Turkey: Concluding Statement of the 2016 Article IV Mission1
February 02, 2016
Growth last year was stronger than expected, and the current account deficit fell. Domestic demand is expected to continue to drive growth this year, owing to the higher minimum wage, lower oil prices, and supportive monetary and fiscal policies. External financing needs will remain high, however, while weak capital inflows will put pressure on reserves and inflation will remain above target and increasing. In the short run, tighter fiscal and monetary policies can help address vulnerabilities. A longer term solution will require progress with the authorities’ ambitious structural reform agenda to boost potential growth and domestic saving.
Outlook and Risks
1. The economy is estimated to have grown by 3.8 percent last year, driven by domestic demand. Despite political uncertainty, unfavorable geopolitical developments, and a sharp weakening of the lira, private consumption was resilient. Monetary tightening was insufficient to reduce inflationary pressures, amid sharp lira depreciation. Weak external demand depressed exports growth, but as imports also decreased on the back of cheaper oil, the current account deficit moderated significantly to an estimated 4.4 percent of GDP.
2. Strong growth is set to continue in 2016, but with higher inflation. The 30 percent increase in the minimum wage will raise consumption by an estimated ½ to 1 percent of GDP this year. In addition, the recent further decline in oil prices, and the insufficiently tight monetary stance will also be supportive. GDP growth is expected to be between 3½ and 4 percent this year and inflation to exceed the authorities’ 5 percent target once again by a wide margin.
3. The smaller current account deficit is welcome, but external imbalances persist. Much of the improvement can be traced to lower oil prices, and the non-energy balance has barely changed. The economy’s external position remains moderately weaker than the level consistent with medium-term fundamentals. The current domestic demand-based growth does not help rebalancing and the low private saving rate, if unaddressed, will perpetuate accumulation of external imbalances. Moreover, financing of the deficit remains a concern, with some of it coming from reserves. In addition, net errors & omissions are playing an increasing role in the balance of payments.
4. Although the economy has shown resilience in the face of large exchange rate depreciations and capital outflows, buffers have decreased. The large foreign currency debt of the nonfinancial corporate sector and the dependence of banks on foreign financing expose Turkey to the risk of accelerating capital outflows. While fiscal buffers remain strong, policy space to react to shocks has decreased over time, as international reserves have declined somewhat, and the negative international investment position remains large. The main avenue to diminish vulnerabilities is through limiting external imbalances.
The Policy Agenda
5. The main challenges facing policymakers are to reduce the external imbalance and to boost the potential growth rate of the economy. In the short run, a reduction of external imbalances can be achieved through tighter fiscal and monetary stances. Macroprudential policies may also have a further role to play, but are not a substitute for these macroeconomic policies. If such policies are implemented, slower domestic demand and increased savings would lower external imbalances. This would provide a window of opportunity to implement far-reaching structural reforms to raise the private sector saving rate and potential output, delivering stronger and more sustainable long-term growth.
Monetary and Fiscal Policies
6. A tighter fiscal stance would contribute to reducing external imbalances and lowering inflation. With public debt at 32 percent of GDP, debt sustainability is not a concern. To help alleviate some of the increasing pressure on monetary policy in combating inflation, fiscal policy consolidation could be slightly more ambitious than envisaged in the MTP. On the expenditure side, the consolidation should focus on current spending, including containing the public sector wage bill, rather than reducing capital spending. There is also scope to raise revenues, including through reducing informality and broadening the tax base.
7. A stronger public sector budget position would create additional policy space to react to shocks. Private sector balance sheets have become more stretched in recent years. In addition, the increasing use of guarantees and PPPs to finance investment entails contingent liabilities that may materialize during a downturn. Their rapid growth requires stronger central oversight, approval and disclosure. A more comprehensive overview of the public sector fiscal position, transactions and risks, could also be supported by enhancing the coverage of fiscal reporting, including on pension and PPP liabilities, and publishing a fiscal risk statement.
8. A tighter monetary policy stance is needed to bring inflation back to the 5-percent target in the medium term. Inflation remains well above target and has started to increase recently. As a consequence, inflation expectations have remained unanchored. The real policy rate should be increased into decisively positive territory. This would also alleviate the depreciation pressure on the lira.
9. The monetary policy framework needs to be improved to strengthen the effectiveness of monetary policy. Narrowing the interest rate band and providing all liquidity demanded by the market at a single policy rate will provide a clear signal on the policy stance and strengthen the monetary transmission mechanism.
10. Reserves should also be boosted. Given the improvement in the current account balance, the CBRT should embark on policies to increase its net reserves. Interventions should be restricted to periods of disorderly market conditions.
Financial Sector Policies
11. Banks remain adequately capitalized. While on a long-term declining trend, capital adequacy ratios remain above regulatory minima and are mostly based on high-quality capital. Still, the gradual introduction of Basel III may increase the need for banks to raise capital in an environment of decreasing profitability. Nonperforming loans are low and well provisioned. However, banks remain very reliant on external wholesale funding. In tandem, foreign currency exposures in the economy remains high, as the non-financial sector’s net open foreign exchange position stands at US$174 billion.
12. Macroprudential policies have lengthened the maturities of banks’ wholesale FX external financing, adding some resilience. Longer maturities imply lower annual rollover, and thus lower external financing needs. Increasing the remuneration differential between TL and FX required reserves could help to slow overall FX wholesale borrowing. Prudential policies should be adjusted to reflect increased risks associated with foreign exchange lending. The recent adjustment of consumer loan risk weights that will take effect in April should be reviewed if consumer credit growth rebounds too sharply. Other macroprudential measures focused on overall indebtedness would also be useful.
13. The authorities’ appropriately ambitious structural reform agenda is central to the goal of successful economic rebalancing. Specifically, reforms aimed at increasing funding of the private pension and the severance pay systems could significantly raise the private saving rate. Addressing the lack of flexibility in the labor market and further developing local capital markets would boost growth and improve competitiveness. The authorities’ reform plans should be implemented swiftly and fully.
14. The increase in the minimum wage could bring potential benefits, but also poses challenges. While the higher wage may improve income distribution and provide a short-term economic boost, it has consequences for labor markets, competitiveness, and the fiscal balance. In the context of rigid labor markets, efforts to improve labor market flexibility would help avoid a surge in informal sector employment, and would diminish the negative consequences of higher wages for competitiveness.
15. The mission welcomes the initiative to integrate refugees. Turkey’s refugee population of more than 2 million is among the highest in the world. While a safe return of refugees to their home countries is always desirable, efforts should be made to help integration in the meantime. In this respect, Turkey is enacting legislation to allow registered refugees to work. This is an important step in effective integration.
The IMF team would like to thank the authorities and our counterparts in the private sector for their hospitality and open and constructive discussions.
1 An IMF team visited Turkey between January 20 and February 1, 2016 for the annual evaluation of the economy as part of the regular consultations under Article IV of the IMF’s Articles of Agreement.