On behalf of the Turkish authorities, we would like to thank Mr. McGettigan and his team for the comprehensive set of reports which reflect the depth and candor of the discussions in Ankara and Istanbul.

Macroeconomic Context

A deterioration in the sentiment toward emerging market economies as well as a number of adverse geopolitical developments have triggered a major bout of stress for the Turkish economy and financial markets in the second half of 2018. Reflecting the run on Turkish assets, the Lira depreciated sharply and market valuations suffered. The adverse developments in the monetary and financial markets led to a temporary spike in inflation, while also undermining broad confidence to hamper private consumption and investment. The authorities responded to these shocks with a host of policy measures -including a significant monetary tightening by the Central Bank of Republic of Turkey (CBRT), a judicious use of the fiscal policy to introduce targeted incentives, and the restructuring of the Financial Stability and Development Committee with a stronger mandate - to (i) reinstate monetary and financial stability, (ii) facilitate the rebalancing of the economy, and (iii) avoid a sharp and protracted downturn in economic activity.

Buoyed by the authorities’ supportive policies as well as a more favorable external backdrop, the Turkish economy has embarked on a recovery path starting from Q1/2019 and y-o-y growth returned to positive territory as of Q3/2019 after having registered negative rates for three quarters. The Lira gained strength which was accompanied by more favorable market valuations as well as a gradual improvement in broad confidence indicators. Inflation, after reaching its peak (25.2 percent) in October 2018, has retreated significantly to 10.56 percent (y-o-y, end-November 2019) reflecting the tight monetary policy stance, supportive demand conditions, favorable base effects, as well as a stronger Lira. The current account has registered a remarkable correction—in the order of US$ 63.8 bn (i.e. around 8.3 percent of GDP)—to return to surplus after many years. The current account adjustment came on the back of resilient exports, decreasing import demand, and a strong tourism performance. Unemployment, on the other hand, has risen to 14 percent reflecting a broad-based slowdown in economic activity as well as the ongoing sectoral rebalancing, particularly affecting the construction sector.

The authorities have used the available fiscal room to avoid an excessive slowdown, and to aid the ongoing rebalancing of the economy. The recently announced New Economy Program has set the year-end central government budget deficit target at 2.9 percent of GDP, implying a 0.9 percentage point widening in the fiscal deficit relative to 2018. The headline figures reflect both the deliberate fiscal stimulus provided via targeted transfers and temporary tax breaks, as well as the role of automatic stabilizers (e.g. weaker indirect tax revenues). The authorities also took some steps to compensate for the weak tax revenues by non-tax revenues. Beyond the central government, the authorities do not envisage a deterioration in the balances of the rest of the public sector, including local governments. Consequently, the EU-defined general government debt stock is forecast to be at 32.8 percent of GDP as of end-2019.

Outlook and Policies

The New Economy Program¹ 2020-2022 (NEP), released in September 2019, is prepared in line with the key themes of Balance, Discipline, and Transformation and aims to uplift economic growth back to its historical averages while enhancing price and financial stability and consolidating gains on external balances.

The authorities are more sanguine on the growth outlook as they expect 5 percent real growth over the planning horizon. Following the weak performance in 2018 and 2019, the authorities believe that the slack in the economy will enable a convergence of economic activity toward its long-run trend under a moderate growth momentum without necessarily jeopardizing the price stability and external balance objectives. This ‘U-shaped’ recovery hinges on the assumption of a benign external environment which would enable a continued improvement in financial conditions for the Emerging Market Economies. Policies will continue to be geared towards supporting the tradable sectors, increasing R&D expenditures, improving the energy and logistical infrastructure, as well as upgrading the human capital. With the gradual dissipation of sectoral drags on employment (i.e. mostly from the construction sector), the authorities expect employment generation to gain pace and the unemployment rate to decline to 9.8 percent by the end of 2022.

Monetary Policy

Inflation is projected to decline to low single-digit levels. The CBRT, while retaining the medium-term inflation target at 5 percent, has set interim targets to better anchor expectations in the short term. As such, the headline CPI, which is forecast to be at 12 percent as of end-2019, is projected to decline gradually to 8.2 percent in 2020, 5.4 percent in 2021, and stabilize around the target by 2022.

The authorities concur that managing inflation expectations is critical for a sustained disinflation process. Currently, 12 and 24-month ahead expectations hover above the CBRT’s forecasts while there is a gradual convergence of expectations toward the authorities’ interim targets. On that note, the authorities believe that the CBRT’s improved forecast accuracy since October 2018 has significantly supported the credibility of the monetary policies and help anchor expectations. With medium-term expectations still lying outside the uncertainty band around the inflation target, the authorities agree that all macroeconomic policies should be coordinated to bring the inflation down.

The authorities consider the current monetary policy stance consistent with the projected disinflation path. The CBRT has cut the interest rates by a cumulative of 1000 bps since July 2019, in view of the improving inflation outlook amid upbeat indicators for underlying inflation, supply-side factors, and favorable import prices. Additionally, the authorities take the global monetary conditions into consideration in their decision processes as well.

The recent rate cuts by the CBRT led to a downward shift in the yield curves of bond and swap markets confirming a more favorable inflation outlook, the improvement in expectations, and a decline in the risk premium.

The authorities concur with the staff on the need to accumulate international reserves as economic and financial conditions permit. They also underscore that the international reserve data is compiled and published in a timely, comprehensive, and transparent manner, consistent with international standards.

Fiscal Policy

Fiscal policy will be growth-friendly and fiscal prudence - the long-standing anchor of the Turkish economy’s resilience - will be preserved. The overall fiscal policy stance, which was recalibrated in 2018-19 to buttress economic activity, will be broadly kept unchanged in 2020. On a similar note, the budget deficit-to-GDP ratio is targeted to remain below 3 percent in the outer years of the planning period as well. The authorities believe that stronger economic activity as well as improvements to the revenue administration will help reverse the relatively weak tax performance in 2019. Currently, the authorities do not intend to introduce new tax policy measures in addition to what was already enacted in 2019. Efforts to restrain expenditure growth as well as to improve the composition of the spending envelope will continue. Consequently, public debt is set to remain broadly flat between 32–34 percent of GDP throughout the NEP period.

Even though debt sustainability is not a source of concern, fiscal discipline will be used as a policy tool to complement the monetary policy efforts to tame inflation. In this regard, the 2020 central government budget aims to strike a delicate balance between buttressing economic activity and consolidating the gains of rebalancing. Furthermore, the authorities will continue to set public wages through a rules-based methodology and in line with the projected inflation path.

On Public-Private-Partnership (PPP) projects, building on the assessments and recommendations of the very productive technical assistance mission conducted in late 2017, a framework arrangement will be prepared to ensure efficiency, productivity, affordability, and integrity in PPP applications. On the Sovereign Wealth Fund (SWF), the authorities assured staff that they will adhere to international best practices in accounting of its activities.

Current Account

The current account will be kept at sustainable levels. The rapid and sizable adjustment in the current account is a defining feature of the rebalancing story of the Turkish economy. In view of the volatile external environment, the authorities are keen to keep the current account in close check and avoid any undue expansion of the deficit that would expose the economy to the swings in the global sentiment. In that vein, the current account is expected to post a deficit of 1.2 percent of GDP in 2020 - a level that is in broad conformity with the Fund’s norm current account assessments and will keep the external financing needs at a reasonable level. The authorities will also give prominence to structural policies that aim to increase exports of high value-added products, reduce import dependence on key sectors, and bolster the tourism potential.

Financial Sector

The Turkish banking system has proven its resilience in the face of severe adverse shocks. Turkish banks are well capitalized with a system-wide capital adequacy ratio above 18 percent (latest data as of October 2019) which is well above the regulatory minimum. The total non-performing loan ratio, notwithstanding a modest increase, remains at manageable levels (i.e. 5.15 percent). By regulation, banks are not allowed to carry net open FX positions beyond a certain limit (i.e. 20 percent of regulatory capital) and therefore, the balance sheet of the banking system is effectively immune to the direct effects of currency valuation, including through appropriate use of off-balance sheet hedging instruments. The authorities do not agree with staff’s assessment of a continued positive credit gap and believe that although the latest credit developments indicate a revival of loan growth, the credit gap is still in negative territory. Furthermore, both the banking regulator as well as the analysts from the banking sector concurred that the weakness in loan growth is primarily driven by sluggish credit demand rather than supply side constraints. The authorities, while acknowledging the possible confidence effects of a third-party asset quality review, consider the current supervisory framework robust—aided by regular, detailed on-site examinations as well as an effective stress test framework.

The authorities agree that an effective insolvency regime and an out-of-court restructuring system will be crucial to resolve remaining balance sheet issues in the non-financial corporate sector. Therefore, the authorities are working on a new legislation that will modernize the legal framework as well as address identified stretches in the current system, including those pertaining to debtor-creditor rights. The authorities also encourage private-sector driven initiatives to facilitate voluntary restructuring of debt contracts.

Structural Reforms

The current political landscape gives a window of opportunity 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. Policies are already underway to improve the efficiency of inter alia the labor market, business environment, public financial management, capital markets, and judicial and education systems. Targeted incentives will continue to support the renewable energy as well as other critical and technology-intensive sectors. With a stronger focus on social inclusion, poverty alleviation, and providing equal opportunity to all, the authorities are also intensifying their efforts to improve social outcomes in Turkey. These efforts are bearing fruit as the rank of Turkey in World Bank Doing Business Indicators has improved to 33 in 2019, from 60 in 2017. The authorities acknowledge the need for better prioritization of the reform agenda and appreciate the thematic analysis by staff which has provided valuable insights.

International Development Efforts and Refugees

Turkey, despite recent economic challenges, continues to expand its global humanitarian outreach in support of the UN Sustainable Development Goals, with its total development assistance reaching USD 9.3 billion just in 2017 - affirming its position as one of the most generous countries globally.

With more than 4 million refugees, Turkey continues to host the largest population of displaced people globally. Significant efforts and funding were mobilized to provide essential public services, including education and health for these people. The authorities continue to take measures to integrate refugees to social and economic life in Turkey, while also spearheading international efforts to secure a safe and voluntary return of these people to their home countries.

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. The authorities will continue to work closely with the Fund.