Turkey
Selected Issues

This Selected Issues paper on Turkey reviews a decline in private saving and adoption of a fiscal rule. As economic confidence has improved, capital inflows have surged while private saving has fallen. Together, these developments have produced current account deficits and a strong lira, raising concerns that Turkey may be exposed to sudden reversals in investor sentiment. A fiscal rule with appropriate mechanisms to monitor its compliance should deliver predictable policies, thus allowing further reductions in debt and risk premiums, thereby contributing to macroeconomic stability.

Abstract

This Selected Issues paper on Turkey reviews a decline in private saving and adoption of a fiscal rule. As economic confidence has improved, capital inflows have surged while private saving has fallen. Together, these developments have produced current account deficits and a strong lira, raising concerns that Turkey may be exposed to sudden reversals in investor sentiment. A fiscal rule with appropriate mechanisms to monitor its compliance should deliver predictable policies, thus allowing further reductions in debt and risk premiums, thereby contributing to macroeconomic stability.

I. Introduction

1. Turkey has enjoyed a remarkable economic track record since the 2001 crisis. Disciplined fiscal and monetary policies have produced a stable macroeconomic environment (including sharp reductions in inflation and the government debt ratio), which in turn has facilitated brisk growth, stronger bank balance sheets, and surging FDI.

2. However, this success has brought new challenges, several of which are studied in this paper, including by borrowing from other country experiences. As economic confidence has improved, capital inflows have surged while private saving has fallen. Together, these developments have produced current account deficits and a strong lira, raising concerns that Turkey may be exposed to sudden reversals in investor sentiment. At the same time, the environment for economic policymaking is evolving: (i) rapidly falling debt ratios may require a new fiscal anchor to replace the current 6.5 percent of GNP primary surplus target; and (ii) ongoing financial deepening is strengthening the monetary policy transmission mechanism. Improved confidence and financial liberalization (especially the recently approved mortgage law) have also laid the groundwork for rapid credit expansion, which should promote growth, but also create challenges for supervisors. This paper explores these developments and suggests possible policy responses.

3. chapter II uses time series analysis to examine a driving force behind the high current account deficits—the sharp fall in the private saving rate since 2001. The chapter finds that this fall has partly been in response to higher public saving and increased consumer confidence in the context of falling inflation and macroeconomic stabilization. The findings suggest that the private saving rate may recover somewhat in the coming years, as Turkey continues to make progress in raising income levels. However, higher domestic saving (public plus private) could also be actively promoted to reduce dependence on volatile foreign saving. Continued fiscal discipline and pension reform are the most promising avenues in this regard.

4. Chapter III discusses whether Turkey’s fiscal policy framework needs to be adapted over the medium term. In Turkey’s case, the chapter suggests that a fiscal spending rule may be particularly helpful in anchoring fiscal policy around the medium-term objectives of reducing debt and creating fiscal space for growth-enhancing tax cuts—although deficit-based rules also have some advantages. To be effective, any rule needs to be accompanied by improvements in public financial management to ensure proper monitoring and enforcement.

5. Chapter IV assesses whether the bank lending channel has become a significant source of monetary transmission as financial intermediation deepens. The bank lending channel refers to the adverse effect of higher interest rates on bank loan supply (due to restricted liquidity), which can be distinguished from the standard monetary channel of a demand-driven decline in bank loans due to higher interest rates. The chapter examines the importance of this effect in Turkey using the exogenous shock of the May-June 2006 financial market turbulence and the associated monetary tightening. It finds that less liquid banks were more likely to reduce their lending in response to the interest rate shock, suggesting that a bank lending channel was at play. The central bank may thus wish to consider banks’ liquidity conditions in judging the expected impact of any given interest rate change.

6. Chapter V analyzes how the recently adopted mortgage law and the emerging mortgage market may affect Turkey’s economy. Drawing on international experience, it notes that mortgage markets can support long-run growth and deeper financial intermediation. However, they can also affect macroeconomic management by reinforcing cyclicality and contributing to swings in asset prices. The introduction of adjustable rate mortgages may also strengthen the effect of interest rate changes on economic behavior. The challenge for policymakers is thus to incorporate such changes into their policymaking and ensure proper regulation of the mortgage market so as to minimize macroeconomic and financial risks.

7. A key theme that emerges from staff research is the need to continue strengthening Turkey’s monetary, fiscal, and regulatory institutions. Much progress has been made in this regard in recent years. Continued reform will pay significant dividends in terms of bolstering Turkey’s resilience to shocks, entrenching macroeconomic stabilization, and raising living standards.

Turkey: Selected Issues
Author: International Monetary Fund