Abstract
Although Turkey’s economic performance has been strong, growing external imbalances exposed the country to a reversal of sentiment. In the wake of recent market turbulence, the authorities have recommitted to strong policies and stepped up program implementation. The authorities’ commitment to tighter fiscal policy will help preserve market confidence and resume disinflation. These delays are wide ranging, including on the landmark pension reform, tax reform, bank supervision, and state bank privatization. Political developments added to market concern, and discussions focused on the appropriate monetary policy response.
The staff appraisal is fair and balanced. Turkey’s economic policies under its Fund-supported program have considerably strengthened the fundamentals of the economy and its resilience to shocks. High growth, rapid disinflation, declining public and external debt burdens, and a significant increase in foreign direct investment, all are proof of and reward for a track record of good policies. Yet, the widening current account deficit, some delays in implementing structural reforms and political developments, both in Turkey and abroad, explain why the economy has been hit harder than the economies of other emerging market countries during the recent episode of tightening global liquidity conditions.
Turkey is well on its way to overcome the consequences of the recent excessive market volatility, thanks to the enhanced resilience of the economy, adequate policy responses, and the country’s firm adherence to the Fund-supported program.
The floating exchange rate regime, the much higher level of external reserves, the improved debt situation and the soundness of the banking sector, are the foundation for maintaining market confidence. To bolster this confidence, restore strong economic performance and return to the path of disinflation, monetary and fiscal policies have been tightened and structural reforms reinvigorated.
Market reactions to these policy actions have been favorable. The current account deficit, a significant source of vulnerability, is expected to shrink in the medium term as domestic demand slows, and in response to the recent exchange rate adjustment. Moreover, not least because of much larger FDI inflows – USD 8.1 billion so far this year, and expected to reach at least twice that amount next year – the financing of the current account deficit is now on a sounder footing than it was before.
It is encouraging that the recent Investment Advisory Council, which took place after the recent market fluctuations, confirmed that major global investors continue to see Turkey as a profitable investment location. It is clear to all that Turkey’s economic prospects would remain bright, if appropriate policies are maintained. With this goal in mind, the Turkish authorities request the continued support of the Fund for their policies as outlined in their Letter of Intent of July 7, 2006. We would like to summarize these policies and expand on a few topics.
Fiscal policy
The authorities regret that – contrary to projections - the end-2005 fiscal targets were missed because of unexpected deficits in the social security system and state enterprises.
The root cause of the weakness of the social security system has now been addressed with the implementation of the recently enacted social security reform. Moreover, in Turkey, as in many other countries, health spending is a source of cost overruns that the country is now addressing with a wide spectrum of measures to rein in spending at hospitals and on pharmaceuticals. The Universal Health Insurance scheme, to be introduced in 2007, will also help to make the system more cost efficient and sustainable.
The government is committed to save any revenue overperformance during the remainder of 2006. A firm ceiling on the central government’s primary spending will be respected. To bolster market confidence further, the government proposes that adherence to the latter fiscal policy intention be a performance criterion under the SBA. The government is confident that under its strengthened fiscal policy the primary surplus at the end of this year will be more than the original target of 6.5 percent of GNP.
Fiscal Structural Reforms
The new social security law is a milestone designed to ensure lasting fiscal discipline in an area plagued with inefficiencies. Both the parametric pension reform and the administrative overhaul of the social security address the financial sustainability problems of the system.
This major reform will be complemented by smaller administrative measures such as paying wages through the banking system in order to enhance efficiency and reducing the unrecorded portion of the economy.
Making the tax system more efficient is a major goal of the government. In order to be efficient, the tax system must yield the desired level of revenues with minimal or no economic distortions. As part of this strategy, the corporate income tax rate has been reduced from 30 percent to 20 percent while total revenues have been preserved by broadening the tax base, inter alia, by eliminating the investment tax allowance.
In tandem with the corporate tax reform, the forthcoming reform of the personal income tax aims at introducing a simpler system by reducing tax brackets and replacing consumption credits with a standard credit.
A functional reorganization of the Tax Administration will enhance flexibility and efficiency and should contribute to better tax compliance.
Monetary Policy
Recent price developments suggest that the end-year inflation target will be missed. However, the medium-term inflation targets remain realistic. High international oil and gold prices and the stickiness in the services sector have increased inflationary pressures. The pass through of the recent correction in the exchange rate will also have its impact.
The Central Bank’s response to recent market developments has proved effective. After increasing its policy interest rates by a cumulative 400 basis points, another 25 basis points increase was announced after the Monetary Policy Committee meeting of July 20, 2006. The interest rate hikes were accompanied by open market operations to mop up excess liquidity.
In its communications, the Central Bank of Turkey (CBT) continues to emphasize its commitment to both inflation targeting and the floating exchange rate regime, as well as its readiness to tighten monetary policy as necessary to ensure that inflation converges back to the medium-term target.
The policy actions of the CBT are expected to ease inflationary pressures. However, the CBT remains cautious because of rising oil and other commodity prices. Developments in international liquidity conditions and domestic demand, as well as the pricing behavior of businesses and public sector wage developments will all be considered when shaping the CBT’s monetary policy.
Financial Sector
After five years of comprehensive reforms, the financial sector is now on a broadly sound footing. The new Banking Law ensures more efficient supervision, inter alia, by allowing on-site and off-site supervision to be merged, and by a reorganization of monitoring activities. Even so, the recent market turbulence is a reminder that prudent bank management and close and effective supervision are needed at all times.
The Turkish banking system is now much more resilient to external shocks because of stronger balance sheets, higher capital adequacy ratios, limited open foreign currency positions that respect prudential limits, low levels of non-performing loans and supervision on a consolidated basis. The authorities are well aware of the sources of vulnerabilities in the banking sector. They include the recent rapid credit expansion, maturity mismatches and, to a lesser extent, the potential impact of currency risk on the corporate sector. The Banking Regulation and Supervision Agency (BRSA) increased its supervision activities in the wake of recent market developments. Strict monitoring, close dialogue with the banks and improved transparency are key factors to keep the sector under control.
Debt Sustainability
Monetary tightening in advanced economies has led to a reassessment of emerging market country risk and a reallocation of portfolio investments. It resulted in capital outflows from emerging market countries. Shifting portfolios from equities to fixed income and money market instruments triggered a sharp fall in emerging market asset prices. Fortunately, Turkey’s debt indicators had improved more than envisaged in the program and the debt to GNP ratio has declined significantly over the last 5 years. Reduced and better structured public debt and a comfortable financing position, thanks to the Treasury’s cash account at the CBT, are safeguards for debt sustainability. Nonetheless, recent developments may temporarily halt the downward trajectory of debt. Privatization proceeds and asset recovery revenues of the Saving Deposits Insurance Fund (SDIF) exceed 3 percent of GNP which help mitigate the effects of the recent market volatility. The authorities remain convinced that achieving high primary fiscal surpluses during the last 4 years was the most important factor that reduced the debt-to-GDP ratio. Fiscal prudence will, therefore, continue to be the main policy tool to improve the debt dynamics further.