1. Macroeconomic Performance

With 5 percent output growth, the economy has continued to expand, but at a more sustainable pace. In the last four years, the cumulative increase in labor productivity was 35 percent. Higher total factor productivity will have a major impact on Turkey's growth potential in the coming years.

Inflation expectations declined significantly. Recent market surveys suggest that end-year inflation will be below 8 percent. For the third year in a row, inflation would be better than the program target.

This year's current account deficit is expected to reach 6 percent of GNP, mainly because of high oil prices. This deterioration is a concern, and the authorities are aware of its risks and are monitoring developments carefully. So far, net capital inflows have exceeded the current account deficit. Structural changes in the economy, particularly in production, contributed to the behavior of the current account. Total domestic investment is on an upward trend because of prudent policies. Trade data suggest that raw material and intermediary goods constitute the bulk of Turkey's imports. This is partly due to the fact that imports of some intermediary goods became cheaper with the appreciation of the Turkish lira. However, data also indicate that industries have been stock piling these goods.

2. Fiscal Consolidation

The 2006 budget aims at a primary surplus for the general government of 6.6 percent of GNP, excluding the expected profits of the recently privatized Turk Telecom and Tupras, which amounted to 0.2 percent of GNP last year. Thus, compared to previous years, the fiscal stance has been tightened, inter alia in response to the growing current account deficit.

Because of a lower public sector borrowing requirement and a projected decline in interest rates, the overall deficit of the 2006 budget is expected to drop below 1 percent of GNP. And, because this year's budget is for the first time part of a three-year medium-term fiscal framework, fiscal policy will gain predictability and credibility.

3. Fiscal Structural Reforms

The approval of legislation introducing universal health insurance and making parametric changes to the pension formula across occupational groups is facing delays, mainly because of the summer recess of Parliament and the need to extend consultations to ensure broad public support. To this end, the government has started discussions about major aspects of the reforms with all social and political partners. One strong outcome of these discussions was that all parties have agreed on the need for a reform of the social security system. Parliament will resume discussions of the social security reform legislation after the adoption of the 2006 budget.

To contain the social security deficit, last October the government submitted to Parliament a draft legislation for improving the collection of social security contributions. In addition, lump-sum budgets for the state hospitals, and improved auditing and payment mechanisms will help better control health care spending, which is one of the major causes of the social security deficit.

In June 2005, the new legislation restructured the tax administration as part of larger tax reforms aimed at widening the tax base, reducing the informal economy and improving the business climate. With these objectives, the government recently announced the reduction of the corporate income tax (CIT) rate from 30 percent to 20 percent. Changes in the personal income tax (PIT) include the elimination of the top rate of 40 percent and the merger of the different taxation schemes for wage and non-wage personal income. To offset the costs of these reforms, investment incentives have been abolished in CIT and the tax brackets in the PIT have been aligned, making the tax rate reductions possible without compromising overall fiscal objectives.

4. Monetary Policy

The relatively low levels of inflation, the assurances of fiscal discipline and the completion of the technical work have allowed the central bank to pursue formal inflation targeting from 2006 onwards. This will provide a reliable nominal anchor and further enhance the credibility of the central bank's commitment to price stability.

The central bank closely monitors the exchange rate behavior and smoothes excessive volatility with preanounced exchange purchase auctions. The ample capital inflows have allowed the central bank to build international reserves to a comfortable level without compromising the commitment to the floating exchange rate regime.

5. Financial Markets

The rehabilitation of the banks, comprehensive reforms in the financial sector and the reduction of the public borrowing requirement have resulted in a large increase in bank credit, mainly for housing. Even so, the volume of housing loans in Turkey is still very low compared to other countries with similar income levels. The significant decline in long-term interest rates will further support the credit expansion and domestic demand. Needless to say, the authorities are closely monitoring these developments in order to ensure monetary and financial stability.

With the — delayed — enactment of the new banking law, banking supervision will be further improved. The Banking Regulatory and Supervisory Authority (BRSA) should soon adopt the needed secondary legislation and adjust its operations according to best practice.

The Savings Deposit Insurance Fund (SDIF) has sold assets acquired from closed banks for US$ 5 billion. This significantly reduces the burden of the financial costs on the government of the recent banking crisis.

6. Privatization and FDI

This year a number of large public enterprises were sold and, so far, privatization receipts amount to US$ 3.2 billion. Strong foreign interest in these enterprises reflects confidence in Turkey's macroeconomic stability. Privatization will continue with Turkish Airlines and Petkim — a petrochemical company — next on the list.

The negotiations for the EU accession will result in further improvements for foreign and domestic investment. Because of its relatively low labor cost and the improved institutional framework and business environment, Turkey has significant potential of attracting large volumes of foreign direct investment (FDI). In the first nine months of 2005, FDI reached US$ 2.8 billion. This is encouraging in light of the past experience, but admittedly still low when compared with other emerging-market countries. We are confident that FDI will become a major source of international capital if Turkey maintains macroeconomic stability and implements further reforms to ensure a favorable business environment.

Although public investment is recovering, its current level, particularly in infrastructure, is still insufficient to support robust growth over the medium term. Given the limited room in the budget to boost public investments, the authorities will work toward better prioritization and rationalization of investment expenditures.

7. External Vulnerability and Debt Management

In recent years, the historically low interest rates in advanced economies have caused global funds to flow into emerging-market economies, particularly those with improved policies. We concur with the staff that reversal of this trend could cause fluctuations in financial markets. Hence, monetary policy should be conducted with vigilance and the debt management strategy should be forward-looking. The authorities' medium-term debt management strategy aims at lengthening maturities and reducing vulnerability to interest and exchange rate shocks. The current favorable economic outlook provides a welcome opportunity to advance more rapidly towards these goals.

Improved macroeconomic fundamentals have increased the resilience of the economy to external shocks. The prominent role of the private sector, strong productivity growth, sustained high output growth and continued fiscal consolidation, all are part of a virtuous circle of lower interest rates, output growth, buoyant tax revenues and sound public finances.