1. Encouraging results are the basis for continued progress

The implementation of ambitious and coherent policies over the last three years has decisively transformed the performance of the Turkish economy. During this period output grew by almost 26 percent; inflation fell below 10 percent; the net debt to GNP ratio declined by 25 percentage points to 63.5 at the end of 2004. Political stability, orderly economic policy making and responsible management of the public finances have restored confidence of economic agents, allowing interest rates to drop to their lowest levels in decades.

More progress is needed. The authorities are determined to build on their record of success to strengthen convergence with the economies of the European Union. To achieve this goal, the authorities firmly intend to further reduce inflation to low single digits; strengthen public finances; improve the quality of government spending and taxation; make the financial sector more robust and efficient; improve the climate for investment and employment creation; and make the economy more resilient to shocks by strengthening the international reserve position and the competitiveness of the Turkish economy.

To support their reform program, the Turkish authorities are requesting a three year Stand-By Arrangement with the Fund with an access of SDR 6.7 billion. This amount is justified by the balance of payments outlook and the objective of the authorities to substantially reduce the amount owed to the Fund by the end of the program. Since Turkey’s balance of payments justifies continued financial support from the Fund, the authorities request that repurchases falling due in 2007 should not be advanced by one year, as was expected at the outset of the previous arrangement.

2. Reducing inflation to low single digits

Prudent fiscal policies, central bank independence and skillful implementation of monetary policy have been central in reducing annual inflation from 70 percent to below 10 percent. These features will be maintained. The redenomination of the currency by dropping six zeros last January marked the end of the era of high inflation and further enhanced policy credibility.

During the past several years, the Central Bank of Turkey (CBT) has carefully prepared for a formal inflation targeting regime. With inflation now in single digits, public debt burden further declining, and the financial sector substantially stronger, the CBT believes that formal inflation targeting can be successfully introduced in early 2006. The program projects that CPI inflation will drop to 4 percent by 2007.

3. Strengthening Public Finances

Strict control of public finances and debt reduction will continue to be the cornerstone of the strategy. The program aims at reducing the net public debt to GNP ratio by about 10 percentage points to 53.4 percent by the end of 2007. Achieving a primary surplus of 6.5 percent of GNP during the program period is a critical component of this strategy. With interest rates declining steadily, the overall public sector deficit is expected to fall to about 4.5 percent of GNP in 2005 and be well below 3 percent in 2006. By the end of the program, the overall public sector budget could approach a balanced position. Any revenue overperformance will be saved to help contain the current account deficit.

Continued tight fiscal policy will help ensure that interest rates continue to fall and generate the resources needed for investment and growth.

4. Improving the quality of government spending and taxation

Turkey not only needs to restore macroeconomic stability but such stability should also be lasting. In addition, the functioning of the public sector and the economy as a whole must be made more efficient. Enhancing productivity is required for high growth per capita and rapid real convergence with EU countries. Enhancing the quality of government spending and taxation is critical to achieve these objectives.

In 2004, expenditures for personnel and transfers, in particular to social security institutions, represented 78 percent of the non-interest outlays of the public sector. The program aims at reducing this share and correspondingly increased public investment in infrastructure and human capital. Therefore, the government has introduced in Parliament draft legislation reforming the pension and health care systems and the social security administration. Details of this legislation are well explained in the staff report. The pension law will correct the trend of increasing social security outlays by stabilizing the deficit to 4.5 percent of GNP during the program period. In the long run, the pension deficit would be reduced to 1 percent of GNP from 3.5 percent in 2004. In 2006, Turkey will introduce universal health insurance, taking care to ensure that, over the medium-term, its costs will fall below the pre-reform trend.

The government is working with the World Bank on a full review of public expenditures in order to set medium-term spending priorities and improve efficiency in public employment and other public services, including health care and education.

Improving the composition of expenditures is only one facet. Improving expenditure management is another critical requirement for achieving overall effectiveness of the public sector. To this end, secondary legislation to implement the recently enacted “Public Financial Management and Control Law” will soon be adopted. This legislation aims at improving public accountability, including at the local levels, budget preparation and execution, and debt and cash management. The authorities have requested the Fund to update the Fiscal Transparency ROSC for Turkey.

Turkey’s tax system will be greatly improved under the program. At present the tax base is small because of many exceptions. And, because tax rates are high, a large informal economy has grown resulting in low tax receipts, distorted competition, and inhibiting efficiency gain throughout the economy.

The government’s strategy to deal with these weaknesses is multi facetted and will be further developed in the course of the program. Part of the strategy is to strengthen tax administration, inter alia, by establishing a semi-autonomous Revenue Administration, including a large tax payers unit.

The other part is reform of the tax legislation itself, primarily by reducing exceptions, simplifying legislation and reducing the number of tax rates. The corporate income tax regime will be brought more in line with practices in the EU. Financial intermediation taxes will be phased out. The taxation of earnings from financial assets will be harmonized.

5. Making the financial sector more robust and efficient

Banking regulation and supervision has been greatly improved in the past several years. Insolvent private banks have been closed or restructured and recapitalized. There is now considerable interest on the part of foreign banks to invest in Turkish banks. We expect further consolidation in the banking sector, improved competition and financial deepening.

However, recent experience has revealed that several shortcomings remain in the legal and supervisory regime. To address them, a new banking law has been enacted which will bring the legal framework more closely in line with EU standards. The staff report provides the details.

Another key financial sector component of the program consists of actions to strengthen the organization and functioning of the supervisory authorities, including their onsite and offsite supervision.

Lastly, specific strategies will be adopted and implemented to further restructure state banks and prepare them for privatization. These strategies should level the playing field in the financial sector by phasing out special privileges and obligations of the state banks.

To support these reform plans, the authorities have requested a Financial Sector Assessment Program in early 2006.

6. Improving the climate for investment and employment creation

The staff’s background study on Turkey’s potential growth rate shows the huge potential for improving total factor productivity and increasing potential growth rate. The labor participation rate, annual gross fixed capital formation and the level of foreign direct investment in Turkey are lower than in any of the 10 countries that joined the EU last year. At the same time, the growth of Turkey’s working age population is, by far, the highest as compared to these 10 countries. Enhancing Turkey’s fixed capital base and its human resources will unleash a dynamism which is likely to make the Turkish economy grow faster than any EU country over an extended period of time. Indeed, this is required to achieve meaningful real convergence during the next decade.

Enhancing the investment climate requires a comprehensive set of actions, many of which go beyond the core mandate of the Fund. But taken together, they are critical to ensure growth and lasting macrofinancial stability.

These include measures to improve the efficiency of the judicial system, streamlining administrative procedures, and adopting EU standards and regulation. There is no doubt that action in these fields will be greatly stimulated by the negotiations on EU accession in the coming years. It is heartening that since the decision of the EU council on December 17, 2004 to start these negotiations, the confidence of investors, both domestic and foreign, has indeed improved. The authorities are well aware that, in this area, efforts will have to be long lasting and comprehensive in nature. They are determined to conduct this process professionally, while seeking technical support from the European authorities, other EU member states, the Fund and the World Bank.

7. Making the economy more resilient to shocks

All the actions outlined above will greatly enhance the flexibility of the economy and the confidence of investors. By reducing the interest burden on both public and private debt, and by lengthening the maturities, the government and other economic agents will greatly reduce their roll-over risks. Most important, increased foreign direct investment and long –term portfolio investment will put the financing of the current account deficit on a much sounder footing.

In this climate of enhanced confidence and credibility, the central bank plans to strengthen its net international reserves during the program. In the same vein, the Treasury’s public debt management will aim at further lengthening the maturity of new domestic debt issues, increasing the Treasury’s cash position, help foster the development of a domestic capital market, and broaden the investor base for government paper in domestic currency. These developments will gradually reduce the vulnerability of the public finances to interest- and currency risk.

8. Financial Support by the Fund

The authorities are well aware that the level of financial support provided by the Fund has been exceptionally high. However, their determined implementation of the program and the intense cooperation with the staff has made this support highly effective and successful. The main cause of Turkey’s high financial need, three years ago, was the extreme deterioration of its public finances. Reversing such a situation while remaining current on the existing debt requires a prolonged period of sustained fiscal discipline and comprehensive reform in the economy. For Turkey, this period clearly exceeds the normal repurchase period of a Stand-By Arrangement. The authorities are, therefore, requesting a three year successor arrangement with an access level that enables Turkey to avoid a situation in which reserve coverage would fall to dangerously low levels and roll-over rates of domestic debt would become uncomfortably high. At the same time, the Fund’s current exposure to Turkey will halve by the end of the three year program. Moreover, the strength of the program and Turkey’s proven ability to implement an ambitious program, provide adequate safeguards to the Fund. The authorities are committed to treating the arrangement as precautionary, should the balance of payments turn out significantly stronger than expected.

In order to ensure robust access to financial markets, the authorities are committed to maintaining a high level of transparency about economic developments and policies, according to best practices. Turkey adheres to the SDDS and the Fund’s standards for transparency of monetary and fiscal policies. The central bank will further enhance transparency of monetary policy as part of its inflation targeting framework. Finally, the authorities are committed to publish the letters of intent and memoranda of economic and financial policies in support of their SBA and consent to the publication of the staff reports.