The staff report for the 2007 Article IV Consultation highlights Turkey’s economic revival and policies to entrench macroeconomic stability. Turkey has experienced an impressive economic revival in recent years. Exports have continued to gain market shares, as the effects of an appreciating currency have been largely offset by productivity gains. Executive Directors considered that Turkey needs to manage vulnerabilities carefully and address structural challenges to increase the economy’s growth potential and resilience to shocks.
In the last five years economic management in Turkey has been successful. The policy anchors provided by the IMF supported programs and by the EU accession negotiations have been very helpful. The Turkish authorities are grateful for the close collaboration with Fund staff and for the support shown by Management and the Executive Board.
Fiscal consolidation and reforms to improve economic governance and investment conditions have transformed the Turkish economy. Public debt has been significantly reduced, as has been inflation. Confidence increased and risk premia dropped. Investment by residents and foreigners has been buoyant and GDP growth strong and sustained.
Encouraging as these developments have been, remaining challenges must be addressed. Turkey’s ambition is to achieve rapid real convergence with income levels in the European Union. This requires preserving and strengthening macroeconomic stability and further transforming the economy to effectively use all its resources and boost productivity.
Current Account Deficit
The authorities are closely monitoring developments in the current account. The deficit which stood at 7.9 percent of GDP in 2006, is projected to narrow from this year on. During the last four years Turkey’s production sector has started using more imported technological and intermediate goods. This led to increased imports, but also helped increase exports. Since last year, export growth in volume terms has exceeded that of imports. Staff projects that from this year onwards, export growth will outpace import growth in both volume and value terms.
When assessing the current account position we should of course not neglect how the deficit has been financed. Developments in this regard have been positive since FDI now covers half of the deficit. The remainder is increasingly financed by credit to the export industry. Thus, both the dynamics of the current account and its financing provide reason for confidence. Nonetheless, the authorities are committed to take any necessary measure if the current account were to worsen.
Continuing fiscal prudence and maintaining a high primary surplus is the main policy anchor for the Turkish economy. Fiscal performance during the last four years has been outstanding, with an average public sector primary surplus of 6.5 percent of GNP. The authorities are determined to preserve their hard-won credibility with respect to fiscal discipline.
In 2006 the primary surplus was 6.6 percent. Although this is exemplary by any standard, it fell 0.7 percentage point short of the revised program target. Nonetheless, this outcome did not hamper any program objectives, as is evidenced by the continuous decline in the net public debt ratio which is now 45 percent of GNP, well ahead of the program projections. The authorities would therefore like to request a waiver for missing the relevant performance criterion.
As pointed out, fiscal rigor remains a pillar of the government’s program. For 2007, the primary surplus is targeted at 6.7 percent. To secure this outcome the authorities have taken fiscal measures equivalent to 0.83 percent of GNP, to offset both the 2006 expenditure overrun and the slippages in the first quarter of 2007. The authorities are keen to adhere to fiscal discipline despite the elections scheduled for July 2007.
Fiscal policy is of course not limited to expenditure measures. Important steps have been taken to reduce tax rates while broadening the tax base. An autonomous Revenue Administration was established including a large tax payers’ unit. The problem of staffing this unit has been addressed by appointing 37 auditors. As a result, revenue collection is expected to improve.
The Constitutional Court has annulled some provisions in the new social security law. In response, the government has decided in favor of a modified reform which respects the constitutional ruling while preserving the main elements and the estimated savings of the original reform. These new proposals will soon be published in a White Paper and the reform is expected to be implemented by mid 2008.
After 30 years of high inflation, Turkey has succeeded in reducing inflation to slightly below 10 percent. Reducing inflation further has been difficult. In April 2007, consumer prices rose by 1.21 percent, and year-on-year inflation reached 10.72 percent. Price stickiness in the services sector and prices for energy and unprocessed food largely explain developments in the overall price level. And although the pass-through of the exchange rate depreciation in spring 2006 has moderated, some lagged effects still persist. The disinflation process is expected to continue in the coming months, converging, by the second quarter of 2008, to 4 percent as the mid-point of the targeted range for inflation.
The tight monetary policy stance was maintained during the first quarter of 2007 because of prevailing uncertainties in the global economy, and uncertainties regarding the lagged effects of monetary tightening. The delayed impact of the tight monetary policy stance on domestic demand suggests that demand conditions are critical for disinflation.
There are several risks to the disinflation process, such as backward looking price setting and stronger than expected inflation inertia, including the stickiness of inflation expectations. Nonetheless, the CBT is confident that inflation expectations will come down gradually as the headline inflation eases. The CBT signals that it will keep its cautious monetary stance for an extended period.
The CBT continued its preannounced daily foreign exchange buying auctions in the first quarter of the year in order to absorb the excess foreign exchange supply. Gross reserves now exceed 15 percent of GNP.
The 2005 banking law has brought the supervisory framework up to best international practices. In the last four years, prudential regulation and supervision have been significantly upgraded. Supervision is conducted on a consolidated basis. Weak banks have been restructured, recapitalized, merged or closed. Public banks have been restructured both financially and operationally. Capital adequacy ratios are now among the highest in emerging market countries. Open foreign currency positions are well within prudential limits. The level of non-performing loans is low.
The Turkish authorities found the recent Financial Sector Assessment Program highly useful. Its recommendations have been considered carefully and some have already been implemented, including raising required general provisions, strengthening the minimum capital adequacy ratio, issuing inflation indexed debt and adopting a mortgage credit law.
The entry of foreign financial institutions in Turkey is strengthening competitiveness and improving management practices. Credit growth is very high, considerable financial deepening being under way. Obviously, banking supervision will need to keep up with new developments and constantly update its capacity, in-step with developments in the financial sector.
A New Mortgage Credit Law
The recently adopted mortgage credit law will contribute to the expansion of housing credit. It also provides for improved monitoring of financial sector developments. The authorities did not favor tax incentives for mortgage loans as this could have been both costly for the budget and a source of distortion in the housing market.
The public share offering of 25 percent of Halkbank, the second largest state-owned bank, yielded US$ 1.80 billion. The sale shows confidence in the robustness and prospects for the Turkish economy in a critical election year. With this sale Turkey complied with a prior action for the completion of this review. These results will certainly be carefully evaluated when planning the next steps for privatizing state banks.
Increasing the Role of the Private Sector and Improving the Business Environment
A wide range of measures has been taken to enhance the role of the private sector and improve the investment climate. This would further improve medium-term growth and employment prospects. Various legislative changes have been made in key sectors with a view to increasing market efficiency. To this end, the energy, telecommunications and tobacco sectors have been deregulated.
Reforms have significantly improved the investment environment. A key achievement has been limiting bureaucracy. The time required to register a company is now less than one week. In many cases the formalities can be processed in one day, well below the OECD average.
The improved FDI regime was reflected in some recent highly successful large privatizations. In the last three years, Turkey attracted almost US$ 33 billion FDI, of which a record US$ 20.2 billion in 2006 alone. In the first quarter of 2007, FDI was US$ 9.2 billion. Turkey’s international direct investment base is growing very fast. More than 15,000 companies with international capital are now operating in the country.
Labor Market Reform and Employment
Although the level of unemployment has remained unchanged for the last couple of years, the number of employed has been increasing. The economy has been going through a transformation, with a shift from agriculture to services and industry. While it was the dominant sector in the past, the number of people working in agriculture is now shrinking rapidly.
However, Turkey needs to improve labor market flexibility if the recent strong growth performance is to absorb unemployment. A strategy to achieve this goal will be developed in consultation with the Fund staff and consistently with the fiscal framework.