Turkey—2010 Article IV Consultation and Post-Program Monitoring: Preliminary Conclusions
May 28, 2010
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.
A. Background and Overview
1. The Turkish economy entered the global financial and economic crisis following a six-year growth surge that was fuelled by far-reaching policy reforms and greater political stability. The reforms of the past decade, particularly fiscal discipline, introduction of inflation targeting, and overhaul of financial sector oversight, together with political stability and opening of EU accession negotiations, significantly improved confidence in the management of the economy. These factors contributed to a high fiscal primary surplus, rapidly falling public debt, and moderate inflation.
2. The aforementioned policy reforms kept pre-crisis vulnerabilities more contained than elsewhere in the region, enabling Turkey to better weather the ensuing international economic and financial disruption. Good policies in the context of surplus global liquidity attracted strong capital inflows that relaxed the financing constraint and enabled a domestic-demand led expansion. The resulting boom in private investment and fall in private savings led to a widening of the current account deficit in a strong currency environment. Nonetheless, Turkey’s domestic and external imbalances remained more contained than in the rest of Emerging Europe, reflecting a smaller foreign-financed credit boom, macro policies that were better focused on resisting the cyclical upswing, and more restrictive prudential regulations.
3. Growth has resumed, but risks being overly reliant on consumption, which would feed external vulnerabilities—especially in the current global environment. Vigilance and timely policy responses are required to avoid rising inflation and an unsustainable widening of the current account deficit in a strong capital–inflows environment, particularly if these flows are mostly short term.
B. Recent Developments and Outlook
4. The Turkish economy recovered quickly from the precipitous drop in output triggered by the global crisis. Globally-synchronized capital outflows and a sharp decline in confidence led GDP to fall by a seasonally adjusted 12 percent during Q4 2008-Q1 2009. Inflation and the current account deficit declined markedly on falling commodity prices and a widening output gap. Temporary tax cuts, an unprecedented reduction in policy interest rates, and deep price discounts fuelled a rapid recovery of demand from the second quarter, which contained the annual decline in GDP to 4¾ percent. Recently, increased indirect taxes and other price shocks and the rebound in demand and commodity prices caused inflation, the current account deficit, and the real exchange rate to quickly reverse. Unemployment, which initially jumped up sharply, has moderated somewhat, but remains elevated.
5. The banking sector—a source of instability during the 2000-01 crisis—proved remarkably resilient. Large capital and liquidity buffers, little direct foreign currency exposure, and reliance on deposit-based funding helped insulate banks from global deleveraging and the ensuing output decline. Wider interest margins boosted profits by 50 percent in 2009 and, combined with some relaxation of loan classification regulations and banks’ shift to zero risk-weighted government securities, lifted already strong capital adequacy ratios even higher to around 20 percent. Although maturing credits were generally rolled over, net credit expansion (especially by private banks) was weak for most of 2009, but picked up robustly from late in the year. Year-to-date, credit has grown at an annualized rate of 30 percent as banks compensate narrowing interest margins with larger volumes.
6. The bounce back in growth appears set to continue, accompanied by a rising current account deficit and, in the near term, above–target inflation. Robust within-year momentum and strong carry-over from a weak base will propel GDP growth to around 6¼ percent in 2010, gradually moderating to around 4 percent thereafter. The strong real exchange rate and slower recovery in major trading partners will tilt demand toward consumption and investment in nontradables, with imports comprising a growing share of final domestic demand and intermediate inputs. As a result, the current account deficit is expected to widen gradually from around 4¾ percent of GDP in 2010 to near 6 percent of GDP in the medium term. Inflation, which temporarily hit double digits in recent months, is expected to moderate slowly as base effects from excise increases dissipate and monetary policy reacts to return inflation gradually to target.
C. Policy Assessment and Recommendations
7. A fairly strong starting position allowed Turkey to respond decisively to the global deleveraging and ensuing output decline with a package of measures that was timely, targeted, and broadly appropriate in magnitude. Aggressive monetary loosening and liquidity injections lowered private sector borrowing costs (including on existing corporate loans) and was instrumental in reducing fiscal funding costs and stimulating banks’ appetite for government paper. Fiscal policy was initially relaxed sharply, including through effective cuts in indirect taxes on consumer durables which supported a recovery in private demand. Rapid erosion of the primary balance, much of it from cyclical revenue loss, caused the government in mid-2009 to raise excises on tobacco and fuel to contain the deterioration. Several changes to prudential regulations—including easing conditions for restructuring loans, a one-time reclassification of banks’ holdings of government securities, and regulatory approval for payout of bank dividends—were introduced to encourage new lending and preserve banks’ high capital adequacy ratio.
8. The authorities have begun to gradually implement comprehensive exit strategies from fiscal and monetary stimulus. The medium-term program (MTP) for 2010-12, adopted in September 2009, foresees a gradual improvement in the fiscal balance, supported by a deficit-based fiscal rule from the 2011 budget cycle. Predicated on a mild growth recovery of 3½ percent, the 2010 budget targets a primary deficit for the nonfinancial public sector of 0.3 percent of GDP, which has been supported by further increases in excises on fuel and tobacco at the beginning of this year and savings in healthcare costs. In view of increased uncertainty on the revenue outlook and a desire for prudent budgeting, the authorities intend to adhere closely to the original 2010 target. On monetary policy, the Central Bank of Turkey (CBT) plans to gradually reverse foreign currency and lira liquidity measures, with increases in the policy rate beginning in Q4 2010 under its baseline scenario. However, a temporary exemption from the general provisioning for new loans was recently introduced and the aforementioned loan restructuring regulations were extended in order to continue to support credit growth.
9. Turkey’s existing countercyclical inflation targeting framework is an important strength, and from 2011 will be accompanied by a comprehensive fiscal rule that sets prudent deficit ceilings. The draft fiscal rule legislation, which is expected to be approved next month, sets an annual deficit ceiling that adjusts to cyclical conditions while converging gradually to the medium-term deficit target. The formulation of the rule, choice of parameters, and comprehensiveness of institutional coverage will together establish prudent, feasible, and countercyclical deficit ceilings. The draft legislation also proposes important improvements to Turkey’s public financial management procedures, including more transparent and comprehensive reporting of fiscal projections and outturns, tighter oversight of local government borrowing, and strengthened controls to deliver spending outturns more in line with the budget. Mechanisms are also needed to encourage conservative budget forecasts, ensure timely implementation of within-year deficit-reducing measures when needed, and strengthen fiscal coordination between central and local governments. While adoption of the rule will be a major milestone for entrenching fiscal discipline, success will ultimately depend on the strength of commitment to implementing the rule’s provisions.
10. To prevent the emergence of an unbalanced and unsustainable growth path, policy stimulus injected to respond to the crisis should be withdrawn and exit plans accelerated. While capacity utilization has not fully recovered in export sectors, plans to tighten policies should be brought forward because domestic demand, which is growing very rapidly, is an imperfect substitute for external demand as a significant part of domestic demand falls on imports owing both to the strong real exchange rate and the different commodity composition of domestic demand and local production. Hence, in the baseline scenario, policies should aim at containing domestic demand and lowering the relative price of locally supplied products to help support net exports. Policies to promote domestic saving will also reduce reliance on volatile short-term capital inflows to finance investment.
11. Risks to the baseline scenario are broadly balanced, but substantial, and require a modified policy response from the one discussed in the sections below should they materialize. Direct spillover channels through banking and trade from the most severely affected euro area countries are limited. Therefore, with the continuing robust recovery in many emerging markets, Turkey could face higher capital inflows and commodity import prices than envisaged in the baseline, exacerbating inflation and current account deficit pressures. In this event, fiscal and monetary exit would need to be further accelerated. However, a generalized increase in risk aversion and further weakness in the euro area’s recovery pose significant downside risks for Turkey’s exports and growth. If accompanied by reduced inflationary pressure in Turkey (due to lower aggregate demand and weaker commodity prices), monetary tightening should be halted and even reversed if necessary. Fiscal consolidation should continue apace in this scenario in order to support monetary easing and promote confidence in fiscal and external sustainability.
12. Fiscal policy in 2010 should preserve the cyclical adjustment envisaged in the 2010-12 MTP in the context of now faster growth, thus also establishing an appropriate starting point for the fiscal rule. While suitable when conceived in the midst of the crisis, the ambition of the 2010 primary balance target has been overtaken by the stronger 2009 outturn and upward revisions to 2010 growth and inflation forecasts. Adhering to the original target would now imply no structural improvement this year, while macroeconomic conditions and external developments argue for a structural tightening. Therefore, spending should adhere closely to the plans legislated in the 2010 budget (allowing for mandatory adjustments for inflation indexation-related increases in wages and pensions, and revenue sharing), while avoiding revenue-reducing policy changes. Such a policy would help contain current account and inflation pressures, limit private sector crowding out, and promote the fiscal rule’s success by reducing the adjustment required in 2011. It would also reinforce Turkey’s fiscal discipline credentials by more quickly reducing government debt and adopting a sound fiscal stance for the period ahead.
13. Revenue and expenditure policies should support the fiscal improvement required by the rule. The authorities implemented important expenditure policies to support the MTP, including demand- and supply-side measures in health care and prudent public sector wage increases. These policies, and earlier social security reforms, should be strictly pursued in order to avoid medium-term pressures that would complicate compliance with the rule; to the extent any revenue overperformance is used to ramp up non-reversible expenditure, the medium-term adjustment becomes tougher. On the revenue side, efforts should focus on improving compliance, including through closer joint scrutiny of wage reporting by the Revenue Administration and Social Security Institution, and augmenting both institutions’ audit resources.
14. The sequencing of the CBT’s monetary policy exit strategy is appropriate. Liquidity measures introduced during the crisis, together with the resumption of daily foreign currency purchases, have eased funding conditions and kept interest rates low. With real activity recovering rapidly, the CBT recently began a gradual retreat from regular short-term funding operations and, as a result, market interest rates have begun to pick up slightly, with longer maturities rising by a larger amount on expectations of future tightening. The CBT has also started to tighten liquidity through hikes in reserve requirements, which will be accompanied later by measured increases in the policy rate in its baseline scenario.
15. However, the pace of tightening should be accelerated in view of elevated inflation expectations and rapidly growing bank credit. Proceeding slowly when real policy rates based on year-ahead inflation expectations are currently negative risks a further deterioration in inflation expectations. That could be especially costly in the surplus global liquidity environment because higher inflation expectations require a larger increase in the nominal interest rate to deliver the same real rate, thereby making Turkey more attractive to short-term capital inflows, which would lead to a further weakening of competitiveness. Postponing a decisive tightening may also necessitate a large, abrupt increase in policy interest rates in order to re-anchor inflation expectations, but that could be disruptive because of banks’ maturity mismatch. Therefore, a broad-based monetary tightening—through withdrawal of liquidity and small sustained increases in the policy rate—should be accelerated. An even faster monetary tightening would be needed if the anticipated cyclically-adjusted fiscal consolidation is not forthcoming.
16. Simultaneously stepping up foreign currency purchases would rebuild reserve cover more quickly and help alleviate excessive upward exchange rate pressures. Reserve cover of short-term debt at remaining maturity has fallen since end-2007 and would increase only gradually under current auction amounts. It would be preferable, should capital inflows remain stable or strengthen, to increase the amount of regular predetermined foreign currency auctions to more quickly accumulate reserves, improve precautionary balances, and avoid compressing prices of tradables and pushing demand toward imports.
17. Important steps have been taken to maintain the strength of the Turkish financial sector, although some additional measures are needed. The signing of the Memorandum of Understanding and related protocol on systemic risk management by the Treasury, CBT, Banking Regulation and Supervision Agency (BRSA), and Savings Deposit Insurance Fund (SDIF) is a welcome development. Further enhancing stress testing methodologies, including to assess the implications of more complex scenarios (such as possible direct and indirect impacts from unsettled international financial markets) should be considered. While the regulation to allow onshore foreign currency lending to unhedged corporate borrowers will improve transparency, risks should be carefully supervised and adequately priced, with prudential norms tightened further if warranted. To further identify potential stress emanating from the corporate sector, data collection and monitoring for unlisted corporates should be enhanced.
18. To ensure coherence between monetary and financial sector policies in response to the strong rebound in economic activity, eased financial sector prudential regulations should be allowed to expire as early as possible. While temporary easing of prudential norms may be appropriate in the midst of a crisis to discourage panic sell-offs or the calling-in of loans, maintaining these measures when credit is reviving is unnecessary, could possibly reduce transparency of asset quality, and undermine sound risk management practices. In addition, maintaining and expanding the regulatory measures longer than necessary weakens the effectiveness of the CBT’s tightening, while keeping these measures in place during the recovery would limit their effectiveness if more difficult times were to return. Moreover, such prudential measures may not increase banks’ willingness to extend credit, because long-term loans are likely constrained by the limited availability of longer-term funding and banks’ reluctance to increase maturity mismatch in advance of monetary tightening. Priority could instead be given to removing legal deterrents to lending, including provisions in the existing bankruptcy law that benefit debtors through unduly lengthy court procedures.
19. In view of the interconnectedness of Turkey’s banking sector with the rest of the world, measures to amend financial sector regulation should be developed in close coordination with partner countries, and appropriately calibrated to Turkey-specific conditions. The ongoing international debate is centered on ways to strengthen the financial system, including through countercyclical prudential tools and better regulation and supervision of systematically important financial institutions. Regulatory changes will likely need to be phased in gradually to ensure their introduction does not cause unnecessary disruption to the financial system.
20. A multi-pronged approach to structural reform is required to improve competitiveness and achieve job-rich growth. High formal sector labor costs tend to reduce competitiveness and discourage employment in firms operating in the formal sector. The severance pay scheme is among the most generous in OECD countries and the minimum wage is higher than in almost all new EU countries and binding in lower-income regions of Turkey. To enhance competitiveness and formal-sector employment, reforming minimum wage and severance pay should go hand-in-hand with measures to shrink the shadow economy. This would avoid a drop in tax collections that may result from minimum wage restraint (since many workers declare only the minimum wage rather than their true income). Over time, improved tax compliance would facilitate a revenue-neutral cut in labor taxes that would further enhance competitiveness in the formal sector. In addition, expanding energy generation capacity and improving demand efficiency through cost recovery pricing via uniform application of the pass-through pricing formula would reduce dependence on imported energy, narrow the current account deficit, and further support fiscal consolidation.
We thank the Turkish authorities and our private sector interlocutors in Ankara and Istanbul for their hospitality and informative discussions.