Statement by Mr. Prader and Mr. Yalvac on Turkey - 2012 Article IV Consultation, November 16, 2012

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.

Abstract

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.

We thank staff for the comprehensive set of papers. Our authorities appreciate the dialogue with staff.

After the strong growth performance in 2010 and 2011, the authorities targeted a rebalancing of the economy in 2012. With prudent monetary, fiscal and macro prudential policies, Turkey has managed to slow down the economy and reduce imbalances without risking the favorable medium term outlook. In addition to the positive reaction in the equity markets, CDS levels and spreads, the latest rating upgrade by Fitch to investment grade reflects the authorities’ success in rebalancing the economy.

As an important policy anchor, the Medium-Term Program (MTP) for the period 2013—2015 was announced on October 9, 2012. The program was prepared under a gloomy global economic and financial outlook despite all the commendable measures taken by the major key players in the world economy. The authorities have continued their cautious stance for this program period, taking the downside risks for the global economy into consideration.

The MTP aims at gradually converging to potential output growth, further reducing the current account deficit, achieving inflation targets, maintaining a strong fiscal balance, and strengthening financial stability. In addition to the favorable fiscal position, a strong financial sector, household and corporate sector balance sheets will be critical to achieve the targets put forward in the MTP.

Growth Outlook

Following the high growth of 9.2 percent in 2010 and 8.5 percent in 2011, the authorities decided on a policy induced economic slowdown to contain the imbalances which could jeopardize macroeconomic and financial stability. Since strong private sector consumption and the appreciation of the Turkish Lira (TL) were the underlying reasons for imbalances, the authorities designed a framework that would curb private credit growth and reverse the real appreciation trend of the TL. However, the weaker than expected global growth outlook and higher than forecasted energy prices have negatively affected the planned growth path. The Turkish economy is expected to grow by 3.2 percent in 2012. Towards the end of the MTP period, the economy is expected to gradually reach the medium-term growth target of 5 percent, which is higher than staff’s estimates.

The economy has adequate resources to reach the targeted growth levels. Since 2009, 4.2 million jobs have been created and the unemployment rate has declined to its lowest level in the last decade. The young population with positive employment prospects and a strong banking sector will be critical for achieving sustainable growth targets in the medium term. Additionally, a favorable fiscal stance in terms of a low debt-to-GDP ratio and budget deficit is important to eliminate the bottlenecks in infrastructure, human capital and public administration.

Monetary Policy

Faced with excessive cross-border capital inflows, rapid credit growth, and a deterioration in the current account deficit in the second half of 2010, the Central Bank has enhanced the conventional inflation targeting regime. They adopted financial stability as a complementary objective and added a set of policy instruments with a particular emphasis on credit growth. Accordingly, since the end of 2010, the Central Bank has been implementing a new framework supported by a mix of credit, liquidity and interest rate policies.

The new framework has supported a healthier outlook in the composition of growth as well as improvements in the current account balance. The annual rate of credit growth has declined from 35 percent to around 14 percent. The current account deficit to GDP ratio is expected to come down from 10 percent in 2011 to 7.3 percent at the end of 2012. More importantly, this adjustment has been achieved without a contraction in the aggregate demand, thanks to a marked improvement in the contribution of net exports. Despite the slower growth in the Euro area, exports have increased with the support of a successful market and product diversification.

Although the adjustments in energy prices in September have led to a revision of headline inflation forecasts for end-2012 from 6.2 percent to 7.4 percent, inflation has recently been on a declining trend. Core inflation has been easing since the beginning of the year and is expected at around 6 percent at the end of the year. The risks are on the downside due to the favorable outlook of unprocessed food prices. Moreover, existing output gap and the tapering-off of last year’s exchange rate pass- through effects are expected to bring inflation down to the target of around 5 percent at the end of 2013.

So far, the new policy framework has been successful in rebalancing the economy without hampering the price stability objective. Moreover, exchange rate volatility in Turkey has been lower than in peer emerging economies with current account deficits. Overall, the last two years have illustrated well the importance of establishing a flexible policy framework with a broad range of instruments in order to cope with the variety of shocks arising from global factors. The asymmetric interest rate corridor and the reserve option mechanism, which are important tools developed by the Central Bank, are likely to support the flexibility of the policy framework going ahead. Should the new framework continue to function well, it could be a good alternative to the standard inflation-targeting framework with sterilized interventions under a floating exchange rate regime. Nevertheless, the authorities are thankful for staff’s valuable contribution to the policy discussion and they will closely follow the developments under the new framework.

Fiscal Policy

The fiscal outlook remains strong. The ratio of public debt to GDP in 2012 is expected to decline from 39.2 percent in 2011 to 36.5 percent in 2012. The central government budget deficit is forecast to be around 2.3 percent, which is higher than last year’s target of 1.5 percent. As is well illustrated in the staff paper, the difference derives from primary expenditure overruns in 2012. The two main factors for the increase in primary expenditure are public spending which should improve the economy’s growth capacity, as well as uncertainties in the global and domestic growth outlook.

The latest episode of strong growth, which resulted in the high level of the current account deficit, has once again highlighted the need for measures to eliminate the bottlenecks in the economy and to improve the economic growth capacity. In this vein, the government has increased the resources for education, infrastructure, research and development, and better public administration. According to the latest budget figures, investment expenditures in education as well as in infrastructure, including energy and transportation, were significantly increased.

The uncertainties in the global and domestic economy have also resulted in a cautious stance in tightening the fiscal targets. The latest policy framework for curbing credit growth and limiting an appreciation of the TL has initiated a successful soft landing in private domestic demand, which has been the driving force of growth. Therefore, the authorities’ fiscal stance has been cautious, to avoid a hard landing in a highly uncertain global environment.

Having said that, the authorities are aware of the delicate balance between public expenditure needs and fiscal stability for long-term sustainable growth. In order to achieve the budget targets, in September 2012, the authorities announced a package of fiscal measures, including tax increases and adjustments in energy prices. The latest measures have been a strong signal of commitment to fiscal discipline.

On the other hand, the authorities are also attentive to the need for changing the tax structure from indirect to direct taxes and broadening the tax base. The size of the informal economy is seen to be the most important obstacle. Therefore, the authorities have been working on the “Strategy of Action to Fight the Informal Economy”. Part of this strategy is for example to increase the number of social security inspectors from 700 to 1500 by the end of 2012.

Financial and Corporate Sectors

The strength of the financial sector has supported strong growth during the global financial crisis. Although the banking sector has started to implement the Basel II and II.5 standards, the capital adequacy ratio has broadly preserved its already high level. The NPL ratio has also maintained its low levels. According to the Basel Quantitative Impact Studies, banks also seem to be well-positioned for the introduction of Basel III.

The authorities are closely following best practices in supervision in line with the FSAP recommendations. The Banking Regulation and Supervision Authority signed a “consolidated supervision protocol” with the Undersecretariat of Treasury, Capital Markets Board, Savings Deposit Insurance Fund, and the Central Bank to expand the coverage of consolidated supervision for banking groups. The authorities are keen on strengthening the financial stability with the support of macro-prudential tools. The developments in household, corporate and bank balance sheets have been closely evaluated in the Financial Sector Committee.

Regarding the corporate sector, the authorities closely follow the short FX position of the non-bank corporate sector, which has reached USD 126 billion. However, there are two comforting aspects; the short-term portion of the liabilities is very small (only USD 9 billion) and the rollover ratios are very strong. As it is well depicted in the graph on the rollover rates (page 6), the non-bank financial sector has been able to rollover over 100 percent during times of high financial stress. This reminds of the fact that most of these loans could be used against cash collateral. The authorities are working to obtain more data to understand the risks stemming from this.

The authorities are aware of the importance of improvements in AML/CFT. The draft legislation, which is expected to improve the framework, is submitted to parliament.

Structural Policies

The authorities agree that one of the most crucial structural policies is improving the savings to GDP ratio. The past episodes have shown that public savings did not automatically improve national savings. Therefore, more efforts will be directed to improving private savings. The private pension system has been revised to increase the number of the participants and the amount of funds under these schemes.

A simple and predictable tax policy is key to enhancing the competitiveness of the economy and reducing the informal sector. The authorities will continue to take steps to increase tax compliance and broaden the tax base.

Turkey’s dependence on energy imports necessitates more efforts in diversifying energy sources and improving energy efficiency. The authorities have been allocating more resources to decrease Turkey’s energy bill.