vulnerabilities, and introducing further decisive steps toward structural reforms. Fulfilling the economic conditions is a prerequisite for initiating negotiations on the economic chapters of the acquis communitaire, such as competition policy, industrial policy, taxation, financial control, EMU, and customs union.

Accession negotiations with Turkey will be a multi-stage process, largely following the pattern of previous enlargements. A “screening process” at the outset identifies existing discrepancies between the acquis communitaire and practices in Turkey. Each of the over thirty chapters of the acquis, which comprise the entire body of EU legislation, are opened individually for negotiation. Closure of each chapter requires the consent of all member countries. Building on the lessons learned from previous enlargements, the EU will place heightened emphasis on the implementation of the commitments that Turkey makes during the negotiations before it agrees to close a chapter. Thus, negotiations are likely to specify concrete implementation benchmarks for closure. Once all chapters are closed, the Commission will be asked to recommend that the negotiations be concluded. In case of a positive assessment, an Accession Treaty will be drawn up for the approval of the Council, the European Parliament, EU countries, and Turkey. Some EU member countries might hold referenda on Turkey’s accession – a source of uncertainty as Turkey’s EU membership currently lacks sufficient popular support in many countries.

The accession process should bring Turkey many economic benefits. The firm membership perspective reassures investors that economic policies will remain prudent. This should lead to an upfront reduction of risk premia and a gradual rise of inward investment, consistent with the developments witnessed since the December 17 decision. Structural improvements, institutional upgrading, and infrastructure investment resulting from adjustment to the acquis should greatly enhance the business environment and raise living standards. Turkey will also benefit from EU financial transfers: grants under the pre-accession facility will rise gradually from €250 million in 2004 to €1 billion annually by the end of the decade. After accession, the net transfers to Turkey, mainly for agricultural and regional policies, would be even larger. However, this depends on future revisions of the acquis and economic developments in Turkey and the EU. The framework for negotiations explicitly states that for a conclusion of the negotiations it is necessary that the financial aspects of accession fit into the EU’s Financial Framework for the period from 2014.

6. Growth in 2004 surpassed program projections for the third successive year. Annual GNP growth reached 9.9 percent for the year as a whole, twice as strong as the original 5 percent projection. Growth was driven by private domestic demand, with almost equal contributions from consumption and investment expenditures. Spending on durable goods and machinery and equipment were particularly strong, fueled by lower interest rates and a credit boom. However, domestic demand slowed markedly in the second half of the year, bringing production down to more sustainable levels and helping to cut the large negative contribution from net exports. Most recent indicators point to a soft landing for the economy, with domestic demand indicators growing much more slowly while production indices continue to show relatively robust activity. The contribution from net exports is becoming less negative, and growth seems to be converging towards the program projection of 5 percent in 2005 (Figure 2 and Box 3).

Figure 2.
Figure 2.

Turkey: Output and inflation, 2002–05

(in percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

Sources: State Institute of Statistics; and Central Bank of Turkey.1/ From January 2005, Producer Price Index (PPI).2/ Negative indicates appreciation.
uA01fig06

Contributions to GDP Growth

(In percentage points)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

uA01fig07

Contributions to Domestic Demand

(In percentage points, excl. stockbuilding)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

7. Despite strong growth, inflation has come in below the central bank target. Annual CPI inflation ended 2004 at less than 10 percent compared with an original target of 12 percent. Continued slack in the labor market and rising productivity prevented strong domestic demand from translating into price pressures. Pass-through from the weakening of the lira in April-May 2004 turned out to be limited, and inflation expectations remained broadly stable even during episodes of exchange rate volatility. Since the beginning of 2005, year-on-year consumer price inflation has continued to decline on the back of a strong lira and lower-than-expected winter food prices. CPI inflation fell to 7.9 percent in March, and although more recent oil price hikes and some weakening of the lira may be reflected in April prices, the latest expectations survey continues to indicate strong confidence that the central bank will be able to attain or even outperform this year’s 8 percent target.

Turkey: Recent Growth Performance

Growth in 2004 was driven by strong private domestic demand, which boomed in the first half of the year and then slowed markedly in the second. Domestic demand surged by over 20 percent in the first half of 2004 relative to the same period in 2003 and then slowed to an average growth rate of just above 8 percent in the second half of the year. The contribution to this growth came in almost equal parts from both private consumption and investment spending, and the pattern of this spending (consumer durables, machinery and oil) created a similar pattern for imports. On the production side, this was reflected in strong output growth in manufacturing and retail and wholesale business services. At the same time, Turkey experienced a boom in tourism, which contributed to exports and prevented an even larger deficit in the external balance. For the year as a whole real GNP (GDP) grew by 9.9 (8.9) percent.

Turkey - Quarterly Real Output and Expenditure in 2004

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Sources: State Institute of Statistics, SPO and CBT.

Very preliminary indicators for the first quarter of 2005 seem to support the scenario of a soft landing, with output growing broadly in line with potential.

Industrial production increased by an average of almost 11 percent year-on-year in the first two months of 2005. Even though indications are that producers may have further built up inventory in those two months and their production may slow in upcoming months, this robust performance dampens concerns about a too rapid decline in production.

On the demand side, sales of cars and durable goods, the main components of private consumption in 2004, have become subdued, after a steep decline in their growth rates in the second half of 2004. Although demand may be shifting into other goods, in particular semi-durables, thus far there has been no strong indication of such a shift (e.g. prices in CPI subcomponents).

Import growth has been slowing further in 2005. In February, the three month average of imports grew at a slower pace than the same average for exports (year-on-year) for the first time since November 2003. A combination of robust production and strong export growth could reduce reliance on domestic demand to more export-driven growth, which was already partly observable in the converging growth rates of GDP and final domestic demand in the final quarter of 2004.

Year-on-year growth rates for consumer credit have not reversed their declining trend thus far in 2005, despite some recent signs of a pick up in week-on-week growth rates. However, confidence seems to remain strong despite the volatility in some of the indices. Thus, in an expectations-driven economy like Turkey, private consumption demand may quickly revive, possibly propelled by falling interest rates and rising asset prices as a result of resurging inflows.

Against this background, the growth target of 5 percent seems well attainable, and closer to the economy’s potential. However, a stronger-than-expected decline in production, e.g. due to an appreciated exchange rate that impairs export growth could possibly put the target at risk.

uA01fig08

Consumer credit

(year-on-year percent change)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

uA01fig09

Industrial production

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

uA01fig10

Durable goods demand

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

uA01fig11

Real output and final domestic demand

(y-o-y growth rate)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

8. Monetary developments have also been positive:

  • Credit growth (Figure 3). Reflecting the pattern of economic growth, credit grew rapidly in early 2004, but eased in the second half, especially on the consumer side. Although consumer credit growth regained momentum in the early months of 2005, possibly reflecting lower interest rates, this has not yet fed through to higher overall credit growth.

  • Currency substitution. Turkish lira deposits increased strongly during 2004, as did public demand for Treasury paper. While foreign currency deposits also grew rapidly, these have fallen in dollar terms in recent months (to a low of 40 percent of total deposits, also reflecting valuation effects), signaling a possible resumption of reverse currency substitution.

  • Capital inflows. Demand for Turkish lira assets by foreign investors has also been strong, with bond and equity flows averaging US$3¾ billion and US$1¼ billion over the past two years, and the pace of inflows picking up in the early months of this year.

  • Base money. Reflecting strong economic growth, increasing confidence in the lira in a declining interest rate environment, and ongoing financial deepening, base money has registered strong growth over the past two years—increasing by more than 20 percent in real terms each year.

Figure 3.
Figure 3.

Turkey: External indicators, 2002–05

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

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

Sources: State Institute of Statistics; and Central Bank of Turkey.1/ From January 2005, uses Producer Price Index (PPI).2/ Net international reserves measured at cross-exchange rates under previous arrangement.
uA01fig13

Turkey - Net Capital Flows into Stock and Bond Market

(in billions of US$)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

uA01fig14

Base Money

(in billions of new Turkish lira)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

9. Preliminary data indicate that the authorities achieved a record primary surplus of nearly 7 percent of GNP in 2004. The central government primary surplus exceeded the program target, largely on the strength of increased revenues. Corporate income tax and VAT receipts were particularly robust, but cuts in fuel taxes early in 2004 left annual excise collections below target, despite increases in the second half of the year. There were also shortfalls in the write-over of extrabudgetary special revenues, which the authorities offset with cuts in defense and capital transfers late in the year. These reductions were facilitated by savings on foreign-currency expenditures, reflecting the stronger-than-expected lira. Overall, primary expenditures were kept in line with the program. Outside the central government, the state economic enterprises (SEEs) overperformed, notwithstanding the impact of high oil prices on the railway, airline, and electricity companies. The social security institutions were modestly under target, but this was more than offset by savings on procurement by the Defense Fund, and higher revenues for local administrations and revolving funds (hospitals and other fee-based institutions).

10. The main macroeconomic concern has been the widening current account deficit (Figure 3). The current account deficit for 2004 exceeded 5 percent of GNP, as the strong performance of exports and tourism receipts could not compensate for the even faster growth of imports, which surged due to strong domestic demand for imported durables and investment goods. Higher oil prices added to the problem. To contain the current account deterioration, the authorities took active measures, which included stopping state banks’ aggressive expansion of consumer credit, reducing generous tax credits for buying new cars, and raising the intermediation tax on consumer credit. In November and December, they raised natural gas prices, and petroleum and motor vehicle excises, while saving much of the 2004 revenue overperformance. As a result of these measures and a moderation of pent-up demand for consumer durables, import growth has been slowing and the current account deficit appears to have peaked.

uA01fig15

Import Growth, in percent

(3 month average, year on year)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

11. Despite the large current account deficit, gross reserves increased as a result of strong capital inflows, a large share of which remained short-term and debt-creating. Although the maturity structure of these inflows improved somewhat relative to 2003, Turkey remained exposed to a sudden reversal in market sentiment. At the same time, the inflows consisted mainly of foreign borrowing (trade-related credits, interbank and corporate borrowing) as foreign direct investment remained low and portfolio investments into government bonds were larger than those into equities.

Composition of External Financing

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Source: CBT

Excluding Reserve Asset Movements

Excluding Reserve Asset Movements and E&O

III. The Authorities’ Three-Year Program

The staff and the authorities were able to reach consensus quickly on the main objectives of the program and on a three-year macroeconomic and financing framework. However, developing the policies needed to help achieve these goals proved a more prolonged process than expected. This was in part because of the inherent complexities and sensitivities associated with key structural reforms such as social security and banking supervision. From the staff’s point of view, it was also essential that the authorities’ request for exceptional access was accompanied by policies that addressed decisively the remaining vulnerabilities and the structural reform agenda identified during the 2004 Article IV consultation.

12. The authorities have developed a detailed new three-year economic program in support of their request for exceptional access (¶2).1 The overriding goals of the new program are to create conditions for sustained growth that will raise living standards and reduce unemployment; facilitate convergence towards the EU economies; and bring about an orderly exit from Fund support. To achieve this, the program aims to:

  • Deal effectively with short-term macroeconomic challenges and, in particular, reduce the current account deficit to more sustainable levels.

  • Secure permanently lower inflation, by retaining the floating exchange rate, preserving central bank independence, and adopting formal inflation targeting.

  • Make the government debt position more sustainable through continued sizable primary surpluses, shifting towards longer debt maturities, and underpinning the fiscal adjustment with structural fiscal reforms.

  • Restore Turkey’s net foreign exchange reserve position and lower its vulnerability to balance of payments shocks.

  • Maintain financial sector stability by further improving the supervisory and regulatory framework, accelerating asset recovery and restructuring state banks.

  • Implement a structural reform agenda that enhances Turkey’s growth prospects, lowers unemployment, and improves the investment climate.

A. Macroeconomic Framework

Both sides agreed that the program’s macroeconomic framework should be built on a robust but sustainable rate of growth, a continued decline in inflation towards EU levels, a reduction in the current account deficit to improve external sustainability, and a 10 percentage point reduction in the ratio of public debt to GNP.

13. The program’s macroeconomic framework is centered on achieving high and sustained growth but at a more moderate pace than in the past three years (¶3). With the output gap now considerably diminished, growth is assumed to converge towards potential. However, past volatility makes Turkey’s potential growth rate hard to determine. Staff analysis presented during the 2004 Article IV Consultation and recently updated indicates that potential growth in Turkey could be as high as 7 percent per year provided macroeconomic stability is maintained and in particular declining inflation, trade liberalization, and structural reforms continue (Chapter I of the Background Studies). The authorities noted the many improvements in factors that had constrained growth in the past, including greater political and macroeconomic stability, and progress in structural reform, as well as the prospective benefits (including additional FDI) that would come from the EU accession process and implementation of the program. However, it was agreed that the program should be based on a more prudent medium-term growth rate of 5 percent.2

Macro-framework for Previous and New Program

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14. Slower domestic demand and continued growth of exports are expected to lower the current account deficit to around 4.5 percent of GNP in 2005 (Table 3). The authorities believed that much of the import surge in 2004 reflected pent-up demand for durables and investment goods. Indeed, the sharp slowdown in the rate of growth of domestic demand as well as imports in the second half of the year was consistent with this hypothesis. The elimination of tax incentives for purchase of cars and the increase in special consumption taxes should also help curtail consumer spending in 2005. Export volume growth continues to be robust and business surveys point to strong export orders. Productivity growth should help sustain the increases in export market shares and net tourism receipts should continue to cover a sizeable share of the trade deficit. The program also envisages a 5 percentage point decline in the overall fiscal deficit that should help facilitate a further improvement in the current account deficit over the program period.

Table 3.

Turkey: Balance of Payments, 2003–10

(In billions of U.S. dollars)

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

Until 2003, remittances include tourism receipts from foreign citizens. These are now classified under the services account. Also, the “imports with waiver item” was reclassified in November 2004, leading to a revision of the current account balance for 2003 as well as 2004.

Including privatization receipts.

Non-bank external debt minus the net foreign assets of the banking sector and the central bank.

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

15. However, there are risks to the current account projections, and policies need to remain flexible to ensure program targets are achieved. The phasing out of international quotas on Turkey’s textile exports (one-third of merchandise exports) means that export projections face risks and the increase in international energy prices—if sustained—would weigh heavily on the trade balance. At the same time, the positive outlook for EU accession and a reinvigoration of structural reforms could lead to a surge in confidence, stronger demand, upward pressure on the lira, and larger current account deficits than envisaged. There were glimpses of such a pattern emerging in the first few months of this year. The authorities pointed out that they had allowed the automatic stabilizers to work in 2004 by saving the revenue overperformance, and had taken additional fiscal measures to contain the current account deficit. They stood ready to repeat this in 2005 and take measures, if needed, to ensure the current account deficit does not endanger the macroeconomic objectives of the program (¶11).

B. Monetary and Exchange Rate Policies

Monetary policy will aim at bringing inflation closer to EU levels. The move to formal inflation targeting should help, as should continued fiscal prudence. Safeguarding the independence of the CBT will also be critical. On the external side, the net international reserve position will be further improved to reduce Turkey’s vulnerability to shocks.

16. While bringing inflation closer to EU levels will be a challenge, both the authorities and staff agreed that this should be the program’s objective (¶4):

  • Prospects for continued disinflation were good. For three successive years, the CBT had outperformed its end-year inflation target. As a result, monetary policy credibility had improved considerably, and reliance on forward- rather than backward-looking price-setting had increased. The move to formal inflation targeting would also help, if handled carefully.

  • Even so, there were still risks to the inflation outlook, both domestic and external. Although growth had recently moderated, rapid (though declining) credit expansion (Figure 4), high capacity utilization, and the shrinking output gap meant that demand pressures on inflation could emerge. The CBT noted that inflation stickiness in non-traded goods could be a problem (although lower traded goods inflation might simply reflect productivity growth or more rapid exchange rate pass-through). The use of indirect tax increases to meet the primary surplus target could also add to price pressures. Attainment of the inflation target could be disrupted if the exchange rate adjusts sharply to correct the current account deficit or in response to a worsening of the external environment.

Figure 4.
Figure 4.

Turkey: Recent Credit Developments, 2002–05

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

Source: Central Bank of Turkey.
uA01fig16

Inflation Credibility Gap 1/

(in percent)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

1/ Expected annual inflation minus CBT’s announced inflation target.
uA01fig17

Turkey: Weight of Expected Inflation In Price-Setting 1/

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

1/ See Celasun and McGettigan, 2004, for details. Chart shows the weight of future prices in a price-setting equation. The higher the weight on future prices, the greater the credibility of the inflation target.
uA01fig18

Turkey: Annual Goods and Services Inflation

(in percent)

Citation: IMF Staff Country Reports 2005, 412; 10.5089/9781451838152.002.A001

17. Staff and the authorities noted that inflation could not be lowered permanently unless fiscal discipline were maintained and recent institutional reforms preserved. Safeguarding CBT independence remained critical. Looking ahead, staff cautioned that public debt servicing costs remained highly responsive to short-term interest rates, which could lead to conflict if monetary tightening is required. Continued high primary surpluses, underpinned by credible structural fiscal reforms, were needed to help address these fiscal dominance concerns.

18. Both the CBT and staff agreed that the introduction of formal inflation targeting early in the program would make it easier to achieve the inflation reduction (¶5). With inflation now much lower and shifts in money demand assuming greater importance, the deficiencies in base money targeting were becoming more apparent (Tables 4–5). In response, over the past few years the CBT had adopted a form of implicit inflation targeting. Although formalizing this approach was not without risks, the government’s commitment to sustaining high primary surpluses over the course of the program lent support to such a move, as did the improved condition of the banking system.

Table 4.

Turkey: Monetary Aggregates, 2000–05

(In quadrillions of Turkish Lira) 1/

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In billions of new Turkish lira from 2005 onwards.

Evaluated at current exchange rates, monetary authorities and deposit money banks.

Includes credit to local governments and state economic enterprises.

Evaluated as percent of nominal GNP over previous four quarters.