Macroeconomic Context

Growth regained momentum with strong employment generation. In the wake of a period of significant headwinds, the authorities entered 2017 with a recalibrated policy mix to stave off emerging contractionary pressures, and buttress lingering confidence. As such;

• Fiscal policy was used judiciously and on a strictly measured basis to preserve the production and employment base via targeted transfers, investment and employment incentive schemes, temporary tax breaks, and an emphasis on key public investment programs upgrading the education, health, energy, transportation and telecommunications infrastructure – including through public-private-partnerships (PPPs). All in all, the drag on Turkey’s public indebtedness is estimated to be very limited as the general government debt to GDP ratio is expected to remain at around 28.5 percent as of end-2017.

• The Credit Guarantee Fund (CGF) was restructured and scaled up to provide Treasury guarantees to a portfolio of TL 250 billion (about USD 65 billion) for a period of 3 years. In designing the CGF, the authorities (i) aimed to support the ailing credit market against the backdrop of substantial economic and non-economic uncertainties, (ii) uphold the market dynamics as key marketing, due diligence, and liquidity decisions are retained within the banking system, and (iii) carefully contain the contingent fiscal liabilities by imposing a 7 percent ceiling on the possible Treasury assumptions of problematic loans, which effectively limits the maximum fiscal burden to about USD 4.5 billion over a three-year period. The authorities appreciate the analyses by the staff on the CGF and its impact on various macroeconomic indicators, and see these analyses broadly in line with their own assessments, particularly as regards the contributions to 2017 growth. Beyond being an effective anti-recessionary tool, the CGF is also seen by the authorities as an instrument to address the inherent market failures owing to the prevailing uncertainties and information asymmetries stemming from a conflux of shocks in 2016, including a failed coup attempt.

Buoyed by these supportive policies as well as a more favorable external backdrop, the Turkish economy rebounded very strongly last year with an estimated growth of around 7 percent, placing Turkey among the top performers among major economies. Continuing its impressive track record post-global recession, employment generation was robust again in 2017 as 1.6 million new jobs were added throughout the year. Notwithstanding these impressive outcomes, the magnitude and pace of the economy’s response went beyond what the authorities had envisaged as growth targets in their initial (i.e. covering 2017 – 2019) and revised Medium-Term Programs (i.e. covering 2018 – 2020) – which are 4.4 percent and 5.5 percent, respectively.

Despite the strong export performance and rapid recovery in the tourism sector, the current account deficit has widened from 3.8 percent in 2016, to an estimated 5.5 percent of the GDP in 2017. Exports (fob) increased by 10.2 percent, driven among other factors by the firm recovery in trading partners, notably in the EU; and net tourism receipts soared by 26 percent, reflecting mainly a significant improvement in broader security and geopolitical conditions. Nevertheless, imports (cif) inched further by an increase of 17.7 percent, on account of buoyed domestic demand, deteriorating terms of trade and a significant uptick in net gold imports – reaching USD 10 billion (more than 1.1 percent of GDP) last year. On the financing side, solid investment appetite towards Turkish equities and bond markets bore the brunt of net external funding needs.

Consumer prices edged up by 11.9 percent (y-o-y / end-2017), while recent inflation readings show signs of moderation. In view of the rising inflationary pressures, the Central Bank of Republic of Turkey (CBRT) tightened the monetary stance, and the weighted average funding cost has risen by almost 500 bps throughout 2017. Despite this substantive policy tightening, the exchange rate pass-through of previous bouts of Turkish lira depreciation, recovering global energy commodity prices and continued pressures from food prices have fueled inflation up. Headline CPI inflation recently lost momentum, as the y-o-y inflation receded to 10.3 percent in February 2018 on account of favorable base effects, and dissipating first-round pressures from FX pass-through.

Outlook and Policies

The Medium-Term Program¹ 2018–2020 (MTP), announced in October 2017, is appropriately geared towards promoting strong and inclusive growth while ensuring macroeconomic stability, taming inflation, and reducing external imbalances.

The authorities, while envisaging a gradual moderation in the program period, are more sanguine on the growth outlook. GDP growth is expected to moderate to 5.5 percent in 2018 and onwards – slightly higher than staff’s forecast – more in line with the potential of the economy. In view of the rising inflationary pressures and widening current account deficit, the authorities see a gradual moderation in growth, conducive to the rebalancing of the economy. That said, the authorities disagree with the staff on the estimate of the potential growth rate and thus, the precise cyclical position of the Turkish economy. While acknowledging the fact that estimating potential output is a daunting task and that pinpointing a precise number is not possible, the authorities see the discussion on potential growth as a crucial one that would underpin the direction of the entire policy debate. Particularly at the current juncture, where widening imbalances have accompanied a year of very strong growth, identifying the dynamics at play and putting forward an accurate diagnosis could not be more important. The authorities see the current staff range estimate of 3.5 – 4.0 percent for potential growth as too conservative, in light of the following considerations:

• Historically, since the establishment of the Republic, the Turkish economy has managed to record an average real growth rate of about 4.8 percent per annum. More recently, in the period 2011 – 2016, the average growth rate of the economy soared above 6.4 percent per annum. While acknowledging the forward-looking nature of potential output estimates, the authorities see a disconnect between the staff projections and Turkey’s past growth trajectory.

• Methodologically, the authorities concur that the recent episode of growth in Turkey relied primarily on factor (i.e. capital and labor) accumulation, and that the non-factor residual (a.k.a Solow residual) remained subdued, at times negative. The authorities, however, attribute the recent subdued trend of the Solow residual to a number of economic and non-economic shocks that have hindered effective allocation and utilization of resources in the economy, and thus, argue that this phenomenon is transitory and could not be extrapolated to a negative long-run total factor productivity (TFP) contribution to growth. The authorities further believe that an adjustment to staff’s negative TFP growth estimates that would simply take into account Turkey’s past 15 years’ TFP growth average (i.e. close to 1 percent per annum) or an international benchmark based on peer countries with similar convergence potential could materially raise staff’s potential output estimates.

• Judgmentally, the authorities observed that some of the assumptions by the staff on the respective contribution of labor to output were too conservative and in particular, failed to duly incorporate a sustained increase in the female labor force participation and thus, the active population growth rate. Reflecting the facts that (i) average years of schooling in Turkey are fast converging to the OECD average on the back of 12-year compulsory schooling, (ii) at all levels of education, female students now constitute about half of the student cohorts, and (iii) female labor force participation is strongly correlated with educational attainment – reaching above 70 percent among university graduates; the authorities envisage a higher path for labor contribution to long-run output. Staff assumptions on population and labor also beset the calculated optimal investment rate.

The current account deficit will be contained. The authorities closely monitor the developments on the current account and put external rebalancing as one of the key policy objectives. The MTP set the official target for the current account deficit at 4.3 percent of GDP in 2018. Under a set of assumptions that would include (i) moderation of growth from its current levels, (ii) a reversion of net gold trade towards its historical averages (USD 1.5billion), (iii) no material terms of trade shock, (iv) continued recovery of the tourism sector and shuttle trade, (v) continued export performance underpinned by inter alia firm trading partner growth and increased competitiveness, the authorities see the MTP target attainable.

The authorities also concur with the staff on the need to accumulate international reserves towards more comfortable levels, as financing conditions permit.

Monetary Policy

Inflation is projected to moderate. The authorities appreciate the staff’s work on re-estimating the Philips Curve for the Turkish economy. They see that the rise in the headline inflation in Turkey can be mainly attributable to core inflation – which inter alia reflects pass through pressures from previous bouts of lira depreciation, and to exogenous supply-side issues epitomized by Turkey’s structural reliance on energy imports, and inherent inefficiencies in the food supply-chains. The CBRT estimates the output gap to move towards negative territory in the second half of 2018 and assumes continued moderation of credit growth as the CGF gradually tapers, implying limited inflationary pressures from the demand side. The authorities also see the strong monetary-fiscal policy coordination help keeping administered price inflation at low levels.

Against this backdrop, the authorities see their current monetary policy stance tight enough to contain broad inflationary pressures and allow for a gradual easing of the inflation to single-digit levels this year (with the current end-year inflation estimate standing at 6.5 – 9.3 percent). Recent developments in exchange rates and oil prices have led to upside risks to this forecast, but the monetary policy maintains a tightening bias and is ready to further tighten policy stance if needed. The authorities also pursue a gradual shift towards a simpler policy framework, with all funding executed from a single facility, implying an effective policy rate of 12.75 percent. Interbank rates have converged to CBRT funding rate and the predictability of monetary policy has improved considerably. In broad agreement with the staff assessment that the cost of disinflation in Turkey has recently edged higher, and taking into account the nature of the shocks to the economy, the authorities opt for a more gradual, but steady convergence towards the target inflation.

Beyond the cyclical drivers of inflation, the authorities are determined to continue to address the root causes of the supply-side hindrances to price stability, notably from energy and food. With respect to energy, in line with the Development Plan objectives, measures to break structural dependence on energy imports continue. As for example, the share of renewable sources (including hydro) in electricity generation in Turkey has already surpassed 30 percent of the energy mix, with further significant investments in generation capacity in the pipeline. Beyond their obvious climate-related benefits, these steps will also help alleviate inflationary inertia and current account pressures. On a similar note, the Food and Agricultural Products Markets Monitoring and Evaluation Committee continues to monitor food prices and take necessary measures to curb undue price changes, including by selective relaxation of import quotas.

Fiscal Policy

The fiscal policy stance will be growth-friendly, and fiscal prudence – the linchpin of the Turkish economy’s resilience – will be maintained. Fiscal policy, which was at the forefront of the supportive policies in 2017, was gradually recalibrated in lockstep with the strength of the economic activity. In addition to the time-bound elements of the fiscal stimulus that expired in the second half of 2017, the authorities also took steps to restrain expenditure growth, while windfall revenue gains improved the year-end central government budget deficit – expected to be realized as 1.5 percent of GDP – below the official estimates of the revised MTP (i.e. 2 percent). Consequently, the public debt-to-GDP ratio in EU definition is estimated to remain broadly stable at around 28.5 percent, putting Turkey among the top performers in its peer group.

Even though debt sustainability is not a source of concern, fiscal discipline will remain intact to complement the monetary policy’s efforts to tame inflation. The 2018 central government budget, adopted by the Parliament, aims to strike a delicate balance between bolstering growth potential and allowing for a gradual rebalancing of the economy. The budgetary emphasis on capital spending, SME incentive schemes, and R&D expenditures will support growth. The authorities were puzzled about the specific staff recommendation to refrain from backward wage indexation, as in a year when nominal GDP is expected to grow by about 19 percent, the public sector wage bill has contracted in nominal terms, limiting the relevance of such an emphasis. Given the declining share of labor in the overall output of Turkey, they also could not reconcile this advice with the emerging emphasis of the Fund on income inequalities.

On the quasi-fiscal activities and contingent liabilities, the authorities closely monitor the developments on the state loan guarantees, including under the portfolio guarantee scheme (CGF), and do not expect a material impact on the fiscal balances. Under the portfolio guarantee scheme, they see the existing safeguards, particularly the loan assumption ceiling of 7 percent of the portfolio, as sufficiently prudent. For transparency purposes, the authorities also budgeted a contingency (i.e. about 0.1 percent of GDP) for fiscal year 2018 to cover potential assumptions by the Treasury. On PPPs, the authorities appreciate the analyses by the staff as well as a very productive TA mission in December 2017. The authorities will continue to improve assessment, monitoring, reporting and management of the PPP portfolio, including by improving the legal framework, as needed. On the Sovereign Wealth Fund (SWF), the authorities assured staff that they will adhere to the international best practices in accounting of its activities once it will become operational.

Financial Sector

The Turkish banking system is well-capitalized with strong liquidity buffers and asset quality. The capital adequacy ratio of 16.8 percent (latest data – as of January 2018) remained well above the regulatory minimum. The total non-performing loan ratio was stable around 3 percent, thanks to robust economic activity, momentum in credit growth and portfolio guarantees by the CGF. As an early indication of the asset quality of the CGF-backed loans, the NPL ratio currently stands at less than 0.5 percent. By regulation, banks are not allowed to carry net open FX positions and therefore, the balance sheet of the banking system is effectively immune from direct effects of currency valuation, including through appropriate hedging. The 13-week annualized rate of credit growth has slowed down to 12.9 percent recently, signaling a moderation.

The authorities have announced a new protocol for the use of remaining CGF-backed loans (TL 55 billion), with a new set of criteria ensuring a more selective targeting towards mostly manufacturing and export-oriented companies – to account for about ¾ of the new loans, and female and young entrepreneurs.

The corporate sector has weathered well the impacts of the Turkish lira depreciation. There are a number of factors mitigating the FX risk of the corporate sector: (i) Most firms with FX liabilities are either hedged or have a natural hedge in the form of FX revenues or FX receipts from other group of firms in a holding company. (ii) FX loans are concentrated in large companies with the capacity to absorb the impacts of large FX depreciation. (iii) The corporate sector has its net FX long position in the short term. (iv) Offshore FX assets held by firms act as a buffer in times of stress. (v) The share of FX loans in corporate loan volume fell as companies shift to TL financing in the face of FX depreciation.

Nevertheless, with an eye on the macro stability implications, the authorities are determined to use macroprudential measures to curb FX borrowing by non-financial corporates. As a first step in this direction, the authorities put in place a new regulation effective as of May 2, 2018 that will introduce a ceiling (i.e. equivalent to the total of preceding 3 years’ FX receipts) to the FX borrowings of small- and medium-sized enterprises. Although these enterprises account for less than 20 percent of the FX-denominated loan stock, they were deemed as a priority group, given their limitations for effective corporate risk management. To supplement these efforts, the authorities are now working on a more comprehensive prudential framework for containing large corporates’ FX exposures, which is expected to be announced this year. Following these steps, the macroprudential framework on FX borrowing will cover all major balance sheets of the economy – banks, households, and non-financial corporates.

Structural Reforms

There is strong political ownership and resolve to implement comprehensive structural reforms in an effort to improve the Turkish economy’s competitiveness, strengthen its resilience to external shocks, and address impediments to job creation and investments. Against a very challenging backdrop, authorities managed to secure progress in labor market, business environment, public administration and finance, and judicial and education systems through their reform steps in the last couple of years. Authorities acknowledge the need for renewed reform momentum and have identified inter alia the following as their reform priorities:

• Labor Market: Severance pay reform, enhancing active labor market programs, boosting on the job training

• Public Finance: Income Tax Code, Tax Procedures Code, VAT reform, extending the Treasury single account coverage, public expenditures reform

• Capital Markets: Capital Markets Law, Istanbul Finance Center reform, restructuring the private pension system, introduction of new savings and investment instruments (e.g. housing accounts, and gold lease certificates)

• Public Personnel Reform: Civil Service Code

• Education: Increasing share of private sector, lifelong education centers, prioritization of foreign language learning, establishing an academy for teachers, introducing compulsory pre-school education, improving vocational and technical education

• Investment Climate and Competitiveness: Boosting R&D and innovation, easing regulatory burden, access to finance, improving logistics, establishing the Localization Board, restructuring the Scientific and Technological Research Council of Turkey (TÜBİTAK) and the state-owned development bank

International Development Efforts and Refugees

Turkey, reflecting its growing economy and connectivity, has been an important cornerstone of stability in its region and beyond. Turkey has also significantly ramped up its global humanitarian outreach in support of the UN Sustainable Development Goals, with its total development assistance reaching USD 7.9 billion in 2016, making it one of the most generous countries globally.

Turkey continues to host about 4 million refugees and caters to more than 600,000 beyond its borders, making it the largest refugee-hosting and supporting country. Significant efforts and funding were mobilized to establish high-standard refugee camps along with essential public services, including education and health. The authorities continuously take measures to integrate refugees to social and economic life, including through granting work permits. Authorities, while recognizing the challenges facing Syrian refugees in the labor market, see those mostly stemming from market dynamics, rather than administrative restrictions. Turkey and the EU continue to cooperate on the refugee matters.

Final Remarks

The Turkish authorities are grateful for the analytical depth and rigor of the Article IV consultations and associated policy advice, which will carefully be assessed. Authorities will continue to work closely with the Fund, including through targeted Technical Assistance that would support key policy and reform initiatives.