Turkey -- 2007 Article IV Consultation, Concluding Statement of the IMF Mission
March 9, 2007
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
1. Turkey's macroeconomic performance since 2001 has been impressive. A combination of fiscal discipline and prudent monetary policy by an independent central bank has set off a virtuous cycle of falling inflation, declining public debt, and high, private sector-led growth. Political stability, structural reforms, and favorable external conditions have facilitated this good performance. In particular, improvements in the bank supervisory framework, tax reform, and privatization have strengthened the banking system, promoted foreign direct investment, and enhanced productivity.
2. Recently, the economy has entered a more challenging phase. Growth has come down from the high rate (over 7½ percent) during the rebound from the 2001 crisis. Last year's financial market turbulence and widening current account deficit contributed to this slowdown by weighing on confidence and raising risk premia. Moreover, higher interest rates in response to a concurrent uptick in inflation reduced credit growth and dampened the pace of domestic demand. Looking forward, we expect GDP growth to ease to about 5 percent, while, with little slack in the economy, inflation is likely to converge to target only gradually. And, though the trend in the current account deficit is expected to reverse in 2007 (helped by softer domestic demand, lower oil prices, and robust growth in Turkey's main trading partners), external financing needs remain large, leaving the economy susceptible to financial market turmoil.
3. Against this backdrop, the Article IV discussions focused on policies to raise potential growth and increase resiliency to external shocks. While current growth is strong by Turkey's historical standards, it still falls short of the rates seen in the most dynamic emerging market economies, while unemployment has remained high. Raising growth potential will require a decisive improvement in the confidence of markets and potential domestic and foreign investors. In our discussions with the authorities, there was consensus on policies to achieve this objective:
• continued fiscal and monetary discipline to secure low inflation and lessen vulnerabilities, especially from the still high public debt.
• supply-side structural reforms to bolster productivity and increase employment and investment.
Successful implementation of these policies could raise potential growth well above 5 percent. Stronger growth, in turn, would reduce susceptibility to external shocks by improving the economy's ability to sustain current account deficits and by tilting external financing toward more stable sources, such as foreign direct investment.
Maintaining Disciplined Financial Policies
4. Low single-digit inflation would support strong and stable medium-term growth. The significant fall in inflation during the past five years has spurred confidence and enhanced policy credibility. But it has not gone far enough. International experience shows the clear benefits for growth of low inflation. Notwithstanding last year's reversal in the trend of declining inflation, the authorities face a unique opportunity to make the final push to reduce inflation to the 4 percent target. From this perspective, the current level of interest rates is appropriate, and the central bank stands ready to tighten further if inflation fails to converge toward target. Once inflation is firmly on a declining trend, interest rates will be reduced, albeit cautiously. The central bank's operational independence under the new inflation targeting regime along with a flexible exchange rate are essential for the pursuit of low inflation.
5. Achieving the 2007 fiscal targets will help lower inflation and preserve financial market confidence. In recent years, a steady primary surplus has produced enormous benefits-slashing public debt, lowering inflation, reducing real interest rates, creating space for private investment, and bolstering national savings. Maintaining a primary surplus target of at least 6.5 percent of GNP will reinforce these trends, contain the current account deficit, and help shield the economy from adverse shocks. To attain this objective, spending restraint will be crucial; ad hoc initiatives that weaken budget quality and erode the tax base also should be avoided.
6. Over the medium term, the challenge will be to anchor fiscal policies around the key objectives of reducing public debt and cutting distortionary taxes. There was agreement that reducing debt to a safer level (around 30 percent of GNP in net terms) over the medium term remains the overriding fiscal priority. To this end, the primary surplus target of 6.5 percent of GNP should be retained through 2008. Thereafter, there could be room for lowering the primary surplus target, provided the debt objective is within reach. However, a new anchor for fiscal policy will be needed. We suggest consideration of a fiscal rule (such as a formal limit on spending growth or on the overall deficit). Setting an explicit limit on spending would not only help keep debt low, but also create space for growth-enhancing tax reforms, such as cutting the high tax burden on employment and bank transactions. To be effective, any formal fiscal rule would need to be supported by ongoing improvements in public financial management and fiscal transparency, as well as measures, notably civil service and social security reform, to contain nondiscretionary spending.
Deepening Structural Reforms
7. The immediate post-election period should provide an opportunity to launch a new agenda of structural reform. Now is the time to begin preparing reforms to place growth on the high trajectory seen in the most dynamic emerging market economies. Immediate priorities should be given to measures that secure long-term fiscal savings, and bolster productivity and employment.
8. A central element of the reform agenda should be resurrecting social security reform. The Constitutional Court annulled key elements of the 2006 social security law. Such reform remains, however, essential to avoid large future deficits in the pension and health care systems and create fiscal resources for other, growth-enhancing reforms. We recommend early adoption of revised legislation that achieves the originally envisaged savings. At the same time, consideration should be given to additional administrative measures to improve social security collections and make health spending more cost effective.
9. Future growth will depend critically on increasing employment and labor productivity. In our discussions, there was consensus that easing high levels of labor regulation and taxation could lower unemployment, increase labor force participation, and reduce the large informal sector. This would help increase productivity and raise employment to absorb Turkey's rapidly growing population as well as workers released from the secular decline in the agricultural sector. Specific measures to reduce labor market rigidities could include (i) alleviating hiring requirements imposed on medium-sized and large companies; (ii) rationalizing mandatory severance pay; (iii) allowing more flexible terms of employment; and (iv) reducing labor taxes. The overall reform needs to be contingent on the creation of fiscal savings, to the extent necessary.
10. A strong financial system is also a precondition for boosting growth. The financial system has been transformed since the 2001 crisis, including by the recent surge of foreign direct investment into banks. The adoption of the mortgage law is welcome, as it should further expand households' access to credit by introducing adjustable-rate mortgage loans. We see scope for measures to develop further the capital markets, including by increasing the availability of long-term lira financing and reducing its costs. Priorities are to (i) abolish financial transaction taxes as budgetary conditions permit, and (ii) carry forward decisively the privatization of state banks, beginning with the timely completion of the initial public offering of Halkbank.
11. As the financial sector develops, a key challenge will be to ensure that institutional and supervisory frameworks are upgraded in tandem. Building on recent progress in modernizing the institutional framework for bank supervision, the priority is to further enhance supervisory practices to meet the high standards enshrined in the new banking law. As the financial system becomes more complex, supervisors should ensure that risks are assessed on a consolidated basis. The coverage and timeliness of corporate balance sheet data also need to be improved to facilitate closer monitoring of financial risks. Early passage of the Commercial Code, which among other things requires companies to prepare financial statements in line with International Financial Accounting Standards, would help in this regard.
12. Our discussions suggest significant scope to continue improving the investment climate. Foreign direct investment has soared in recent years, led by banking, telecommunications, and real estate. There is substantial scope for further expansion in the future. Advancing the privatization program, continuing reforms aimed at convergence with the European Union, and easing product market regulations so as to lower barriers to entry would help support additional private investment.
13. Opportunities for the Turkish economy are enormous. The goal should be to build on the economic success of the last five years to firmly entrench high growth, secure low inflation, and make the economy more flexible and resilient to external shocks. Continued disciplined fiscal and monetary policies complemented by bold structural reforms are essential to lift Turkey onto a significantly higher growth trajectory. The agenda is large and some reforms could face resistance, but the rewards in terms of sustained improvements in living standards would make the effort well worthwhile.
We thank the authorities and private sector participants for their kind hospitality and spirited and candid discussions during our stay.