Turkey—2011 Article IV Consultation Preliminary Conclusions
September 19, 2011
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. Limited initial vulnerabilities and a flexible policy response to the 2008–09 global crisis were essential to secure the subsequent strong growth rebound.1 Well-capitalized banks with little direct exchange rate exposure and primarily local deposit funding, together with households that had low debt and long foreign currency (fx) positions, allowed Turkey to withstand the global deleveraging and exchange rate fluctuations at the onset of the crisis. The policy response of large interest rate cuts and liquidity support to banks further limited downside effects. A timely fiscal expansion boosted demand, and was unwound beginning in mid-2009 when it became apparent the economy was on track for an early and robust recovery from the brief, but deep, contraction.
2. Since then Turkey’s pace of recovery has been impressive, but increasingly skewed toward domestic demand and imports. After growing 9 percent in 2010, activity accelerated further, and by mid-2011, output stood well above its pre-crisis peak. Domestic demand grew most rapidly, financed by very brisk loan growth made feasible by historically low interest rates and a surge in short-term capital inflows. With demand outstripping domestic supply, imports expanded and the current account deficit widened to 9¼ percent of GDP at mid-2011. Import demand was reinforced by consistently higher inflation than in partner countries during the past decade, which weakened competitiveness.
3. In response to growing imbalances, beginning in late 2010, an unconventional package of monetary policy measures was introduced. To fend off very short-term capital inflows, the Central Bank of the Republic of Turkey (CBRT) facilitated greater volatility of money market rates and marginally lowered the policy rate. Reserve requirements (RR) were raised in several steps to slow credit growth through higher intermediation costs, complemented by guidance to banks on loan growth. These measures delivered a gradual, sizable nominal depreciation of the lira and contributed—with a delay—to the recent slowdown in credit growth.
4. Other policy interventions, however, took more time to adopt or were limited. The Banking Regulation and Supervision Agency (BRSA) imposed loan-to-value ceilings on housing and commercial real estate loans in early 2011. Provisioning requirements and risk weights on general purpose loans (GPLs)—the fastest growing loan category—were increased in mid June, and had an immediate large effect on interest rates. Against the backdrop of transient revenue from very strong output and import growth and the comprehensive tax restructuring, headline fiscal balances improved markedly.
B. Challenges and Outlook
5. Against a weaker global outlook and signs of slowing demand at home, Turkey faces the challenge of achieving a gradual adjustment to a sustainable and balanced growth path.
6. The Turkish economy remains more robust than many economies, but the recent domestic demand boom has begun to affect resilience in some areas. The headline fiscal balance continues to improve, returning the public debt to GDP ratio to a downward path, but this strong performance is contingent on macroeconomic conditions at home and abroad. Turkey is not immune to stress in international financial markets due to its high current account deficit, low share of FDI and long-term borrowing in total external financing, a rising banking sector loan-to-deposit ratio (approaching 100 percent), and an increased net foreign exchange (fx) liability position in the corporate sector. These shifts, which reflect private sector dissaving, leave Turkey exposed to fluctuations in global liquidity cycles and swings in risk appetite.
7. Turkey is aiming to rebalance the composition of demand and narrow the current account deficit. The cumulative 25 percent nominal depreciation against the dollar-euro basket since late 2010 provides a foundation. However, achieving a sizable current account correction while preserving robust growth requires limited exchange rate pass-through to the general price level, low inflation differentials against other countries, and a strong positive domestic supply response. Given subdued external demand, technical constraints on import substitution, and the likely erosion of competitiveness gains, the external improvement may only be partial. Moreover, there is a trade-off between the exchange rate adjustment and the attainment of the CBRT’s inflation targets.
8. Thus, the economic outlook depends on the availability of foreign savings and Turkey’s capacity for import replacement. While alternative upside and downside outcomes are feasible, the mission’s baseline assumption is for more limited external financing through 2012 in view of Turkey’s large current account deficit and a less favorable global environment. This is expected to compress imports and restrain loan growth. Because imports are a key input into domestic value added, GDP growth would therefore moderate from 7½ percent this year to 2½ percent in 2012. The current account deficit is expected to ease from around 10 percent of GDP in 2011 to 7½ percent of GDP in 2012. Thereafter, a domestic import substitution response to the recent real depreciation is projected to gather pace and raise GDP growth, but this effect would be temporary if recent competitiveness gains are not preserved.
C. Policy Recommendations
9. Reconfiguring the policy framework could reduce Turkey’s propensity for volatile capital flow-driven cycles. This requires more effective use of fiscal, prudential, and structural policies. With a tighter structural fiscal position, and financial policies geared toward reducing macroprudential risks, monetary policy would then be better placed to maintain inflation and policy rates at levels prevailing in other countries within a conventional inflation-targeting framework, reducing attractiveness to short-term carry trades. Structural reforms to enhance labor market efficiency, formalize the shadow economy, and improve the investment climate would help stimulate domestic production and reduce dependence on imports. These policy adjustments would deliver a more balanced, less volatile output and bring greater confidence in Turkey’s growth prospects.
10. Targeting a strong structural primary surplus—excluding transient revenue—would support disinflation and protect against large negative revenue shocks. The focus of fiscal policy should extend beyond public debt sustainability to reducing absorption of short-term inflows that contribute to boom-bust cycles. This can be achieved by setting the target for the structural primary surplus sufficiently high to ensure inflation and nominal policy rates are comparable to those of other emerging-market peer countries. While this target should be reviewed periodically to ensure these macroeconomic goals are being met, and with a view to gradually relaxing the target once lower inflation has become entrenched, a structural primary surplus around the level last seen in 2007 would be an appropriate target.
11. How quickly to reach this target depends on the pace of economic activity. While structural fiscal tightening is best implemented during booms, deferring adjustment would leave the economy vulnerable to capital flows. The pace of adjustment should balance the direct drag on growth with the need to reverse the structural loosening of previous years. If growth underperforms by a wide margin, a slower structural adjustment would be warranted. Additional measures will be needed in the next few years to converge to the structural surplus target.
12. Monetary policy should restore its focus on price stability within a transparent and consistent operating framework. Faced with unprecedented monetary easing in advanced economies, the CBRT adopted an innovative approach that simultaneously sought to contain inflation and credit growth, and avoid exchange rate misalignment through a combination of policy instruments. More recently, given concerns about financial contagion from the euro area and slowing domestic activity, the CBRT adopted various measures to avoid currency overshooting, while also lowering the policy rate. However, in some circumstances, as at present, these different goals and policy actions may appear hard to reconcile.
13. Restoring the credibility of inflation targets requires that the policy rate be adjusted if headline inflation is projected to miss the year-ahead point target. Our current inflation forecasts (8½ percent for end 2011 and 5¾ percent for end 2012), indicate that some tightening would be needed to achieve the target for next year. With the expectation of somewhat lower global risk appetite, and to avoid instrument inconsistency, this tightening would best be delivered through an increase in the policy rate, and allowing the realignment of money market rates with the policy rate. In the event of global risk retrenchment, and provided the lira is not under pressure, some reduction in the policy rate may be warranted amid lower inflation and widespread monetary policy easing. Changes to other policy tools, including reserve requirements, should support policy rate actions.
14. Halting foreign currency sales would conserve hard-earned reserves. In the past few weeks the CBRT’s reserves declined by some US$6 billion through sales, lower reserve requirements on fx liabilities, valuation changes, and foreign debt payments. Part of this will be compensated by a new measure allowing banks to maintain up to 10 percent of their required reserves on lira liabilities in fx (adding about US$3.7 billion to reserves if fully utilized by banks). Absent global risk retrenchment (discussed above), it is advisable to increase the policy rate to prevent an overly rapid depreciation.
15. Over time, and in combination with a considerably tighter structural fiscal stance, there is scope to narrow the inflation band and lower inflation targets. Targets are higher than in most other emerging markets and the tolerance band of ±2 percent is considerably wider than in peer countries, pushing up “acceptable” inflation outcomes. Moreover, the top of the band has often been overshot. The adverse consequences of positive inflation differentials persist through the erosion of competitiveness. Narrowing the tolerance band and introducing a continuous target can be implemented as a first step and would reinvigorate the commitment to price stability. Subsequently, supported by tighter fiscal policy, a lower inflation outcome would be feasible with more moderate real and nominal policy rates.
Financial sector issues
16. While the banking sector remains well capitalized, its growing dependence on short-term external funding is likely to propagate liquidity shocks to the real economy.
- Turkish banks have continued to tap syndicated loans at low spreads, and their fx liquidity management practices appear prudent. The CBRT has the policy instruments to lend both lira and fx liquidity to mitigate a funding shock, for instance by relaxing reserve requirements. The BRSA’s regulatory framework for banks’ exchange rate exposure and fx liquidity is conservative, with minimum liquidity ratios on fx and tight limits on net on- and off-balance sheet fx open positions. As a countercyclical measure, the BRSA also limits dividend payouts to reinforce banks’ capital adequacy ratios, which have declined to a still comfortable average of 17 percent.
- However, greater recourse to short-term external financing to fund the recent credit boom is a key vulnerability given renewed funding strains in international markets, and further steps should be taken to lower the sector’s structural maturity mismatch. To reduce exposure to rollover risk that could force banks to contract private sector credit in a downturn, more longer-term funding is needed, permitting a corresponding lengthening of loan maturities. Differentiation of reserve requirements according to the maturity of liabilities has begun to extend the duration of deposits. The BRSA’s new measure to contain interest rate risk through capital charges on large maturity mismatches should help to discourage duration gaps. Introducing minimum liquidity ratios at the 3 month horizon (the current outer limit is one month) would also promote longer non-deposit funding.
17. The new Financial Stability Committee (FSC) provides the basis for a systemic approach to financial supervision that may be better suited to preemptively containing aggregate risks. The recent establishment of the FSC is intended to improve detection of emerging systemic risk and facilitate prompt, coordinated policy action and better integration of the micro- and macro-prudential functions of the respective agencies. The challenge—as in all countries that have introduced such a structure—will be to balance policy coordination with the need to preserve the independence of the respective institutions’ policy objectives and instruments.
18. The Financial Sector Assessment Program (FSAP) update called for further strengthening supervision and regulation. Banks’ sizeable capital buffers were seen as capable of absorbing a short-lived macroeconomic shock, but strains would be much greater if the shock were protracted. While the BRSA has issued the numerous supporting regulations needed to fully implement the Banking Law, the supervisory framework needs to be further strengthened to more effectively address evolving risks, especially regarding more stringent oversight of liquidity and operational risks, banks’ risk management frameworks and models, and more comprehensive supervision of financial system groups—initiatives in all these areas are underway. The BRSA also needs to attract and retain specialist staff to effectively supervise an increasingly complex banking system.
19. Greater flexibility of the formal labor market would increase employment, support domestic production, and distribute the gains from growth more evenly. Reducing restrictions on temporary and part-time employment, and reforming severance pay, would encourage new employment and job mobility within the formal sector. Keeping incomes policy in line with the inflation target would improve external competitiveness and reduce inflation inertia. Policies to raise educational attainment at the lower end of the skill distribution (the median for employed workers is 5 years of schooling) and better tailor education to employers’ needs (through vocational training) would improve labor productivity, reduce skill mismatch, and boost employment and income growth over the medium term.
20. Maintaining robust growth while durably reducing the current account imbalance calls for broad structural reforms. To allow greater domestic sourcing of intermediate manufactured inputs, attention should focus on improving the business environment, including through combating informality to support a reduction in the tax burden on formal-sector employment and activity. Another key element will be reducing dependence on energy imports—about 20 percent of total imports—by promoting greater consumption efficiency. Timely reflection of movements in world prices and the exchange rate to energy prices would provide incentives to energy providers and users. Further deepening of local capital markets and development of new private savings vehicles would promote domestic savings and enhance Turkey’s resilience to swings in global financial conditions.
We thank the Turkish authorities and our private sector interlocutors in Ankara and Istanbul for their hospitality and informative discussions.
1 See the 2010 Article IV and PPM report for staff’s detailed assessment of the crisis response.