Turkey has made significant progress under its Fund-supported economic program. It is true that the volatility in financial markets last spring affected Turkey more than some other emerging-market economies. However, improved economic fundamentals, credibility built up during the past few years and prompt policy action all ensured that this volatility was short lived. The most significant remaining effects of this episode are an overshooting of the inflation target and higher interest rates. Growth bounced back and is now projected to be 6 percent this year, 1 percentage point above the program target. Medium-term prospects have also been strengthened as the authorities remain committed to prudent macroeconomic policies and to accelerate structural reforms.

With lower private sector investment and slowing of credits due to the higher interest rates, real growth should be close to the potential rate of 5 percent next year.

The current account deficit for 2006 is now projected to reach 8.5 percent of GNP, as against the 6.5 percent stated in the program. The authorities and the staff are carefully analyzing the factors behind this increase. Structural transformation of the Turkish economy and the rapid growth of household consumption and private investment have been identified among the major causes. Another significant cause is the rising energy prices. Indeed, the non-oil current deficit is only 2.2 percent of GNP. Energy imports now represent 7.3 percent of GNP against 4.7 percent in the years 2003—04.

The composition of the current account deficit is now significantly different from that in the period before the 2001 crisis. At that time, both investment and domestic savings were low because of loose fiscal policy. However, today public savings have increased dramatically as a result of tight fiscal policy over the past five years, while private investment has also gone up significantly. Moreover, the financing of the deficit has improved markedly. Mergers and acquisitions in various sectors, privatization and favorable international borrowing conditions have helped Turkey secure a record level of capital inflows. Foreign Direct Investment flows are estimated to reach US$ 18.3 billion in 2006. This trend is expected to continue with more green-field investments, as structural reforms steadily improve the investment climate in Turkey.

Strong fiscal performance was sustained in 2006. Collection of tax arrears and of other receivables resulted in a significant revenue over performance. The government is committed to saving this windfall gain but must acknowledge some expenditure overruns in the social security sector. However, on balance, this year the consolidated fiscal sector may reach a primary surplus of about 7.5 percent and the overall fiscal balance may be slightly positive for the first time in many years.

In 2007, fiscal discipline will continue to be the main pillar of macroeconomic policies. The authorities are committed to maintain a primary surplus of 6.5 percent of GNP in 2007 for the fifth year in a row. The draft budget, which is consistent with this target, has been submitted to Parliament. This signals the authorities’ strong adherence to fiscal prudence even in an election year.

The sources of expenditure overruns in 2006 have been identified and actions have been taken to contain expenditure increases, including in the health care sector. These measures will have positive effects on the 2007 budget as well.

The authorities are focusing on improving the quality of fiscal adjustment and making the progress of the past years sustainable. Their strategy focuses on enhancing the efficiency of public expenditures, including growth-enhancing investment. The recent social security reform is a centerpiece of this strategy. Its administrative implementation is well advanced. The government is preparing a civil service reform that will address the deficiencies in the system. Investment decisions will be carefully prepared.

The tax system will be made more efficient by broadening the tax base and reducing distortions and inequities associated with the existing system. A second phase of the personal income tax (PIT) reform has been submitted to Parliament. This reform will improve the efficiency of the PIT and reduce the cost of tax collection. The costly and ineffective repayment of VAT for some selected private consumption will be replaced by standard credit and income tax reductions for spouses and children. A real estate capital gains tax will be introduced.

The authorities are keen to eliminate distortionary taxes, particularly in the banking sector. However, fiscal constraints prevent them from acting more quickly. If revenue over-performs in 2007, the government might be able to phase out the Banking Transaction and Insurance Tax in the second half of the year.

The Central Bank of Turkey (CBT) continues to target an inflation rate of 4 percent for 2007 and beyond. The recent data confirm that aggregate demand continues to slow-down. While private sector demand indicators show a significant slowdown, foreign demand remains relatively strong. Supply shocks for certain goods, the stickiness in service sector prices, and the uncertainties in the global economy are major contributors to the inflationary trends in Turkey. Therefore, the CBT would maintain a tightening bias until inflation shows a clear sign of abating. The CBT closely monitors the lagged effects of monetary tightening and considers the potential impact of recent developments in incomes policy and non-interest public sector expenditures on inflation and inflation expectations. The CBT will take any action needed to keep inflation in check.

The CBT is improving its communication strategy, which is crucial for reflecting the authorities’ policy stance and enhancing the credibility and effectiveness of monetary policy. During the period of volatility last spring, the flexible exchange rate regime served Turkey well. It supported the inflation-targeting framework and helped cushion exogenous shocks.

On November 10, 2006, the CBT resumed foreign exchange buying auctions in order to build up international reserves. These auctions had been suspended last May. Their resumption now should boost confidence in the current economic program. This policy of building up reserves is justified by the still high level of short-term debt and with the aim of gradually reducing the amount of the so-called “Dresdner accounts”. These accounts are high-interest rate deposits made by Turkish workers abroad with the CBT.

Under the floating exchange rate regime, the CBT does not target any exchange rate. Carrying out pre-announced fixed amount auctions should minimize the effects on supply and demand conditions in the foreign exchange market or on the level of the exchange rate, while achieving for a moderate increase in reserves.

The soundness of the financial sector has strengthened significantly. The Turkish banking sector was able to weather well the latest market turbulence, despite the capital outflows and a sharp increase in interest rates which accompanied the currency depreciation. The Banking Regulation and Supervision Agency (BRSA) is closely monitoring developments in the sector and taking the appropriate measures. General provisioning requirements for new loans have been doubled.

The decision of the Privatization High Council to sell the state-owned Halkbank was suspended by the High Administrative Court because the needed parliamentary authorization may be missing. However, the government remains strongly committed to selling Halkbank and has, very soon after the court’s ruling, introduced in parliament a new draft law authorizing the sale of Halkbank. The authorities are confident that the tender process of Halkbank would still be completed by end May 2007.