2012 Article IV Consultation

This report for the 2012 Article IV Consultation with Turkey discusses the macroeconomic conditions after the 2008 global financial crisis. After two years of rapid growth, the economy has slowed and imbalances are unwinding. However, owing to slower domestic demand, the Turkish financial system continues to remain sound. IMF staff supports the authorities’ fiscal objective for 2013 and also the medium-term fiscal plan for 2013–15. But, they recommend a tighter monetary policy stance given the upside risks to inflation.


This report for the 2012 Article IV Consultation with Turkey discusses the macroeconomic conditions after the 2008 global financial crisis. After two years of rapid growth, the economy has slowed and imbalances are unwinding. However, owing to slower domestic demand, the Turkish financial system continues to remain sound. IMF staff supports the authorities’ fiscal objective for 2013 and also the medium-term fiscal plan for 2013–15. But, they recommend a tighter monetary policy stance given the upside risks to inflation.


1. Strong buffers and a prompt policy response to the 2008 global financial crisis helped Turkey recover quickly. Prior to the crisis, the Turkish authorities revamped the policy framework and gained policy space, used at the outset of the crisis. The policy response, the normalization of global financial conditions, and Turkey’s fundamentals—low public sector debt, single-digit inflation, the banks’ healthy balance sheets, and favorable medium-term prospects—resulted in a strong recovery, attracting sizeable capital inflows.

2. However, weak coordination of macroeconomic policies resulted in a slow reversal of the stimulus when the recovery materialized. The delay in implementing coordinated counter-cyclical policies allowed for a credit-fueled domestic demand boom to take hold. This pushed inflation to double digits and widened the current account deficit to 10 percent of GDP (the second largest in the world in dollar terms) in 2011, exposing Turkey to the risks of capital flow reversal at a time of continued global uncertainty.

3. After two years of rapid growth, the economy has slowed and imbalances are unwinding. Domestic demand started to decelerate decisively on the back of tighter macroeconomic policy from the summer of 2011 onwards, coinciding with the deterioration of the external environment. Exports have held up better than expected, with robust trade with the MENA region offsetting weak demand in the EU. The economic slowdown has allowed for a narrowing of the positive output gap and an improvement in the current account deficit and inflation.

  • The immediate challenge is to further reduce the risks presented by the external imbalance. External financing needs will hover above 25 percent of GDP and continue to pose a significant vulnerability; in particular, due to the dependence of banks on short-term foreign borrowing, which in the face of an abrupt disruption to capital inflows could lead to a credit contraction and economic hard landing. At the same time, low interest rates in advanced economies could lead to strong capital inflows and the re-emergence of a domestic demand boom that would reverse the unwinding of imbalances. Such an environment requires navigating a very narrow policy path: maintaining the flexibility to respond in case domestic demand weakens further, while giving priority to reducing the current account deficit and inflation.

  • In the medium term, Turkey must address its low savings in order to reduce dependence on external financing. Tackling the competitiveness gap and improving the policy mix to mitigate real cycles will be crucial toward this end. With a current account deficit norm of around 3 percent and the actual deficit 2–4 percentage points of GDP above what can be explained by fundamentals and desired policy settings, the real exchange rate appears overvalued by some 10–20 percent. The low savings rate, around 14 percent of GDP, results in a sharp pro-cyclicality of investment linked to the availability of external financing, with major consequences for the volatility of output. Better integrating monetary, fiscal, and macro-prudential frameworks would help smooth the cycles through future episodes of capital inflows and maintain financial stability.

4. The Justice and Development (AK) Party continues to dominate the political landscape. It holds a comfortable majority in parliament, helpful in enabling the government to proceed with its legislative agenda. The adoption of a new constitution, possibly to include a strengthened presidential system, is one of the major ongoing institutional issues. Foreign policy concerns loom large, notably the conflict in neighboring Syria. Turkey will enter an extended electoral period in 2013, with municipal elections expected in late 2013, a Presidential election in 2014, and parliamentary in 2015.


A. Recent Developments

5. The economy has cooled off considerably on the back of slower domestic demand. Real GDP growth decelerated to 2.9 percent in 2012Q2 (compared to 9.1 percent a year earlier). In the first half of 2012, real domestic demand contracted by 1.9 percent y-o-y after growing by 15.4 percent in 2011H1, with the deceleration led by private consumption and investment. Net exports became the main driver of growth as imports declined and exports held up despite weak demand in the traditional European markets due to diversification to Middle East and North Africa (MENA) countries.1 Despite the deceleration in economic activity, unemployment fell below 9 percent, a ten-year low.


GDP growth

(SA, 2005Q1 = 100)

Citation: IMF Staff Country Reports 2012, 338; 10.5089/9781475545067.002.A001

Sources: Haver and IMF staff estimates.

6. The deceleration is the result of both policy tightening and exogenous factors. Provisioning requirements and risk weights on general purpose loans were increased in June 2011, while the authorities used moral suasion to guide banks towards an implicit nominal credit growth target of 25 percent for end-year.2 In the last quarter of 2011, euro area related turbulence and uncertainties over the domestic policy framework led to a reversal of capital flows, forcing the CBRT to tighten monetary policy considerably, increasing short-term market rates by 5 percentage points and selling 15 percent of its FX reserves to defend the lira. Tighter monetary policy and credit standards more than outweighed still-rapid public spending growth, seeding the deceleration in consumption and investment, with annual credit growth declining from 35 percent in 2011H1 to about 15 percent in early 2012.

7. The improvement in the current account deficit is mainly the result of demand compression.3 The 12-month rolling current account deficit has narrowed by 2 percentage points of GDP after peaking at 10.2 percent of GDP in October 2011. Imports have played the main role, falling by 2 percent year-on-year through July. Exports have remained buoyant, increasing by 14 percent year-on-year, although non-gold exports grew more modestly by 5 percent.4 The financing structure of the current account deficit has improved with the share of non-debt creating flows and long-term borrowing increasing to 45 percent of CAD in 2012H1, compared to 38 percent last year, and net FDI in line with last year. Finally, gross international reserves of the CBRT have risen to about $110 billion (about 75 percent of short-term external debt on a remaining maturity basis), as banks are using FX and gold to meet their lira reserve requirement obligations, but net reserves remain at around $50 billion.5

Sources: Turkstat and IMF staff estimates.1/ Values in parentheses denote shares of total in June 2012.
Sources: CBRT and IMF staff estimates.

8. Easing domestic demand pressures have helped reduce inflation, although it remains high. After peaking at 11.1 percent in April, inflation was 9.2 percent in September. Food prices, which represent just over a quarter of the CPI basket, have been benign, and the stable exchange rate has helped durable goods inflation. Despite these gains, core inflation, although declining, remains around 7 percent; inflation in services remains around 7 percent; and labor costs increased by 10.3 percent in 2012Q2.

Sources: Turkstat and IMF staff calculations.

9. Overall, financial sector indicators remain robust and Turkish financial assets have performed well. Turkish banks, including subsidiaries of European banks, have maintained adequate capital buffers, with the CAR at 16.3 percent (above peer countries) even after moving to Basel II and II.5 in July 2012. Banking sector leverage remains comfortable at around 8 percent (Basel III definition) and external roll-over rates have been maintained above 100 percent despite global financial tensions. Profitability, although declining, remains high (return on equity at 16 percent), non-performing loans are at 2.8 percent of total assets, and provisioning remains comfortable at 80 percent. Capital inflows have helped lower the government benchmark yield to around 7.5 percent from 11.5 percent in early January, and contributed to the 30 percent increase in equity prices since the beginning of the year. The country’s EMBIG spread is just above 200 basis points. Finally, in June Turkey received a one notch credit upgrade from Moody’s to Ba1, just below investment grade.6

10. More recently, monetary policy has been eased. The CBRT, which allowed the effective interest rate7 to increase to around 8 percent on average during the first half of 2012, has eased it by around 200 bps since July 2012, while cutting the overnight lending rate by 200 bps. Moreover, allowing banks to hold their Lira reserve requirements in foreign currency and in gold8 has released lira liquidity and lowered banks’ funding costs.

11. The authorities announced the medium-term fiscal plan (MTP) for 2013–15. Under the authorities’ assumptions (Box 1), they aim to increase the primary surplus by 0.3 percent of GDP in 2013. The draft 2013 budget is consistent with the MTP target and hence, results in a tightening of the fiscal stance compared with 2012. However, the targeted primary surplus path to 2015 is lower than that specified in last year’s MTP.

B. Outlook And Risks

12. In staff’s baseline scenario, growth will be below potential in 2012, rising gradually as domestic demand strengthens. High-frequency indicators, such as industrial production and credit, point to continued growth in 2012Q3, although at a slower pace than in 2012Q2. The conditions for a recovery in domestic demand appear to be in place, with record low unemployment, positive real wage growth, healthy private sector balance sheets, and low interest rates. Barring new external shocks, staff expects consumption to increase by an annualized 3¾ percent in the second half and investment to remain firm, growing by 4½ percent, altogether leading to real growth of around 3 percent in 2012. In 2013, real GDP and domestic demand are expected to increase by 3½ percent, with the contribution from net exports falling to zero as imports accelerate. In the medium term, Turkey’s favorable population dynamics, robust private sector, and increasing economic openness are supportive of GDP growth of close to 4¼ percent.

Medium-Term Program, 2013–15

The macroeconomic assumptions underlying the medium-term plan (MTP)9 are more optimistic than staff’s, notably: (i) the economy is assumed to grow by 5 percent in 201415 versus 4–4¼ percent in the staff’s scenario, possibly reflecting the effect of yet to be announced structural reforms; inflation is projected to fall rapidly over 2013 and converge close to the central bank’s 5 percent target, whereas staff expect a significant deviation from the target next year, although expected to remain within the band (iii) the authorities see the current account deficit adjusting by some ¾ percentage point of GDP over the MTP horizon despite an acceleration in domestic demand, whereas staff expect the deficit to widen gradually. Taken individually, these gaps are within the margin of forecast error, but cumulatively the differences are non-trivial.

The new MTP envisages a less ambitious path for the public sector primary surplus than its predecessor. Relative to last year’s MTP, the 0.8 percentage points (ppts) of GDP deterioration in the central government’s surplus in 2012 (from 1.0 to 0.2 percent of GDP) is largely explained by spending overruns. This deterioration is fully carried over to the outer years despite higher revenues projected for 2013 and beyond—mainly due to recently introduced tax policy measures—driven by continued pressures on current spending, 1.3 ppts of GDP higher in the medium term relative to the previous MTP, despite assumptions of a compression in personnel spending from 2014 onwards. To compensate for this, the authorities envisage reducing capital spending in 2013 and beyond.

Staff project a less favorable medium-term fiscal outlook. While the authorities expect the central government’s primary surplus to reach 0.7 percent of GDP by 2015, staff forecast a primary deficit of 0.1 percent of GDP. Discrepancies between staff’s projections and the new MTP are centered on the spending side, with revenues relatively similar. In particular, staff assumes that current spending will not decline as a share of GDP, and sees risks to the assumed compression in capital spending.

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13. The staff considers that the output gap was large and positive in 2011 (Box 2), but it is projected to close following two years of below-potential growth. Together with weaker energy prices and positive base effects after last year’s indirect tax hikes, this should bring inflation to 7.5 percent at end-2012 and 6.2 percent at end-2013, albeit still above the central bank’s target. However, the current account deficit will continue to loom large: narrowing to 7½ percent of GDP in 2012 due to domestic demand compression and decreasing oil prices, but then widening back towards 8 percent in the medium term as growth again becomes domestic demand-led and the real exchange rate appreciates due to still high inflation.

14. Despite recent progress, the outlook is clouded by an uncertain external environment, with developments in Europe and global financial markets representing the main downside risk (Box 3). Turkey remains exposed to a sudden stop in capital inflows, as the 2011Q4 episode showed. Although it has so far not encountered significant difficulties securing external financing, Turkey’s annual gross external financing needs are projected to exceed 25 percent of GDP in the years to come. The structure of bank liabilities has worsened with the loan-to-deposit ratio now at about 100 percent and the share of external funding (largely short-term) in banks’ overall liabilities at 15 percent. The short FX position of the non-bank corporate sector has grown to $126 billion (although only $9 billion is short-term). Thus, were global liquidity to dry up or risk appetite for Turkey to turn sour, the economy would be forced into a sharp adjustment.

15. The risks could be exacerbated if the authorities try to stimulate the economy by relaxing macroeconomic policies at this time. If domestic demand were to accelerate significantly more than projected under the staff’s base line scenario, the output gap would reopen thus reversing disinflation and resulting again in a widening of the current account deficit. This, in turn, would further raise the gross external financing needs, and increase the dangers posed by capital flow reversal.

16. The authorities have a more benign view of the cyclical position of the economy and the outlook. They believe that the output gap was close to zero in 2011 and that the acceleration in inflation and widening of the current account were driven mostly by one-off and exogenous factors. Inflation deviated from target due to excise tax increases, adverse developments in unprocessed food prices, and pass-through from the lira depreciation. The authorities point to moderate core and services inflation as evidence of no underlying price pressures. In their view, the current account was negatively impacted by the large deterioration in the terms of trade and a one-off adjustment to the economy’s capital stock. Thus, they see the exchange rate as being close to equilibrium. Hence, relative to staff, they view imbalances to be smaller, vulnerabilities to be lower, and buffers to be larger, with the economy able to grow sustainably at close to 5 percent from 2013 onwards.

The Cyclical Position of the Turkish Economy in 2011

The differences in the assessment of the macroeconomic stance between the authorities and staff are to a large degree driven by differences in views on the cyclical position. The authorities believe that the output gap was close to zero in 2011, while in staff’s view it was positive with the estimates ranging between 2–4 percent of potential GDP.

Assessments of the medium-term potential are not too different (about 4 percent in staff’s view and 4½ percent according to the authorities) and so are the methodologies (univariate filters, the production function approach).10 Hence, output gap differences are driven by differences in the forecasted paths for GDP. As the authorities forecast growth of 4–5 percent in 2012–13, filtering techniques attribute the recent high growth to potential, while the staff’s forecast of lower growth in 2012–13 relocates it to the cyclical component.


Output Gap Estimates

Citation: IMF Staff Country Reports 2012, 338; 10.5089/9781475545067.002.A001

Source: IMF staff estimates.

In staff’s view, a range of observations firmly point to a positive output gap in 2011, given international experience:

  • In 2010–11 GDP grew at a rate twice that of its potential, driven by domestic demand, while employment grew at 6.2 percent compared to 1.4 percent in 2006–09 or -0.2 percent in 1999–2009;

  • CPI inflation accelerated from 4 percent in March 2011 (the lowest since 1969) to 11 percent in April 2012 (the highest since 2008);

  • The growth rate of credit to the private sector peaked at above 40 percent in 2011;

  • In 2009–11 the public sector balance improved by almost 5 percentage points of GDP, while the non-energy current account deteriorated by 6 percentage points of GDP.

  • Lastly, the authorities’ estimate of the 2011 output gap deviates significantly from the predictions of Okun’s law, which otherwise holds well for the 2002–11 period (although 2009 is another exception).


Okun’s Law with the Output Gap Estimates based on 2012–14 Pre-Accession Program

Citation: IMF Staff Country Reports 2012, 338; 10.5089/9781475545067.002.A001

Source: National authorities; IMF staff estimates.

The authorities, meanwhile, point to limited inflation in non-tradables and asset prices as evidence of no overheating and argue that sharp increases in the current account deficit and inflation are due to one-off factors.

Linkages Between Turkey and The Euro Area

Developments in the Euro area impact Turkish economy by affecting trade, FDI flows and availability of funding for local banks, with the latter presenting the main risk in a sudden capital flow reversal.

According to BIS data, out of $218 billion of consolidated foreign claims (including equity ownership parents) of reporting banks on Turkey, $164 billion came from the European banks, with the main creditors being from the UK, Greece, Netherlands, Germany, and Spain. While about 18 percent of the banking sector has ownership links to Euro area banks under stress,11 direct parent funding is low. Hence, an abrupt deleveraging of foreign parent banks presents less of a risk to their Turkish subsidiaries than via foreign banks’ FX loans to Turkish banks and corporates. Also, as of January 2012, the BRSA applied amended minimum capital requirements for banks with foreign strategic shareholders.

The impact on trade is direct (via dampened price and volume of Turkish exports) and indirect (via decline in profits stemming from a weakening euro, in which a large share of exports is priced, against the US dollar, in which inputs are priced). So far in 2012H1, Turkish exports have been resilient (registering 15 percent increase), and profits do not show signs of weakening. Turkey’s proximity to MENA and Asia proves a natural advantage in finding replacements for the European markets—especially for primary products such as apparel, textiles, and food—while maintaining relatively low shipment costs. Prior to the 2008 crisis, more than half of Turkish exports were destined for EU-27, with Germany leading the pack, but since then the share has declined to below 40 percent in 2012H1, while the share of MENA countries increased from less than 15 percent to 31 percent. Exports of gold, food, and building materials to Iran and Iraq have been particularly strong. Nevertheless, two thirds of Turkish exports to the EU-27 are those with medium to high technology components (motor vehicles, electrical equipment, and metals), which may prove harder to diversify. Given this sizeable share of European markets in absorbing the relatively more sophisticated Turkish exports, the impact can be non-trivial. In addition, Europe holds a dominant role in providing tourism and services receipts.

The EU represents around 72 percent of FDI. In 2007–11, FDI from the EU countries averaged US$9 billion per year, representing around 72 percent of total FDI flows to Turkey. Out of the FDI stock of US$134.5 billion at end-2011, EU investors account for 78 percent with the top three sources being Netherlands, Germany, and Austria (21 percent, 9 percent, and 8 percent respectively). FDI flows are in general more stable than other forms of flows and their concentration in the non-tradable sector (25 percent went into financial and insurance services, 21 percent into information and communication services, and 8 percent into wholesale and retail trade) serves as a stabilizing factor, since they rely more on Turkey’s own fundamentals, such as growth potential and population dynamics, and thus, are less susceptible to external developments.

Turkey: Risk Assessment Matrix12

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Policy Discussions

The Short-Term Challenge: Ensuring Prudent Policies

17. There has been some improvement in macroeconomic policies along the lines recommended in recent Article IV consultations. While in 2010–11, both monetary and fiscal policies were loose, contributing to the overheating of the economy and deterioration in the current account, the authorities tightened the stance starting in the middle of 2011 on. Initially, macro-prudential measures, such as increases in risk weights and provisioning were implemented in June 2011. Subsequently, the CBRT delivered much needed policy tightening in late 2011-early 2012, although this was not implemented within a normalized monetary framework as recommended. However, fiscal policy remained expansionary throughout 2012, but the authorities are aiming to tighten the stance for 2013–1513 as there is a shared view on the need to reduce imbalances.

Fiscal Policy

18. In staff’s view, the 2012 fiscal stance is pro-cyclical, when a neutral stance would have been appropriate. Fiscal performance has weakened in 2012, due to overruns in primary expenditures, the impact of lower growth on revenues, and fewer one-off proceeds from the tax restructuring implemented last year. While primary expenditures slowed in the second half of 2011, they reaccelerated in 2012, driven by wage increases granted in May that were above budget provisions and a rapid increase in public employment, mainly because of the recent education reform.14 These have brought into doubt the budget spending ceilings. Additionally, overruns in health spending and higher than expected costs of the equalization schemes of public sector salaries could weigh on final outcomes. Thus, staff’s current projections suggest that the authorities’ primary surplus target of 1.1 percent of GDP could be missed by 1 percent of GDP, despite the introduction in September of a revenue package based on increases in fuel, alcohol, and automobile excises, worth 0.7 percent on an annual basis.

19. Staff support the authorities’ fiscal objective for 2013 as it errs on the tighter side, given that the output gap will be closed next year. In particular, the draft budget target of a 0.5 percent of GDP primary surplus is appropriate as it contributes to the continued reduction of imbalances. However, staff recommended that the budget should aim to keep current spending unchanged as a share of GDP rather than increasing taxes yet again. Moreover, there are risks to the budget spending ceilings as they envision a significant compression in capital expenditure, which may be difficult to achieve. With debt-to-GDP having returned to pre-2008 levels, should the revenue outturns prove weaker than budgeted due to slower than expected growth, there would be room to allow for the operation of the automatic stabilizers.

20. Staff underlined the importance of turning around the weakening trend in the primary balance. Despite the strong recovery since 2009, the primary surplus has declined as primary spending has continued to grow rapidly as share of GDP. In particular, the wage bill, pensions, and health spending, all difficult to reverse, have grown above the economy’s potential and the pace of improvements in tax administration. Given these trends, staff pointed out that at unchanged policies the primary balance would be close to zero for much of the forecast period, bringing to an end a decade of significant declines in the debt-to-GDP ratio, a cornerstone of Turkey’s success. Furthermore, the growing share of current spending in the budget has increased its rigidity and could come at the expense of much needed infrastructure investment. It also reduces the scope for fiscal policy to contribute to a more balanced macroeconomic policy mix as adjustments in current spending are slow to take place.

21. The authorities agreed that there is a need to maintain a sound fiscal stance. However, they believe fiscal policy in 2012 to be appropriate given the downside risks to growth, and argued that the package of fiscal measures implemented in September would make up for the expansion in current spending. The authorities concurred with staff that the 2013 budget should aim at controlling expenditure growth, while recognizing that this could be challenging given the projected growth of wages and pensions.

22. In addition, the authorities believe the deterioration in the budget performance is temporary and not structural. They argued that public debt has fallen to a comfortable level, allowing for lower primary surpluses than in the past. While acknowledging the fast growth of current spending, they pointed to the need to increase the provision of education and health services in order to raise the economy’s potential. Moreover, their efforts to broaden the tax base, fight informality, and improve tax administration will in their view increase revenues in the medium term. Finally, they agreed that a better budgeting process would partly help contain spending overruns, such as through a more synchronized public sector wage bargaining process.

Monetary Policy

23. Staff underscored that despite recent declines, inflation remains high. The inflation outlook has improved somewhat, but there are clear risks to bringing inflation within the target band15 by the end of 2013. Inflation expectations remain elevated relative to the target, wage increases outpace productivity gains, backward indexation of wages—notably in the public sector—leads to inflation inertia, and volatile food prices pose risks. The monetary easing since July may have been premature and, on balance, staff felt that the CBRT should be more forward-looking and cautious in light of the impact that the resumption in domestic demand-led growth may have on inflation and wage formation.

24. The CBRT’s unconventional monetary framework attempts to achieve both price and financial stability in a difficult global environment. The mission is conscious that the CBRT faces a challenging environment of volatile capital flows and low interest rates in advanced economies. In response to these challenges, the central bank has, over time, introduced multiple new instruments aiming at gaining additional degrees of freedom in setting domestic interest rates, achieving a less volatile exchange rate, and safeguarding financial stability (Box 4). However, it is the ability to achieve the inflation target and anchor expectations that ultimately determines the success of monetary policy, and so far inflation has remained well above the target.

25. Staff argued that the CBRT would better serve its objectives within the context of a more standard inflation-targeting framework. Staff cautioned that while the new instruments may each seem appealing, as a whole, they are blurring policy signals and may be weakening the monetary transmission mechanism. With less traction, larger policy adjustments are needed to guide lending rates. Staff pointed to this year’s slow and limited reaction of lending interest rates despite significant declines in the CBRT’s effective rate since July and the cut in the overnight lending rate by 200 basis points. In addition, inflation expectations, which previously reacted to developments in inflation and the changes to the CBRT’s target, have been broadly unchanged since October 2010, suggesting that the capacity to influence expectations has been weakened. Thus, staff recommended a normalization of the framework by returning to the use of the one-week repo rate as the main tool to manage the monetary stance. Given current inflation trends, this rate should be increased to positive levels in real terms. Should this stimulate capital inflows, staff advocated sterilized interventions for rebuilding net reserves, low by international standards, complemented by a more pro-active use of macro-prudential measures.

26. Staff encouraged the CBRT to strengthen its communication policy. The complicated framework, with its multiple tools and objectives—even though openly stated in the inflation reports—blurs the policy signaling, often giving the impression that other objectives take priority over inflation. The plethora of tools has proven challenging for market participants to understand. Clearer communication could help avoid the impression that objectives and tools are at times in conflict, and thus reduce costly uncertainty; in turn, this could help repair the monetary transmission channels.

27. The CBRT believes that its framework has been successful in dealing with multiple objectives. In their view, a standard inflation targeting framework cannot ensure financial stability in a world of volatile capital flows. They point to the declining inflation and current account deficit as proof that, by driving a wedge between domestic interest rates and the rates faced by speculative money, the framework can deliver lower inflation, more sustainable credit growth, and a less volatile exchange rate. The central bank agreed that there are upside risks to inflation, but argued that it has the capacity to adjust policy, seeing no evidence of a weakened transmission mechanism. The central bank concurred with staff that macro-prudential policies may be best suited to deal with some of the financial stability issues, but that in Turkey’s case the CBRT is well positioned to deal with the financial risks. Finally, they agreed with staff that their framework of multiple instruments requires very careful communication, but felt they have made significant progress in this regard.

The Conduct of Monetary Policy in Turkey16

Since late 2010, the CBRT has been implementing monetary policy in a manner referred to as unconventional, in response to a challenging external environment dominated by volatile capital flows. Instead of relying on one interest rate like inflation-targeting central banks generally do, the CBRT has resorted to utilizing a wide variety of instruments—such as reserve requirement (RR) ratios and a mix of various repo facilities—rather infrequently used by “traditional” central banks. In late 2010, the CBRT’s view was that the exchange rate was overvalued, and the framework was supposed to bring about a correction via nominal depreciation while improving the structure of external financing by substituting debt with equity and short-term flows with long-term ones.

The new framework has, in fact, been implemented in two different ways. First, the CBRT changed the required reserve (RR) ratios, differentiating them by currency and maturity; purchased FX via regular daily auctions, changing the amounts in line with the perceived strength of capital inflows; and generated a lot of volatility in the interbank rates by varying the amount of liquidity it was providing to the market via quantity repo auctions. Altogether these operations led to a significant increase in liquidity, sharp nominal depreciation, and a surge in inflation. In late 2011-early 2012 the CBRT stopped changing the RR ratios, stopped intervening in the FX market, and started to vary daily the cost of liquidity it provides to the markets by changing the extent of using its price and quantity repo facilities. Since March it has allowed banks to hold their RR on lira-denominated liabilities in FX and gold, however, applying increasing penalties.

While it is difficult to assess empirically the success of this framework given the rather short time-span of its implementation, the following observations help form a view:

  • It emerges that until the inception of the new framework, inflationary expectations were well approximated by an average of the inflation target and the latest inflation observation. Under the new framework, one-year ahead expectations have remained broadly flat at around 7 percent, suggesting that the link has been broken and survey participants simply report the numbers around the top of the target band.

  • It also emerges that the new framework introduced a non-trivial spread between the cost of the CBRT-provided liquidity and the interbank rates. This spread seems to be affected by markets’ perceptions of the strength of capital inflows.

  • Market participants perceive the monetary policy as leaning towards stimulating growth, as long as the nominal exchange rate is not under pressure.

  • The role the framework played in reducing external imbalances is still unclear. As nominal depreciation fed into inflation, attempts to turn things around led to a significant loss of reserves in the end of 2011. The 12-month current account deficit and its financing structure continued to deteriorate until early 2012. Whether the subsequent improvement is due to the way the monetary policy is conducted or a result of a slowdown in domestic demand—brought about by a range of factors including interest rate tightening per se—remains to be seen.

While headline inflation has started to decrease, the core measures and inflationary expectations remain above the target and the CBRT’s net reserves are low. Were the risk appetite for Turkey to reverse, the ability of monetary policy to jump-start the economy or to defend the exchange rate will be constrained.

Financial Sector Policies

28. Staff noted the progress in implementing the 2011 FSAP update recommendations. The mission found that the BRSA has advanced in closing some of the supervisory and regulatory gaps, has expanded the coverage of consolidated supervision for banking groups, and has tightened the rules on asset classification and provisioning requirements. By successfully introducing Basel II in July 2012, some of the FSAP update recommendations in areas such as capital adequacy, risk management processes, and different types of bank risks were addressed as well. Based on results of the Basel Quantitative Impact Studies (QIS), banks seem well positioned for the introduction of Basel III by 2015, and thus, an accelerated time table could be considered. Staff underscored the instrumental role of the Financial Stability Committee (FSC) in coordinating the work of the involved institutions, as financial stability challenges and concerns will continue emerging.

29. Staff recommended expanding the macro-prudential tool-kit and applying it more proactively (Box 5). The authorities’ prudent dividend payout rules have been very constructive in buttressing banks’ balance sheets, but further efforts may be required to conserve existing capital buffers in times of rapid credit growth. Moreover, there is room to develop measures, within a well-articulated framework, to manage key risks. In particular, staff suggested the following macro and micro-prudential measures: (i) formalizing a consumer debt-to-income limit (DTI), already applied by banks for their internal risk management and credit scoring; (ii) phasing in Basel III liquidity ratios to help address the banks’ structural maturity and currency mismatches; and (iii) applying targeted increases in FX required reserves at shorter maturities to slow down banks’ short-term external borrowing. The BRSA draft regulation on credit risk management should be finalized, as it could improve banks’ risk management and help supervisory examination of banks’ FX lending practices. This in turn would allow tighter conditions on FX borrowing for non-FX earning corporates.

30. The authorities highlighted the strength of the financial system and regulatory framework, but concurred that continued vigilance is needed to maintain financial stability. They consider that the financial performance of the banking system has remained very strong, with sufficient buffers and no difficulty in accessing external funding. They believe that the banking system is in a good position to transition to Basel III sooner than 2015. The BRSA plans to finish drafts of the Basel III regulation by end-2012, and with over 90 percent of regulatory capital constituting core tier 1 capital, it believes a long phase-in period won’t be needed. Moreover, the authorities are of the view that they have already implemented a number of important macro-prudential measures such as loan-to-value limits, minimum payment levels for credit cards, as well as increases in risk weights and provisioning for consumer loans, the latter resulting in a significant decline in credit growth. Thus, they think it would be premature to consider new measures at the current juncture, but see room to examine possible new macro-prudential tools should particular areas in the banking system become a policy concern in the future.

Macro-Prudential Policies in Turkey17

Turkey faces the typical emerging market challenge of maintaining financial stability while dealing with capital flows and the economic cycle. The 2007/8 crisis underscored the need for countries to develop a strong MPP framework as well as enhanced prudential regulation and supervision. Also, in Turkey, macro-prudential measures (MPP) could help relieve some pressures from the central bank in dealing with financial stability issues.

At the outset of the 2008–09 crises, the authorities implemented a number of MPP measures to safeguard the domestic financial sector. These measures were successful in mitigating the impact of the downturn in the banking sector. Additional steps were taken, albeit belated, in the summer of 2011 to deal with the credit boom: increased risk weights and provisioning requirements on consumer loans contributed to the significant slowdown in credit growth.

Turkey made progress on the organizational aspects of its MPP framework. The Financial Stability Committee (FSC) was created in June 2011 to improve coordinating of all the agencies involved in safeguarding financial stability while maintaining operational autonomy of the participating agencies. The 2011 FSAP Update also recommended an increased emphasis on communication, an enhanced interagency coordination, as well as a leading role of the CBRT on the macroprudential committee to harness the central bank’s expertise in risk assessment.

The macro-prudential tool kit could be expanded, but sequencing and calibration of new measures will be important. New measures could be considered in the following areas:

  • Prevent household overleveraging. Household debt, although lower than in many peer countries, has increased to around 50 percent of disposable income during the recent boom phase. Setting a consumer debt-to-income limit (DTI) across the banking system could help maintain household balances’ resilience. Banks already apply such DTI requirements for their internal risk management and credit scoring.

  • Contain short-term FX borrowing by banks. Turkish banks, partly due to improved external sentiment and limited local funding (loan-to-deposit ratio at 103 percent), make extensive use of this source of funding. Introducing a minimum FX liquidity ratio at the 3-month and longer horizons and phasing in Basel III liquidity ratios could help address banks’ structural maturity and currency mismatch. As in the existing liquidity regulation framework in Turkey, the Basel III liquidity rules could be differentiated by currencies. Finally, the application of FX RR increases at shorter maturities could also be considered to slow down banks’ short-term external borrowing.

  • Limit nonfinancial corporate FX exposure. FX corporate loans comprise 26 percent of banks’ total loan portfolio and 40 percent of corporate loans. The BRSA draft regulation on credit risk management should be finalized to improve banks’ risk management and help supervisory examination of banks’ FX lending practices. But there is scant information on corporate FX hedging, and filling this data gap would be important. It would be also possible to tighten the conditions by which non-FX earning corporates could borrow FX in Turkey. Also, higher risk weights and provisioning on unhedged FX lending to corporates could be introduced if growth in this lending segment would become excessive. Data availability would be an important prior condition for such a measure.

31. The mission and authorities agreed on the importance of addressing the AML/CFT deficiencies identified by the Financial Action Task Force (FATF). Since June 2011, Turkey has been included on a list of jurisdictions with strategic AML/CFT deficiencies that have not made sufficient progress in addressing them. Moreover, on October 19 the FATF decided to suspend Turkey’s membership by February 2013, unless the country adopts legislation to address identified AML/CFT deficiencies by then. This development could lead to heightened due diligence from foreign financial institutions regarding transactions with Turkey. The authorities have submitted draft legislation to parliament which has not been enacted yet, but which they expect to meet the standards necessary to deal with the identified deficiencies.

Overall Short-Term Policy Mix

32. Staff argued that policies need to become tighter. Given the external vulnerabilities, high inflation, and buffers smaller than at the start of the 2008 crisis, policies should remain geared towards reducing imbalances. Thus, staff believes that fast growing public spending together with the monetary easing could have been premature. The tightening of the fiscal stance proposed in the draft 2013 budget is therefore appropriate, as further policy loosening to achieve higher growth rates could end disinflation and leave Turkey with a high and growing current account deficit. Accordingly, a period of below potential growth is needed. Staff also suggested that there is much to be gained through better coordination to assure a more balanced overall stance.

33. The authorities agreed that additional reductions in imbalances should be the priority. However, given their assessment of the policy stance, which differs from that of staff in some key areas, they believe that achieving disinflation and a further reduction in the current account deficit does not require growth below 4 percent, as they see potential growth closer to 5 percent. Moreover, they point to the slowdown in domestic demand as an indication that the overall policy mix was sufficiently tight and consistent with their objective of reducing vulnerabilities. However, the authorities agreed with staff that, should the unwinding of imbalances start to reverse, some policy tightening would be required, noting that it would be more appropriate to be done via monetary policy.

Medium-Term Challenge: Rebalancing the Policy Framework and Reducing Dependence on External Funding

34. Staff pointed out that, due to its low savings, Turkey remains prone to boom-bust cycles driven by capital flows. The national saving rate has fallen dramatically over the last fifteen years, reflecting in part improved macroeconomic conditions that reduced the need for precautionary savings, and a cleaned-up banking system able to rapidly expand credit (Box 6). However, the savings rate of around 15 percent of GDP is too low, leaving the country highly dependent on volatile foreign capital and resulting in boom-bust cycles in investment and output. In addition, full realization of the potential offered by the country’s young population and strategic location requires higher investment rates than at present, which could not be sustained given current savings levels.

35. Staff argued that fiscal policy had a role to play in raising national savings and mitigating the economy’s excessive cyclical swings. The decline in national savings over the recent decade happened despite increases in public savings. However, this need not reflect Ricardian equivalence, and indeed, estimates find only a partial Ricardian offset.18 Moreover, since there is no single item that could increase private sector savings quickly and significantly, the public sector would have to lead the way. Increasing the primary balance to its pre-crisis levels (around 2 percent of GDP) could have two important effects. First, it would help boost national savings, perhaps by 1 percentage point of GDP. Second, it would relieve pressure on monetary policy, allowing for a more depreciated real exchange (REER overvaluation—see Box 7—has been an important factor in the savings decline).

36. Staff recommended that the fiscal medium-term plan should anchor the broad guidelines of the adjustment in public savings. The new 2013–15 Medium-Term Program should have targeted a sizable increase in the structural primary surplus, although the adjustment path could be back-loaded. To achieve this, the mission recommended a structure of adjustment that could have helped reduce the budget rigidities. Specifically, staff advocated containing real primary spending growth below the potential growth rate of 4 percent in the next three years and changing the public pension system; in particular, by increasing contribution rates without raising benefits commensurately. Also, public spending on health programs, which has grown significantly in recent years, could be reexamined; and the tax base should be broadened by eliminating tax exemptions and improving tax administration.

37. Staff commended the authorities for their efforts to boost private savings. The mission welcomed the authorities’ recent reform of private pensions, which replaced previous tax incentives with direct government contributions. The new system has wider coverage, including people who are not on formal payrolls, and tilts incentives towards poorer contributors. The reform should help boost private pension contributions, which have much room to grow.

38. Staff also argued that boosting competitiveness more broadly would support domestic savings and rebalancing. The recently introduced Commercial Code helps improve corporate governance and encourages FDI. The recent package of investment incentives could, if properly administered, help stimulate investment in advanced technology sectors and lower the import content of production. Yet, staff pointed out that past experience with similar schemes, depending on tax exemptions, showed mixed results. Thus, expectations should be modest and higher priority should be given to maintaining broad VAT and income tax bases. Staff also asserted that reforms should advance in other key areas:

  • Efforts to address the large informal sector, which have had some success in recent years, need to be sustained.19 There is much evidence that firms in the informal sector are more liquidity constrained, invest less, are less profitable, and grow more slowly. Informal workers also save less than their counterparts in the formal sector.

  • The labor market needs to become more competitive via greater use of part-time and temporary labor, reform of the severance pay system, and slowing the growth of the high minimum wage, while ensuring an adequate safety net. Turkey needs to continue improving the quality of its workforce by bolstering the education system and training programs. Lastly, measures should be targeted at boosting the female participation rate, which at about 30 percent remains well below that of most middle-income countries.

  • Regulatory constraints in some product and service markets are obstacles in what is otherwise a generally vibrant domestic market. Tax policy and administration are complicated and costly for business, routinely cited in surveys as key weaknesses in Turkey’s business climate.

  • Despite impressive efforts to improve infrastructure and reduce energy dependence, more is needed. Efforts to relieve transport sector bottlenecks, important to reducing costs in the economy, are underway. Steps to raise domestic energy production are welcome, but should be paired with further efforts to improve efficiency in energy production and distribution, notably by continued involvement of the private sector.

39. The authorities concurred with the need to increase national savings as the key medium-term goal. They pointed to the steps taken earlier in the year, such as the private pension reform, as likely to deliver significant gains in savings. Moreover, they agreed that public policies have a role to play in boosting savings, but mainly by improving the targeting of some social programs to reduce disincentives to private sector savings. Finally, they outlined policies in the medium-term fiscal plan that would promote higher savings, but felt that a primary surplus of 1 percent on average over the cycle was adequate given the low and still declining debt. In addition they argued that returning the primary surplus to the pre-crises level would be difficult to achieve given current spending needs.

40. The authorities believe that they are undertaking substantial efforts to promote competitiveness. They highlighted the importance of the new package of investment incentives, which, by promoting investment in high technology and lowering labor costs, should boost export potential as well as increase local content, reducing the import dependence of domestic production. Through their significant efforts in improving tax administration—and in time, changes to tax policy—they expect further reductions in informality, which hampers the competitiveness of the formal sector by keeping labor taxes high. Finally, they believe that their education reform will increase educational attainment over the medium term, and produce a better alignment of educational training with the needs of the economy.

Raising Savings In Turkey

Turkey’s national saving rate has fallen dramatically over the last 15 years, from some 25 percent of GDP in the late 1990s to less than 15 percent of GDP now. This decline has been larger than in any G-20 country over this period and stands in stark contrast to the experience in peer emerging economies, even if some of these have enjoyed better terms of trade than Turkey. On the positive side, the national savings rate has increased over the last two years, but these modest gains have yet to fully make up for the loss in savings in the aftermath of the global financial crisis.


National Savings Rate

(Percent of GDP)

Citation: IMF Staff Country Reports 2012, 338; 10.5089/9781475545067.002.A001

Source: Ministry of Development.

G-20: Change in National Savings Rate

(change between 1998 and 2011, ppts of GDP)

Citation: IMF Staff Country Reports 2012, 338; 10.5089/9781475545067.002.A001

Source: WEO, and IMF staff calculations.

The decline in national savings happened despite large increases in public savings. Fiscal consolidation efforts led to an 8.5 percentage points of GDP increase in public savings over the last ten years.20 However, this was more than offset by a 9 percentage point decline in the private saving rate. Independent studies attribute most of this decline to households rather than corporates, and point to a significantly more stable macroeconomic and political environment that reduced the need for precautionary savings, as well as to the rapid expansion in credit via a cleaned-up banking sector. Other factors, such as demographics and appreciation of the real exchange rate, also seem to have played a role. As for the striking public-private offset, it stemmed from a combination of partial Ricardian equivalence (with estimates of the Ricardian offset in the 0.4–0.8 range) and exogenous factors that affected public and private savings simultaneously but in opposite directions, such as the global recovery and normalization of financial conditions post-2008.


Public vs. Private Savings

(percent of GDP)

Citation: IMF Staff Country Reports 2012, 338; 10.5089/9781475545067.002.A001

Source: Ministry of Development.

National savings are too low, and this has been a key reason behind Turkey’s boom-and-bust cycles. At some 15 percent of GDP for much of the last decade, the national saving rate has been well below the investment rate, leaving the economy highly dependent on volatile foreign savings to fill the gap.

As a result, when capital flows are ample, investment expands rapidly and the current account deteriorates;21 in reverse, when external financing becomes scarce, investment retracts rapidly and the current account deficit adjusts. The volatility of investment, closely tied to the capital flow cycle, has been significantly greater than in comparable countries like Brazil or Poland. In turn, investment volatility has been a key reason for booms and busts in economic activity. Looking into the medium term, studies suggest that Turkey will need to invest 25–30 percent of GDP in order to fulfill the potential offered by its young population, strategic location, and low female labor participation rate. Such investment rates will be impossible to sustain at current savings rates.


GDP Growth and Net Capital Inflows 1/

Citation: IMF Staff Country Reports 2012, 338; 10.5089/9781475545067.002.A001

Sources: Central Bank of Turkey; and IMF staff calculations.1/ Includes errors and omissions.

Increasing savings is thus a key objective. The government has recently replaced tax incentives for private pensions with direct government contributions, widening the coverage of the system to the many who are not on payroll, and making it more progressive. The vesting period in the system was also lengthened. These changes go in the right direction and are in line with World Bank recommendations; with private pension assets accounting for only 1½ percent of GDP at present, the gains could be non-trivial. Still, the savings gap is too wide to be bridged through these measures alone, hence other avenues should be considered:

  • Raising the structural primary fiscal balance back to pre-crisis levels: given only partial Ricardian equivalence, fiscal policy can play a role in raising national savings. Tighter fiscal policy would also relieve pressure from the central bank and allow, ceteris paribus, for a more depreciated real exchange rate.

  • Increasing mandatory savings through the pay-as-you-go pension system: this could be achieved by increasing current contribution rates with no increase in benefits. The difficulty of such a reform is political, given that the last decade has already seen major changes to the pension system.

  • Tackling informality: efforts to address the large informal sector, which accounts for about 40 percent of the labor force, need to be sustained. There is much evidence that informal workers save less than their counterparts in the formal labor market, after controlling for other variables.

Still, difficulties in raising national savings should not be underestimated. The fact that the national saving rate has been relatively stable over the last ten years despite large underlying changes in public and private savings should caution about the difficulty of the task at hand.

Turkey’s External Competitiveness

Turkey still faces a competitiveness gap despite the ongoing reduction of the current account deficit. Rising unit labor costs and inflation differentials with trading partners in 2012 have erased almost half of Turkey’s gain in external competitiveness derived from the large nominal depreciation in 2010–11.

Real effective exchange rates, based on consumer and producer prices, rose by around 10 percent in 2012 on the back of inflation differentials, clawing back almost half of the real depreciation accumulated between October 2010 and August 2011. Rising by a similar amount but starting from a higher base, the ULC-based REER remains elevated as real wages increased, labor productivity growth weakened with the increasing participation of low-skilled labor force, and unit labor costs grew with inflation. As a result, some REER indicators are now comparable to the levels prevailing during the crisis, and higher than the levels of the early-2000s.

The US dollar-euro exchange rate is also an important determinant of the competitiveness of Turkey’s exports, especially in view of the high import content—and hence relatively low domestic valued added—of Turkish production. Many raw materials and intermediate inputs are priced in US dollars or currencies that move closely with the US dollar, while many of Turkey’s final products are sold in Europe and priced in euros. Thus, a continued depreciation of euro would further strain the bottom line of exporting industries and the overall current account adjustment process.

Export diversification to the MENA region has allowed Turkish exports to grow despite weak demand in the EU, its main traditional trading partner. Exports to MENA countries following the crisis have increased by around 10 percentage points to 31 percent of total exports in 2012H1, compensating for the loss of market share to the EU. Moreover, in recent months non-monetary gold exports to Iran have picked up significantly. However, penetration by Turkish exporters of emerging and fuel exporters’ markets has declined since the onset of the global crisis, reversing in part the significant market-share gains of earlier years, suggesting that competitiveness remains an issue to be addressed.

The EBA assessments show the current account deficit is 2–4 percentage points of GDP larger than the level that can be explained by fundamentals and desired policy settings, and that the real exchange rate is 10–20 percent higher. This is a similar assessment to the one contained in the 2011 Article IV Consulation Staff Report. It should be noted that these current account assessments rely in part on end-2011 data: since then, the current account has adjusted significantly, leading staff to project a fall in the deficit of some 2½ percentage points of GDP in 2012. However, even if some of this adjustment is structural, the residual current account deficit continues to point to a siginificant competitiveness gap.

In the context of still large capital inflows, however, standard REER assessments may overstate the extent of overvaluation. There is little evidence that industry’s share in GDP is falling (a good proxy for the tradable sector) and investment in industry has grown strongly in the past 5 years (something that is difficult to square with a very uncompetitive exchange rate). Moreover, the recent surge of capital inflows to Turkey has not only financed the current account deficit in an accounting sense but may have also caused it in a behavioral sense, at least partially: by relaxing consumers’ budget constraints to facilitate import demand.

When the inflows abate, as they are beginning to, both the near- and medium-term current account projections would improve which, in turn, would imply smaller misalignment. This is consistent with the notion of “capital account dominance” in Emerging Markets. Alternatively, if the flows—though mostly of a short-term duration—turn out to be more persistent, then the equilibrium exchange rate itself would appreciate accordingly reflecting the changed fundamentals, and hence leading to a smaller estimated misalignment, other things being equal.22

It is essential for Turkey to close the competitiveness gap so as to attract more FDI flows into the tradable sector. That would help to get more closely integrated into the global supply chain and move up the value-added ladder. However, at around 2.0 percent of GDP, FDI inflows are still below the G–20 EM average of around 2.5 percent of GDP, with flows tilted toward non-tradable sectors such as banking and real estate. The government has recently launched an investment incentive scheme aimed at tackling the current account deficit by lowering the import content of production. However, significant barriers remain in the efficiency of the labor market and the general business environment.

1/ Against developing countries.Sources: Central Bank of Turkey; Bloomberg; Turkstat; IMF, Direction of Trade Statistics; and IMF staff estimates.

Staff Appraisal

41. After two years of rapid growth, the economy has slowed significantly, unwinding imbalances. The tighter macroeconomic policies have started to deliver disinflation and a reduction in the current account deficit, while maintaining a more measured pace of growth. The conditions for continued growth this year are in place. Beyond 2012 the economy is in a good position to return to its long-term growth rate of around 4 percent.

42. The Turkish financial system remains sound. Banks’ profitability is high by international standards, while leverage and the level of non-performing loans are low. Introduction of Basel II and II.5 standards has resulted in only marginal reductions in the system’s still-high capital adequacy ratio. Tighter macro-prudential measures have eased concerns over excessive credit growth, and the rising dependence of the system on external financing observed over the last few years appears to be leveling off.

43. However, Turkey continues to face considerable risks given the large current account deficit and uncertain external environment. Priority should be given to fully achieving the orderly rebalancing of the economy. Macroeconomic policies helped engineer the soft landing of the economy, but the authorities must stand ready to adjust their stance if the trends in disinflation and the external deficit reduction start to unwind. In the absence of further efforts, annual gross external financing needs will remain high and the unstable global financial environment will remain a major risk, with a possible reversal in capital flows forcing the economy into a sharp adjustment.

44. Staff support the authorities’ fiscal objective for 2013 as it errs on the tighter side. The 2012 budget deficit target will be missed, mainly as a result of primary expenditure overruns, leading to a pro-cyclical fiscal stance at a time when a neutral stance would have been more appropriate. The 2013 budget should aim to ensure current expenditure does not grow as share of GDP rather than rely on tax measures to meet the target.

45. The medium-term fiscal plan for 2013–15 is a step in the right direction, but a more ambitious effort is needed to set the basis for increasing budget flexibility and resilience to the cycle. Turkey’s budget has structural weaknesses: excessive dependence of revenues on buoyant domestic demand and increasingly rigid expenditures. The public sector wage bill and pensions have grown faster than the economy’s potential and the pace of improvements in tax administration. This could come at the expense of much needed infrastructure investment and reduces the scope for fiscal policy to help establish a more balanced macroeconomic policy mix and respond to shocks. In addition to ongoing efforts to broaden the tax base and improve tax administration, reforms on the spending side—significantly restraining growth in real current expenditure—are needed as well. The authorities’ broad guidelines for the MTP would need to be fleshed out with concrete expenditure proposals and it would be important that more effort be placed in reducing current spending than envisaged now.

46. The monetary policy stance needs to be tighter given upside risks to inflation, and the impact that the resumption in domestic demand-led growth may have on inflation expectations and wage formation. Turkey’s growth outlook, still-high inflation, and a history of deviations from the target call for a positive real policy interest rate. Were capital inflows to accelerate, the CBRT should rebuild net reserves for precautionary reasons through sterilized interventions.

47. The merits of the CBRT’s policy framework have not been fully established. The new framework, relying on a battery of novel instruments to gain degrees of freedom in segmenting domestic and international interest rates, has not yet proved its superiority. A return to a more conventional framework is warranted, and even more so should the inflation target remain elusive or inflation expectations stay high. In the meantime, the CBRT should strengthen its communications, which have at times been confusing to market participants.

48. In the medium term, it is essential to improve the macroeconomic policy mix. Tighter fiscal policy would relieve pressure on monetary policy to achieve its inflation target and deliver an environment less prone to real exchange rate appreciation. This would help deal with Turkey’s competitiveness challenges and support efforts to reorient the economy from import dependence toward export growth. Moreover, it would allow for lower nominal interest rates, reducing exposure to volatile and destabilizing short-term capital inflows.

49. There has been progress in financial sector supervision and regulation, and there is scope to expand the macro-prudential tool kit. Some of the gaps in the regulatory and supervisory framework have been closed; and banks seem well positioned for the introduction of Basel III by 2015. Despite this, the macro-prudential tool kit needs to be used in a more targeted and active manner to ensure financial stability. There is room to expand the macro-prudential measures, within a well articulated framework, to manage key risks.

50. Turkey needs to address its low domestic savings which make it heavily dependent on capital inflows. High investment needs and the current low level of savings leave the Turkish economy exposed to volatile capital inflows. The authorities have correctly identified increasing savings as the key medium-term priority and have recently undertaken several reforms in this area. However, further efforts by the public sector are needed. In particular, the authorities should aim to deliver a sizeable increase in the primary surplus, which would boost national savings. The forthcoming medium-term fiscal plan, based on prudent macroeconomic assumptions, should anchor the broad guidelines of the adjustment, complementing policies to improve the structure of the budget.

51. Boosting competitiveness requires a broad, multi-pronged approach. The new Commercial Code should improve corporate governance and encourage FDI. The package of investment incentives could stimulate investment in advanced technology sectors and lower the import content of production; however, such schemes tend to deliver mixed results and only in the long run. Thus, additional efforts should be considered to improve the functioning of the labor market, reduce informality, increase labor market participation, eliminate red-tape in product and service markets, and improve the capacity and efficiency of the domestic energy sector.

52. It is recommended that the next Article IV Consultation with Turkey be held on the standard 12-month cycle.

Table 1.

Turkey: Selected Economic Indicators, 2007–13

Population (2011): 74.7 million

Per capita GDP (2011): $10,469

Quota (2012): SDR 1,455.8 million

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Sources: Turkish authorities; and IMF staff estimates and projections.

The structural balance is estimated using the absorption gap method and excludes one-off operations.

The external debt ratio is calculated by dividing external debt numbers in U.S. dollars based on official Treasury figures by GDP in U.S. dollars calculated by staff using the average exchange rate (consolidated from daily data published by the CBRT).

GDP in U.S. dollars is derived using the average exchange rate (consolidated from daily data published by the CBRT).

Table 2.

Turkey: Medium-Term Scenario, 2007–17

(Percent change, unless otherwise indicated)

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Sources: Turkish authorities; and IMF staff estimates and projections.

The structural primary balance is estimated using the absorption gap method and excludes one-off operations.

The external debt ratio is calculated by dividing external debt numbers in U.S. dollars based on official Treasury figures by GDP in U.S. dollars calculated by staff using the average exchange rate (consolidated from daily data published by the CBRT).

Table 3.

Turkey: Summary of Balance of Payments, 2007–17

(Billions of U.S. dollars)

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Sources: Turkish authorities; and IMF staff estimates and projections.

Including privatization receipts.

The change in gross reserves in 2012 is likely to significantly exceed the overall BOP surplus, due to gold transactions between domestic banks and the central bank which are not recorded in the BOP.

The external debt ratio is calculated by dividing external debt numbers in U.S. dollars based on official Treasury figures by GDP in U.S. dollars calculated by staff using the average exchange rate (consolidated from daily data published by the CBRT).

Interest plus medium- and long-term debt repayments in percent of current account receipts (excluding official transfers).

Table 4.

Turkey: External Financing Requirements and Sources, 2007-17

(Billions of U.S. dollars)

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Sources: Turkish authorities; and IMF staff estimates and projections.

Includes Central Bank of the Republic of Turkey (excludes IMF purchases and repurchases).

Series reflects stock of short term trade credits at end of previous year.

Portfolio equity and domestic government debt (net).

Errors and omissions and other liabilities.

For 2007, excluding IMF financing.

Table 5.

Turkey: Public Sector Finances, 2007–17

(Percent of GDP)

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Sources: Turkish authorities; and IMF staff estimates.

Excluding privatization proceeds, transfers from CBRT, and interest receipts.

Excluded from consolidated government sector.

Excluding severance payments for retirees.

IMF deficit definition excludes profit transfers of the CBRT, proceeds from the sale of assets of the central government, and dividend payments from Ziraat Bank from revenue.

The structural primary balance is estimated using the absorption gap method and excludes one-off operations.