## 1. Recent Developments in the External Position

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### Context
- Turkey’s growth has been higher than that of nearly all its peers in the wake of the global crisis; the end-2016 revision of national accounts underscored strength of the post-2008 recovery and heavy reliance on investment financed by rapid credit growth (Annex I).
- Both external and internal imbalances are widening: rapid growth over the past year accompanied by a wider current account deficit, inflation well above target, and rising private domestic and external indebtedness.
- Elevated economic and political uncertainty: a state of emergency after the 2016 failed coup, measures that affected predictability of the regulatory environment, high regional geopolitical tensions, and expected local, parliamentary and presidential elections in 2019.

### Recent economic developments — growth, inflation, financial conditions, and fiscal stance
- Growth and demand
  - Real GDP growth averaged 7.4 percent (year-on-year) in the first three quarters of 2017.
  - Fiscal stimulus and a large credit impulse—supported by state loan guarantees and relaxed macroprudential measures—boosted domestic demand.
  - Exports contributed strongly to headline growth due to stronger external demand and sizeable Lira depreciation; imports increased rapidly in H2 2017, tempering net export contribution.
  - High-frequency data suggest slower, albeit still-robust, growth in Q4 2017.
  - Unemployment fell in 2017 but remains high.
- Inflation and monetary policy
  - Inflation reached its highest level since 2003; expectations are well above target.
  - Inflation drivers: large Lira depreciation, higher demand, rising cost pressures, and rising inflation expectations; accelerating core inflation replaced food and energy as main driver in 2017.
  - The CBRT increased the effective cost of funding to banks by almost 500 basis points since November 2016 by shifting liquidity provision to the more expensive late liquidity window (LLW).
  - The ex-post, real effective rate remained low relative to some peer EMs; transmission of monetary policy was blunted by easing financial conditions and policy-induced credit growth; inflation remained in double digits.
- Financial conditions and credit
  - Financial conditions were expansionary in 2017.
  - Increase in state loan guarantees through the Credit Guarantee Fund (CGF) was the main driver behind the surge in Lira loans; commercial credit growth doubled since the start of the year.
  - Growth of FX loans was weak, reflecting elevated FX debt burdens.
  - State-owned banks’ share in total loans increased by 2 percentage points in 2017 to 44 percent of loans.
  - Macroprudential relaxation from September 2016 included lowering provisioning requirements, reducing risk weights of consumer loans, increasing LTV limit for housing loans, and increasing maximum maturity for some loans.
  - Residential and commercial real estate supply increased and is starting to cool; pockets of oversupply in some regions and segments.
- Banking sector soundness
  - System-wide Tier 1 CAR increased by one percentage point to 14.1 percent since end-2016.
  - Headline NPL ratio remains low at 3 percent.
  - Broader impaired-loan definition (restructured credits, “watch list” loans, and NPLs sold to third parties) amounts to around 8 percent of all loans.
  - Banking system’s negative, on-balance sheet, net FX position more than doubled to minus 50 percent of regulatory capital in 2017; this on-balance sheet position is almost completely hedged by off-balance sheet positions.
- Fiscal and quasi-fiscal stance
  - On-budget fiscal deficit expanded in 2016–17 due to temporary tax reductions, continued minimum wage subsidies, and an employment incentive scheme launched in 2017.
  - The 2017 general government primary deficit exceeded the target in the 2017–19 MTP but was below the upward revision in the 2018-20 MTP.
  - Cyclically-adjusted fiscal impulse estimated at close to one percentage point of GDP in 2017.
  - Public debt increased slightly to a still-low 28½ percent of GDP, with financing rollover ratios exceeding 100 percent.
  - Contingent liabilities increased rapidly due to high PPP activity and the expansion of state loan guarantees.
- External sector and markets
  - Current account deficit widened to more than 5 percent of GDP (CAD reached 5.5 percent of GDP in 2017; staff estimates cyclically-adjusted CAD around 4 percent of GDP after adjustments).
  - External debt is about 50 percent of GDP; gross external financing requirements increased to over 25 percent of GDP with annual rollover needs around 20 percent of GDP.
  - Gross reserves around 82 percent of the ARA metric at end-2017; net international reserves declined to $31 billion USD; gross reserves around $108 billion USD at end-2017.
  - NIIP around -53 percent of GDP at end-2017 (deteriorated from -42 percent in 2016).
  - Export performance: Turkey’s share in global exports increased by 42 percent since 1999; exports of goods and services share 0.94 percent in 2017 compared to 0.84 in 2010.

### Outlook and risks
- Medium-term baseline
  - Growth expected to fall to potential of about 3½-4 percent annually.
  - Inflation expected to remain above target; moderation expected as energy prices and exchange rate effects fade (assuming expectations remain contained).
  - Current account deficit and external financing needs expected to remain elevated over the medium term.
  - Absent deep structural reforms, weak productivity growth projected to remain a drag on potential growth.
- Downside risks (tilted to the downside)
  - Risks include Turkey’s large gross external financing needs, low reserves, dependence on short-term capital inflows, widening negative NIIP, high corporate FX exposure, and high bank loan-to-deposit ratios of 123 percent.
  - These weaknesses could exacerbate negative effects of any increase in cost of external financing from US monetary normalization or rising EM risk premia.
  - Inadequate policy adjustment could lead to accelerating inflation; inflation expected to remain well above 5 percent target under baseline but there are risks of materially higher-than-projected inflation.
  - Geopolitical or domestic political risks ahead of the election cycle could undermine confidence.
  - Reputational/financial risks from a potential guilty verdict in a US court against a senior official of a state-owned bank.
- Upside risk
  - US dollar weakness and Euro strength could reduce external debt servicing burden and help narrow external imbalances.

### Policy discussion: overarching objective and required mix
- Main policy challenge: recalibrate macroeconomic policies in a measured yet credible manner to foster sustainable growth while reducing vulnerability to downside risks.
- Required policy mix:
  - Further monetary, fiscal and quasi-fiscal tightening.
  - Careful management of associated build-up of direct and contingent liabilities.
  - Macroprudential policies focused on maintaining financial stability and adequate buffers.
  - Structural reforms to underpin medium- and longer-term growth.
- Scale and cost of imbalances
  - Private credit gap estimates put credit oversupply in the range of 10 to over 20 percent of GDP.
  - The cost of bringing inflation down to target is estimated between 4 and 11 percentage points of potential GDP.
  - Low international reserves do not appear to provide an adequate buffer given large external financing needs.

### Monetary policy, reserves, and FX management (detailed recommendations)
- Reserve targets and FX tools
  - Raise gross international reserves (GIR) to cover at least 100 percent of the ARA metric over 2018–19 from the current 82 percent cover and move closer to the midpoint of the ARA range over the medium term.
  - CBRT could gradually increase NIR through sterilized intervention—as market conditions permit—using preannounced regular auctions to help minimize market disruptions.
  - Non-deliverable forwards have been useful in managing exchange rate volatility without depleting reserves but their use should be limited to illiquid hedging-market circumstances.
  - Cease off-market FX sales to state-owned energy companies; repayment of export rediscount credits in Lira instead of FX at below-market rates should not be used to support FX liquidity.
- Monetary policy stance and staff recommendation
  - Monetary tightening undertaken is welcome but further steps needed to lower inflation and re-anchor expectations.
  - Although the effective CBRT rate increased by almost 500 bps since November 2016, it has not sufficed.
  - Staff recommendation: increase the binding real policy rate—the LLW rate since March 2017—by a further 100–300 bps, in addition to what would be needed to keep pace with any US Fed Fund Rate hikes.
  - Preferably frontload the increase, with a clear commitment to additional measures as needed to restore credibility.
  - Accompany with a change in the policy (one-week repo) rate to move it closer to the LLW rate to improve transparency; over time, move to more conventional monetary policy instruments.

### Fiscal policy: objectives, scenarios, and measure options
- Current outlook and targets
  - Staff expects the general government primary deficit to remain at around 1.3 percent of GDP during 2018-19 on current policy intentions.
  - Required adjustment in the cyclically-adjusted general government primary balance of about 1 percentage point to meet the MTP’s deficit target of 0.4 percent by 2019.
  - Annual public gross financing needs projected at around 5-5½ percent of GDP, with around 20-25 percent of that total to be met by external borrowing.
- Consolidation scenarios
  - Meeting the MTP target: fiscal adjustment of 0.5 (2018) and 0.5 (2019) percent of GDP.
  - Recommended stronger consolidation: achieve general government primary surplus of about ½ percent of GDP by 2019 — equivalent to cyclically-adjusted adjustment of about 1¾ percentage points during 2018-19 relative to baseline. Scenario adjustment amounts: 2018 = 1; 2019 = 0.8 (percent of GDP).
- Measure options (Percent of GDP)
  - (1) Wage bill controls: 2018 = 0.1; 2019 = 0.2
  - (2) Rationalization of transfers/subsidies: 2018 = 0.5; 2019 = 0.4
  - (3) Rationalization of investment incentives: 2018 = 0.1-0.3; 2019 = 0.1-0.3
  - (4) Raising income taxes: 2018 = 0.1; 2019 = 0.1
  - (5) Streamlining VAT exemptions, and raising and unifying the VAT reduced rates: 2018 = 0.4-0.7; 2019 = 0.5-1.0
  - (6) Containment of net lending: 2018 = 0.2; 2019 = 0.2
- Fiscal governance and contingent liabilities
  - Progress in risk management and reporting of quasi-fiscal operations, but further curtailing and full integration into the budget are called for.
  - PPP activity has risen sharply; portfolio estimated at about US$61 billion (221 projects) with US$36.6 billion (60 percent) still under construction (Box 3).
  - Sovereign wealth fund (SWF) not yet fully operational; governance and statistical treatment need alignment with international best practices.
  - Turkey has some fiscal space; public debt low and sustainable over medium term but sensitive to contingent liability shocks.

### Financial sector policies, CGF assessment, and macroprudential measures
- Credit Guarantee Fund (CGF)
  - CGF expanded tenfold in 2017 to about 7 percent of GDP; state guarantee coverage: 100 percent of export loans, 90 percent of SME loans, 85 percent of commercial loans.
  - Usage fee charged to banks: 0.03 percent of face value.
  - In 2017 the CGF contributed close to half of overall corporate credit growth and three quarters of TL-denominated corporate loan growth; estimated impact on 2017 GDP growth ~1½ percentage points.
  - CGF fiscal envelope: government provided 0.8 percent of GDP to cover maximum exposure equivalent to 8 percent of GDP; government paid out 0.02 percent of GDP in 2017 and budgeted 0.1 percent of GDP for 2018.
  - Feb 2018 protocol: unused amount of 50 billion Lira; 5 billion Lira in returned guarantees; envisaged guarantees: 18 billion Lira for capital investment and 14 billion Lira to exporting firms; maximum guarantees in 2018 could be 135 billion Lira (equivalent to 3¾ percent of GDP).
  - Recommendations: scale down new guarantees, shift focus to investment, revisit roll-over provisions (up to 36 months under old protocol), ensure support goes only to SMEs, increase fees, and revise guarantee coverage downward for rolled-over loans.
- Banking liquidity and FX pressures
  - TL loan-to-deposit ratio: 145 percent.
  - NPL ratios: 0.4 percent (noted as currently low, but vintages too recent to show deterioration).
  - Banking system’s negative on-balance sheet net FX position: minus 50 percent of regulatory capital in 2017 (largely hedged off-balance sheet).
- Macroprudential and supervisory recommendations
  - Phase out state loan guarantees over time and limit to cases of clear market failure.
  - Use macroprudential tools to build buffers and contain systemic vulnerabilities; revisit post-2015 relaxations for corporate, construction and real estate sectors.
  - Strengthen BRSA independence, improve NPL data quality, fully account for loan restructuring activity, revise credit classification definitions, and intensify enforcement.
  - Strengthen measures to manage large negative net FX position of private sector; new FX debt to FX-income limits for SMEs and ban on new FX-indexed corporate loans from May 2018 cover just 16 percent of FX borrowers and contain exemptions; staff supports further extension to large companies.

### Contingency planning
- If tail risks materialize:
  - Raise policy rate, allow an orderly depreciation of the exchange rate, and let automatic stabilizers play out.
  - In case of a “sudden stop” of capital inflows, policy rate would need to be increased sharply to avoid more damaging depreciation.
  - Policy response should consider balance of risks to corporate sector from exchange rate and interest rate movements.
  - Given low net international reserves, scope for credible FX intervention limited; preemptive build-up of FX reserves and strengthening balance-sheets recommended.
- Authorities’ contingency stance: authorities highlight fiscal position and banking system strengths and concur that further build-up of FX reserves would improve buffers.

### Structural reforms to underpin medium-term growth
- Need to shift growth model away from input-intensive, credit-fueled expansion as marginal returns diminish and labor market rigidities bind.
- Labor market reforms
  - Reform severance pay system and backward-looking public wage indexation.
  - Align future minimum wage increases with expected inflation and productivity gains.
  - Implement liberalized regime for temporary employment.
  - Increase access to childcare to boost female labor force participation (33½ percent in 2017).
  - Improve educational outcomes and vocational training.
- Promote productive private investment
  - Simplify procedures to set up new companies and shorten bankruptcy proceedings.
  - Restore policy certainty, improve regulatory predictability, and commit to structural reforms.
- Other reforms
  - Pension reform: private pension auto-enrollment started in 2017 but participation limited; proposals include centralizing collection, fostering competitive asset management, removing age limit for participation.
  - Refugee integration: Turkey hosts more than 3½ million refugees; introduce and simplify work permits and business creation for refugees; address informality.

### Selected quantitative tables, stress tests and scenarios (high-level figures)
- Public debt and fiscal projections (selected)
  - Public debt (general government gross debt, Maastricht): 28½ percent of GDP (end-2017).
  - Nominal gross public debt series: 37.1 (2015), 27.6 (2016), 28.3 (2017), 28.5 (2018), 27.8 (2019), 27.9 (2020), 27.9 (2021), 28.0 (2022).
  - Public gross financing needs (percent of GDP): 12.4 (2015), 4.7 (2016), 5.3 (2017), 5.1 (2018), 5.6 (2019).
- Macroeconomic projections (selected)
  - Real GDP growth: 5.1 (2015), 6.1 (2016), 3.2 (2017), 7.0 (2018), 4.4 (2019), 4.0 (2020), 3.6 (2021), 3.6 (2022).
  - Inflation (GDP deflator, percent): 7.7 (2015), 7.8 (2016), 8.1 (2017), 11.0 (2018), 11.6 (2019).
  - Effective interest rate (percent): 11.9 (2015), 9.3 (2016), 8.2 (2017), 8.2 (2018), 8.4 (2019).
- External debt and external financing needs (Annex V)
  - External debt: 53.2 (2017), projected 54.1 (2018), 54.6 (2019) percent of GDP.
  - Gross external financing need (percent of GDP): 24.9 (2017), 25.1 (2018), 26.3 (2019).
  - Stress: permanent 30 percent Lira depreciation would push external debt stock to 83 percent of GDP by 2023 in the simulation.
- Box summaries and key ratios
  - CAD: 5.5 percent of GDP in 2017; staff estimates cyclically-adjusted CAD around 4 percent of GDP; staff assesses CA gap as -0.5 to -2.5 percent of GDP.
  - NIIP: around -53 percent of GDP end-2017.
  - Gross reserves: around 82 percent of the ARA metric at end-2017; net international reserves $31 billion USD.

### Institutional recommendations and implementation
- Move Article IV consultations to a standard 12-month cycle (recommendation).
- Continue IMF technical assistance and coordinate with World Bank on PPP risk management.
- Strengthen data quality and reporting: TURKSTAT rebased series end-2016; work with IMF STA to clarify series; data broadly adequate for surveillance but national accounts and government finance statistics have shortcomings.

*Source: IMF staff report — 1. Recent Developments in the External Position*

### 1. Recent Developments in the External Position ________________________________________________ 18

### 1. Recent Developments in the External Position

### Context
- Turkey’s growth has been higher than that of nearly all its peers in the wake of the global crisis; the end-2016 revision of national accounts underscored strength of the post-2008 recovery and heavy reliance on investment financed by rapid credit growth (Annex I).
- Both external and internal imbalances are widening: rapid growth over the past year accompanied by a wider current account deficit, inflation well above target, and rising private domestic and external indebtedness.
- Elevated economic and political uncertainty: a state of emergency after the 2016 failed coup, measures that affected predictability of the regulatory environment, high regional geopolitical tensions, and expected local, parliamentary and presidential elections in 2019.

### Recent Economic Developments
- Growth and demand
  - Real GDP growth averaged 7.4 percent (year-on-year) in the first three quarters of 2017.
  - Fiscal stimulus and a large credit impulse—supported by state loan guarantees and relaxed macroprudential measures—boosted domestic demand.
  - Exports contributed strongly to headline growth due to stronger external demand and sizeable Lira depreciation; imports increased rapidly in H2 2017, tempering net export contribution.
  - High-frequency data suggest slower, albeit still-robust, growth in Q4 2017.
  - Unemployment fell in 2017 but remains high, indicating ongoing labor market rigidities.

- Inflation and monetary policy
  - Inflation reached its highest level since 2003; expectations are well above target.
  - Inflation drivers: large Lira depreciation, higher demand, rising cost pressures, and rising inflation expectations; accelerating core inflation replaced food and energy as main driver in 2017.
  - The CBRT increased the effective cost of funding to banks by almost 500 basis points since November 2016 by shifting liquidity provision to the more expensive late liquidity window (LLW).
  - The ex-post, real effective rate remained low relative to some peer EMs. Transmission of monetary policy was blunted by easing financial conditions and policy-induced credit growth; inflation remained in double digits.

- Financial conditions and credit
  - Financial conditions were expansionary in 2017.
  - Increase in state loan guarantees through the Credit Guarantee Fund (CGF) was the main driver behind the surge in Lira loans; commercial credit growth doubled since the start of the year.
  - Growth of FX loans was weak, reflecting elevated FX debt burdens.
  - State-owned banks’ share in total loans increased by 2 percentage points in 2017 to 44 percent of loans.
  - Macroprudential relaxation from September 2016 included: lowering provisioning requirements for commercial, consumer and restructured loans; reducing risk weights of consumer loans; increasing LTV limit for housing loans; increasing maximum maturity of general purpose and credit card loans.
  - Residential and commercial real estate supply increased and is starting to cool; pockets of oversupply in some regions and segments.
  - Growth of commercial loans tapered as CGF impulse decreased toward year-end.

- Banking sector soundness
  - System-wide Tier 1 CAR increased by one percentage point to 14.1 percent since end-2016.
  - Headline NPL ratio remains low at 3 percent.
  - Broader definition of impaired loans (restructured credits, “watch list” loans, and NPLs sold to third parties) amounts to around 8 percent of all loans, signaling emerging loan quality weakness—particularly in consumer credit and SME loans, with signs of distress in some larger corporate groups.
  - CGF-backed loans could have temporarily helped contain NPLs to the extent used for working capital and alleviating corporate payment delays.
  - Banking system’s negative, on-balance sheet, net FX position more than doubled to minus 50 percent of regulatory capital in 2017, mainly due to increased resident FX deposits and banks borrowing from abroad to fund CGF-backed Lira loans; this on-balance sheet position is almost completely hedged by off-balance sheet positions.

- Fiscal and quasi-fiscal stance
  - On-budget fiscal deficit expanded in 2016–17 due to temporary tax reductions, continued minimum wage subsidies, and an employment incentive scheme launched in 2017.
  - The 2017 general government primary deficit exceeded the target in the 2017–19 Medium-Term Program (MTP) but was below the upward revision in the 2018-20 MTP.
  - Cyclically-adjusted fiscal impulse estimated at close to one percentage point of GDP in 2017.
  - Public debt increased slightly to a still-low 28½ percent of GDP, with financing rollover ratios exceeding 100 percent.
  - Contingent liabilities increased rapidly due to high PPP activity and the expansion of state loan guarantees.

- External sector and markets
  - Current account deficit widened to more than 5 percent of GDP.
  - Export drivers: strong global and EU growth, significant Lira depreciation, rebound in tourism arrivals.
  - Offsetting factors: higher energy prices, strong gold imports (used to hedge against inflation and uncertainty), and demand-driven import increases.
  - The external position remains weaker than level consistent with medium-term fundamentals and desirable policy settings (Annex II); widening CAD occurred despite a real depreciation of around 10 percent (Box 2).
  - External debt is about 50 percent of GDP, sustainable but increased rapidly and sensitive to exchange rate valuation risks and liquidity risks from large annual rollover needs of around 20 percent of GDP (Annex V).
  - Turkish financial markets are sensitive to international investor sentiment; Turkey was among the countries most affected by the November 2016 EM asset selloff. Domestic and external government bond yields fell after the April 2017 referendum but gains were partially reversed in Q4 2017 as the Lira weakened again.

### Outlook and Risks
- Medium-term baseline
  - Growth is expected to fall to potential of about 3½-4 percent annually.
  - Inflation expected to remain above target; moderation is expected as energy prices and exchange rate effects fade (assuming expectations remain contained), and the CBRT’s current interest rate should be enough to stabilize it, albeit at a level well above target.
  - Current account deficit and external financing needs expected to remain elevated over the medium term.
  - Absent deep structural reforms, weak productivity growth is projected to remain a drag on potential growth (Annex I).

- Downside risks (tilted to the downside; Annex III)
  - Policy imbalances raise risks, including Turkey’s large gross external financing needs, low reserves, dependence on short-term capital inflows (Box 1), widening negative NIIP, high corporate exposure to FX risk, and higher reliance on market funding (bank loan-to-deposit ratios of 123 percent).
  - These weaknesses could exacerbate negative effects of any increase in cost of external financing from US monetary normalization or rising EM risk premia.
  - Inadequate policy adjustment could lead to accelerating inflation; inflation expected to remain well above 5 percent target under baseline but risks of materially higher-than-projected inflation and weaker CBRT credibility remain.
  - Further deterioration in geopolitical tensions or domestic political risks ahead of the election cycle could undermine investor and consumer confidence.
  - A guilty verdict in a US court against a senior official of a state-owned bank on money laundering and evasion of US sanctions on Iran poses reputational and financial risks.

- Upside risk
  - US dollar weakness and Euro strength could reduce external debt servicing burden and help narrow external imbalances.

### Policy Discussions
- Main policy challenge: recalibrate macroeconomic policies in a measured yet credible manner to foster sustainable growth while reducing vulnerability to downside risks.
- Required policy mix:
  - Further monetary, fiscal and quasi-fiscal tightening.
  - Careful management of associated build-up of direct and contingent liabilities.
  - Macroprudential policies focused on maintaining financial stability and adequate buffers.
  - Structural reforms to underpin medium- and longer-term growth.
- Scale of imbalances and costs:
  - Estimates of private credit gap (deviation of private debt from what fundamentals would support) put credit oversupply in the range of 10 to over 20 percent of GDP (Annex I).
  - The cost of bringing inflation down to target is estimated between 4 and 11 percentage points of potential GDP.
  - External position remains weaker than implied by fundamentals despite real effective exchange rate broadly consistent with fundamentals (Box 1).
  - Low international reserves do not appear to provide an adequate buffer for sizeable external shocks, given large external financing needs.

### Authorities’ Views
- Authorities acknowledge last year’s growth was above potential but do not see a risk of overheating going forward.
  - They estimate growth potential at about 5–5½ percent, expect the output gap to close this year and remain around zero on current policies.
  - Authorities view current monetary stance as sufficiently tight.
  - They reaffirm commitment to fiscal discipline and advancing the structural reform agenda.
- On external balance, authorities saw wider current account deficit as largely reflecting external factors but agreed reserves could be rebuilt as conditions allow.
  - They expected the current account deficit to narrow as growth returns to potential.
  - They considered financing underpinned by attractiveness of Turkish assets to foreign investors and viewed recent reliance on short-term inflows as mainly cost-driven and not a longer-term trend.

### Monetary Policy Recommendations (staff view)
- The monetary tightening already undertaken is welcome but further steps are needed to lower inflation meaningfully and re-anchor expectations.
  - Although the effective CBRT rate increased by almost 500 bps since November 2016, it has not sufficed to contain inflation or prevent expectations unanchoring.
  - The real effective policy rate appears well below what a simple Taylor rule would imply (a 200–300 bps mark-up over the neutral rate, estimated by staff in the range of 1–3 percent) given a positive output gap and inflation well above target.
  - Recommendation: increase the binding real policy rate—the LLW rate since March 2017—by a further 100–300 bps, in addition to what would be needed to keep pace with any US Fed Fund Rate hikes.
  - Preferably frontload the increase, with a clear commitment to additional measures as needed to restore credibility.
  - Accompany this with a change in the policy (one-week repo) rate to move it closer to the LLW rate to improve transparency of the policy framework.
  - Over time, aim to move to more conventional monetary policy instruments to underpin credibility.

*Source: IMF staff report — 1. Recent Developments in the External Position*

### 19.      A credible monetary tightening would help underpin the Lira and allow the CBRT to

### 19.      A credible monetary tightening would help underpin the Lira and allow the CBRT to

### Monetary policy, reserves, and FX management
- Gross international reserves (GIR) should be raised to cover at least 100 percent of the ARA metric over 2018–19 from the current 82 percent cover and move closer to the midpoint of the ARA range over the medium term.
- With still-favorable global liquidity conditions, the CBRT could gradually increase NIR through sterilized intervention—as market conditions permit—using preannounced regular auctions to help minimize market disruptions.
- Non-deliverable forwards—introduced by the CBRT to manage the demand for FX and support hedging by banks and corporates—have been useful in managing exchange rate volatility without depleting reserves, but their use should be limited to circumstances when the market for hedging instruments is illiquid.
- The improvement in systemic FX liquidity management should continue, notably through the ceasing of off-market sales to state-owned energy companies.
- The repayment of export rediscount credits in Lira instead of FX to the CBRT at below-market conversion rates should not be used as a tool to support FX liquidity conditions.

*Source: CBRT and staff estimates.*

### Authorities’ views on monetary policy
- The authorities acknowledged the risks of inflation inertia and FX-depreciation passthrough to inflation.
- They saw monetary policy as sufficiently tight to bring inflation below 8 percent by the end of 2018.
- They argued that in 2017, despite a tighter monetary policy stance, aggregate demand and credit conditions delayed the improvement in inflation.
- They considered that better coordination between fiscal and monetary policy and administrative measures to reduce inefficiencies along the agricultural supply-chain and boost its productive capacity would help the disinflation effort.

### Fiscal policy: objectives and current outlook
- Front-loaded fiscal consolidation would support internal and external rebalancing, and buoy investor sentiment.
- The expiration of temporary tax breaks and new tax measures in 2018—such as the CIT rate increase, reductions of income tax exemptions, and an increase in consumption taxes on motor vehicles—were welcome, but consolidation is likely to be slower and weaker than envisaged in the MTP due to new tax exemptions, continuation of the minimum wage subsidy, and new employment incentives.
- High outlays on security, public wage rigidities, and conversion of temporary workers into permanent public employees add to spending pressures ahead of the 2019 elections.
- Staff expects the general government primary deficit to remain at around 1.3 percent of GDP during 2018-19 on current policy intentions.
- This implies a required adjustment in the cyclically-adjusted general government primary balance of about 1 percentage point to meet the MTP’s deficit target of 0.4 percent by 2019.
- Annual public gross financing needs are projected at around 5-5½ percent of GDP, with around 20-25 percent of that total to be met by external borrowing.

### Fiscal consolidation scenarios and measure options
- Going beyond the MTP target: Stronger and front-loaded fiscal consolidation—aimed at achieving general government primary surplus of about ½ percent of GDP by 2019—would help counteract continued expansionary quasi-fiscal and financial policies. Such a target would be equivalent to an adjustment in the cyclically-adjusted, general government primary balance of about 1¾ percentage points during 2018-19 relative to the baseline.
- Turkey: Measure Options for Fiscal Consolidation (Percent of GDP)
  - Fiscal adjustment to meet the MTP target: 2018 = 0.5; 2019 = 0.5
  - Fiscal adjustment to meet the recommended scenario: 2018 = 1; 2019 = 0.8
  - Measure options:
    - (1) Wage bill controls: 2018 = 0.1; 2019 = 0.2
    - (2) Rationalization of transfers/subsidies: 2018 = 0.5; 2019 = 0.4
    - (3) Rationalization of investment incentives: 2018 = 0.1-0.3; 2019 = 0.1-0.3
    - (4) Raising income taxes: 2018 = 0.1; 2019 = 0.1
    - (5) Streamlining VAT exemptions, and raising and unitfying the VAT reduced rates: 2018 = 0.4-0.7; 2019 = 0.5-1.0
    - (6) Containment of net lending: 2018 = 0.2; 2019 = 0.2

### Fiscal governance and contingent liabilities
- Progress has been made in strengthening risk management and reporting of quasi-fiscal operations, but further curtailing and full integration into the budget are called for.
- PPP activity has risen sharply; other fiscal risks—from expansion of state loan guarantees and public bank balance sheets, and energy price setting effects on SOEs—are increasing.
- A growing share of fiscal risks has fallen outside of Treasury’s approval and monitoring system.
- The sovereign wealth fund (SWF)—not yet fully operational—carries potential fiscal and financial risks; governance and statistical treatment need to be fully aligned with international best practices, including published annual reports, audited financial statements, transparent investment policy, and categorization under general government in official statistics.
- Turkey has some fiscal space to cushion negative shocks; public debt is low and sustainable over the medium term, being most sensitive to the contingent liability shock. Use of fiscal space should be preserved for systemic events and remain conditional on maintaining market access.

### Authorities’ views on fiscal policy
- Authorities highlighted fiscal policy’s role in stimulating the economy and reaffirmed commitment to fiscal discipline.
- They argued tax exemptions and employment incentives would encourage businesses to increase investment and employment, boosting growth and tax revenues.
- They emphasized that new employment incentives are likely to be financed by the Unemployment Insurance Fund and thus would not result in central government budget overruns and higher government borrowing.
- Authorities considered fiscal risks to be low given the economy’s resilience and ample fiscal buffers but agreed on merits of better monitoring and management. Plans include expanding disclosure of fiscal risks beyond central government and strengthening PPP management.

### Financial sector policies and macroprudential measures
- State loan guarantees should be phased out over time and limited to cases of clear market failure.
- The CGF expansion was large and frontloaded: at close to half of the stock of end-2016 SME loans and 7 percent of GDP, and contributed to a procyclical credit increase.
- The government announced it will release the unused capacity of the CGF (about TL 50 billion), targeted to supporting investment and credit to exporters; better targeting of CGF is appropriate, with scope to further focus on SMEs. Support should not be permanent nor used for multiple loan restructurings.
- Macroprudential tools should be used to build buffers and contain systemic financial vulnerabilities, focusing on risks rather than demand management. Some post-2015 relaxations could be revisited, particularly for the corporate sector and construction and real estate sectors.
- Further progress needed on bank governance and supervision: strengthen independence of the BRSA, improve quality of NPL data, fully account for loan restructuring activity, revise credit classification definitions, and intensify enforcement.
- Measures to manage the large, negative, net FX position of the private sector are steps in the right direction but need strengthening. Authorities introduced FX debt to FX-income limits for SMEs and banned new FX-indexed corporate loans starting in May 2018; the new framework covers just 16 percent of FX borrowers and contains exemptions.
- Staff commended plans to introduce additional measures targeting large companies and supported ongoing stress-testing and technical assistance.

### Authorities’ views on financial sector policies
- Authorities considered rapid CGF expansion and macroprudential relaxation necessary after the 2016 shock.
- They acknowledged framework weaknesses in the CGF and reflected plans for improvement.
- Authorities viewed macroprudential policies as in line with international best practice and helpful in managing credit growth.

### Contingency planning
- In case tail risks materialize, authorities should raise the policy rate, allow an orderly depreciation of the exchange rate and let automatic stabilizers play out.
- In case of a “sudden stop” of capital inflows, the policy rate would need to be increased sharply to avoid a more damaging and disruptive depreciation of the Lira.
- Policy response should be proportionate and consider balance of risks to the corporate sector from exchange rate and interest rate movements.
- Automatic stabilizers should be allowed to cushion negative shocks; discretionary measures reserved for a serious recession. Use of fiscal space conditional on maintaining market access.
- Given low net international reserves, scope for credible FX intervention would be limited.
- Preemptive build-up of FX reserves and strengthening of bank and corporate balance-sheets—through restrictions on liability structures and higher risk weights or provisioning on lending to NFCs in FX—would help insulate the real economy.

### Authorities’ views on contingency planning
- Authorities highlighted strengths of the fiscal position and banking system as sufficient to absorb negative external shocks and concurred further build-up of FX reserves over time would help improve buffers.

### Structural reforms to underpin medium-term growth
- The current growth model relying on rapid capital accumulation and growing labor force is approaching limits; marginal boost from additional credit diminishes and labor market rigidities bind.
- Implement reforms to address lackluster total factor productivity growth:
  - Improving labor market conditions: reform severance pay system, reform backward-looking component of public wage indexation, align future minimum wage increases with expected inflation and productivity gains, implement liberalized regime for temporary employment, increase access to childcare facilities to boost female labor force participation (33½ percent in 2017), improve educational outcomes and vocational training.
  - Promoting productive private investment: simplify procedures to set up new companies and shorten bankruptcy proceedings; restore policy certainty to address investor concerns about public institutional capacity, regulatory predictability, and commitment to structural reforms.
- Further long-standing reform priorities:
  - Further reforming the pension system: private pension auto-enrollment started in 2017 but participation limited; improvements include centralizing collection, fostering competitive asset management, removing the age limit for participation.
  - Easing refugee integration: Turkey hosts more than 3½ million refugees; introduction of work permits for those under temporary protection is important, but many work in the informal sector; simplify application process for work permits and business creation and continue active communication strategy on refugee work permits.

### Authorities’ views on structural reforms
- Authorities commit to structural reforms to enhance the business climate, improve human capital and labor force participation, expand coverage of auto-enrollment pensions, and continue work on severance pay reform with broad stakeholder consultation.

*Source: CBRT and staff estimates.*

### 37.      Following a slowdown in 2016, growth recovered sharply last year, helped by strong

### 37.      Following a slowdown in 2016, growth recovered sharply last year, helped by strong

### Recent macroeconomic developments and risks
- 2017: sizeable credit impulse—driven by state loan guarantees—and fiscal policy (including increased PPP activity) supported the economy after 2016 weakness.
- Exports increased sharply in 2017 due to stronger external demand and a softer Lira.
- Signs of overheating in the economy:
  - positive output gap;
  - inflation well above target;
  - wider current account deficit.
- Underlying vulnerabilities that have increased:
  - large external financing needs;
  - limited foreign exchange reserves;
  - increased reliance on short-term capital inflows;
  - high corporate exposure to foreign exchange risk.
- Emerging sectoral concerns: signs of possible oversupply in the building and construction sector.
- Risk triggers cited: domestic developments, regional or international geopolitical developments, or changes in investor sentiment towards emerging markets.

### Assessment of the growth model and need for policy recalibration
- The input-intensive growth model is increasingly ripe for a reset as:
  - marginal boost to real activity from additional credit expansion diminishes;
  - labor market rigidities become more binding constraints on growth.
- Accommodative international financing conditions have allowed a sharp increase in private sector leverage, masking an underlying deceleration of total factor productivity growth.
- External financing conditions and commodity prices cannot be relied upon to remain supportive; policy focus should shift toward addressing short- and medium-term challenges.

### Immediate policy stance and medium-term orientation
- Overarching objective: recalibrate macroeconomic policies in a measured yet credible manner to foster sustainable growth and guard against downside risks, accompanied by focused structural reforms over time.

### Monetary policy recommendations
- Monetary policy should be tightened further in a frontloaded manner to:
  - contain inflation;
  - re-anchor expectations;
  - underpin the Lira;
  - allow reserves to be rebuilt.
- Over time, move toward more conventional instruments to underpin transparency and effectiveness of monetary policy.

### Fiscal and quasi-fiscal policy recommendations
- Fiscal and quasi-fiscal policies need to be further contained, as do associated contingent liabilities.
- Further measures will be needed to achieve a general government primary surplus next year.
- Potential fiscal steps include:
  - broadening the revenue base;
  - raising direct taxation;
  - improving VAT efficiency;
  - limiting public wage rigidities;
  - containing ad-hoc subsidies.
- Strengthen PPP risk management and reporting framework, supported by IMF and World Bank technical assistance.
- Define and monitor scope and role of extra-budgetary and other non-central government entities, and institutions such as the newly created SWF, with maximum transparency.

### Financial sector policy recommendations
- Aim to further strengthen oversight, stability and governance of the banking sector.
- Recent steps taken:
  - enhanced risk management and reporting of quasi-fiscal operations, including the CGF;
  - introduction of limits on borrowing in foreign currency, starting with SMEs.
- Further needed:
  - strengthen bank supervision;
  - reinforce macroprudential policies, focusing on highest vulnerabilities, particularly in the corporate sector.

### Structural reform priorities to underpin medium-term growth
- Total factor productivity growth has been lackluster over the past decade; use current cyclical strength to implement growth-friendly reforms.
- Institutional capacity and predictability of the regulatory environment should be maintained and improved to strengthen the investment climate.
- Labor market reform priorities:
  - address labor market rigidities;
  - close skills gaps to exploit demographic advantages;
  - raise the improving, but still low, female labor participation rate.
  - further reforms could focus on improving educational outcomes including vocational training; enhancing opportunities for more flexible work; and reforming the severance pay system.
- Other reforms to reduce vulnerabilities and improve growth prospects:
  - create conditions conducive to long-term local currency borrowing (including institutional aspects);
  - generate a deeper pool of domestic saving;
  - foster higher participation in the voluntary private pension system to help alleviate the sizable current account deficit.

### Institutional recommendation
- Recommendation: next Article IV consultation with Turkey be held on the standard 12-month cycle.

### Box 1 — Recent developments in the external position (summarized)
- 2017: current account deficit (CAD) widened; gross external financing requirements increased to over 25 percent of GDP.
- Staff assessment: external position weaker than implied by fundamentals; real effective exchange rate (REER) broadly consistent with fundamentals following sizable depreciation over 2016-17.
- NIIP and external liabilities:
  - NIIP around 53 percent of GDP (estimated to be the lowest among G20 EMs);
  - valuation factors contributed 5 percent of GDP to the 10 percent of GDP decline in the NIIP in 2017;
  - external liabilities increased to nearly 80 percent of GDP, with FDI comprising less than a quarter of the total.
- External assets and reserves:
  - external assets, half of which are gross reserves, are mostly liquid;
  - gross liquid external assets nearly sufficient to cover short-term debt at remaining maturity but declining since the global financial crisis;
  - external debt around 50 percent of GDP and sensitive to exchange rate valuation risks and liquidity risks (annual rollover needs around 20 percent of GDP);
  - more than a third of external debt falls due within the next 12 months.
- CAD detail:
  - CAD reached 5.5 percent of GDP in 2017;
  - staff estimates underlying cyclically-adjusted CAD around 4 percent of GDP after controlling for the output gap and the one-off impact of large non-monetary gold imports.
  - EBA CA approach gives a deficit norm of close to 0.5 percent of GDP; ES approach suggests medium-term norm of 2.5 percent.
  - Staff assesses the CA gap as -0.5 to -2.5 percent of GDP consistent with a norm in the range of -0.5 to -2.5 percent of GDP.
- Financing composition and reserves:
  - net FDI declined to less than 1 percent of GDP in 2017;
  - share of non-resident net purchases of government and bank debt securities in total net inflows more than doubled in 2017;
  - financing increasingly reliant on easily reversible flows, with net inflows into government domestic securities and through short-term debt and deposits rising;
  - capital outflows in the first and fourth quarters of 2017 triggered a sizable drawdown of reserves.
  - net international reserves declined by 13 percent in 2017;
  - gross reserves around 82 percent of the IMF reserve adequacy (ARA) metric at end-2017;
  - gross reserves cover only around half of the external financing need; net reserve coverage significantly lower due to bulk of reserves constituting liabilities to banks for reserve requirements.
- Export performance:
  - Turkey’s share in global exports increased by 42 percent since 1999;
  - exports of goods and services share 0.94 percent in 2017 compared to 0.84 in 2010, helped in part by REER depreciation.

### Box 1 (concluded) — Competitiveness and REER
- Staff assesses REER as broadly consistent with medium-term fundamentals:
  - EBA REER index approach gives a 9 percent undervaluation;
  - level approach gives a 2 percent undervaluation;
  - staff considers REER broadly aligned with fundamentals following significant recent depreciation.
- Unit labor cost REER measures:
  - REER based on manufacturing unit labor costs depreciated by around 10 percent since 2016 and by 26 percent from its peak in 2010.
- Structural competitiveness weaknesses:
  - solvency regime, ease of starting a business, and labor market flexibility;
  - Global Competitiveness Index ranks Turkey 127 out of 137 countries on labor market efficiency, noting weakness in female labor participation and severance costs.

### Box 2 — Current account and REER drivers
- Since 2013, gap between CAD and that implied by fundamentals has persisted despite significant REER depreciation.
- Factors explaining muted CA adjustment:
  - export orientation toward more import-intensive sectors (e.g., vehicle exports increased by nearly 40 percent since 2013), raising import intensity of exports and blunting REER depreciation effects on trade balance;
  - relatively inelastic fuel trade balance to energy prices: despite sizable increase in real fuel prices in 2017, real fuel imports estimated to have increased by nearly 20 percent year-on-year, partly due to lags in administered energy price adjustments;
  - increase in quasi-fiscal activities (PPP megaprojects) may have decoupled imports from REER movements through high tradable intensity of capital spending leading to import leakage without commensurate pressures on non-tradable prices.

### Box 3 — Fiscal risks from Public-Private Partnership (PPP) projects
- PPP portfolio size and concentration:
  - overall PPP investment portfolio in Turkey estimated at about US$61 billion (covering 221 projects), six times the level a decade ago;
  - concentration in transportation, energy, and health sectors;
  - of total PPP portfolio, investment value of US$36.6 billion or 60 percent of the total portfolio is still under construction.
- Nature of fiscal risks:
  - direct liabilities from government-funded PPPs;
  - contingent liabilities from demand, exchange rate, and investment guarantees, contract termination clauses, and debt guarantees issued by the Treasury or other public institutions;
  - many PPP projects involve explicit minimum revenue guarantees (MRGs) and components expressed in FX terms, exposing government to demand and exchange rate risks.
- Information and institutional gaps:
  - Ministry of Development (MoD) published commitments exclude some PPP projects contracted by SOEs and municipalities, and PPI projects related to energy and ports;
  - limited detailed information on all issued guarantees and associated risks and on overall PPP portfolio structure and risk composition;
  - Debt Assumption Commitments (DACs) in the monthly Public Debt Management Report cover only the Treasury’s loan guarantees to five PPP projects with a total investment value of US$14.6 billion or a total loan amount of US$11.3 billion;
  - legal and institutional PPP framework is fragmented across sectors, projects, and public agencies without a strong central overview unit.
- Staff simulation on contingent liabilities:
  - simulation covers MRGs of just under half of the total PPP investment portfolio given limited information;
  - macroeconomic shocks could trigger an increase in primary expenditure to finance materialized contingent liabilities and increase the fiscal primary deficit by about 0.2-0.25 percent of GDP a year.
  - illustrative example: a permanently lower GDP growth by 2 percentage points and a 5 percent depreciation of the Lira could increase the stock of contingent liabilities by 0.25 percentage point of GDP per year.
- PPP investment trajectory:
  - cumulative PPP investment portfolio and total investment commitments rose notably through 2017 (figures presented in source).

*International Monetary Fund — staff assessment and recommendations from the Turkey consultation (as presented in the source).*

### 2.5 standard deviation

### 2.5 standard deviation

### Sensitivity scenario headline
- lower GDP growth and FX depreciation in 2018
- Permanent 2 ppts lower GDP growth and 5-percent FX depreciation
- Sensitivity of Contingent Liabilities Related to MRGs (Percent of GDP)
- Source: IMF staff estimates.

### VAT efficiency and reform priorities (Box 4)
Findings
- VAT revenue collection captures less than 40 percent of the potential VAT base.
- VAT collection efficiency has worsened over time, mainly due to increasing use of reduced rates and exemptions, weakening compliance, and shortcomings of the overall VAT design.
- The current stock of deferred VAT refunds is estimated to be more than 5 percent of GDP.
- VAT collection is helped by “deferred” VAT refunds incurred from the requirement for taxpayers to carry forward their excess input VAT credits until fully offset against the output VAT.
- Only exporters and taxpayers with zero-rate domestic supplies, subject to reduced rate and VAT withholding, are entitled to claim VAT refunds.

Reform priorities and recommendations
- Focus on improving revenue potential, removing distortions, and simplifying the VAT system.
- Eliminate the zero rate for domestic supplies.
- Limit the use of reduced rates.
- Enhance compliance by revisiting anti-avoidance and anti-fraud measures.
- Adopt a clear principle-based VAT legislation and a modern VAT system without too many permanent and temporary exemptions and with a limited number of special regimes.
- Reform the VAT refund mechanism to allow for unrestricted refunds of excess input VAT credit and amortize the existing stock of deferred VAT refunds, while designing these changes in a simple and budget-neutral way.
- Implement compensating revenue measures alongside reforms to the refund system because the reform will result in revenue losses.
- Increase VAT revenue collection efficiency by unifying and raising reduced rates, eliminating exemptions, and implementing a unified flat rate of VAT on real property to enhance revenues and offset the cost of fixing the VAT refund mechanism.

Key statistics (VAT)
- VAT revenue collection captures less than 40 percent of the potential VAT base.
- The current stock of deferred VAT refunds is estimated to be more than 5 percent of GDP.

### Credit Guarantee Fund (CGF) (Box 5)
Background and design
- Initially created in 1993; expanded tenfold in 2017 to a total size of about 7 percent of GDP.
- State guarantee coverage: 100 percent of export loans, 90 percent of SME loans, 85 percent of commercial loans.
- State guarantee applies as long as the individual bank portfolio does not reach an NPL ratio of 7 percent.
- 80 percent of the guarantee-supported credits are selected directly by banks.
- The maturity of the portfolio is about 3 years on average.
- The average interest rate stands at 15 percent (vs. 17 percent for non-CGF backed corporate loans).
- The usage fee charged to banks is just 0.03 percent of the face value of the guarantees made.
- Compared to mechanisms in other countries (e.g., Chile, Korea), those typically provide a lower level of guarantee coverage, charge much higher fees, are restricted to SMEs, and occasionally provide other types of support for SMEs (technical guidance etc.).

Impact on credit and the economy
- In 2017, the CGF contributed close to half of overall corporate credit growth.
- In 2017, the CGF contributed three quarters of TL-denominated corporate loan growth.
- Its impact on 2017 GDP growth has been estimated by private sector analysts at around 1½ percentage points in total.
- Quick take up occurred in about four months.
- 90 percent of CGF loans are recorded as used for working capital purposes.
- The heavy use for working capital purposes and quick take up suggest use for rolling over loans, liquidity, and even purchase of consumption goods.
- Three sectors (trade, manufacturing, construction) took more than 80 percent of guarantee-supported loans.

Effect on banks and fiscal implications
- The portion of the loan guaranteed by the CGF is currently risk weighted at zero, while the remainder of the loan, if any, is risk weighted in line with the risk weight of the counterparty.
- This has provided a powerful incentive for banks to supply credit, with an estimated capital adequacy relief of about 0.7 percent.

*Source: IMF staff estimates and IMF staff prepared material.*

### 2017. However, it has also amplified banks’ needs for TL funding, further increasing TL loan-to-deposit ratios (now

### cr18110 - 2017. However, it has also amplified banks’ needs for TL funding, further increasing TL loan-to-deposit ratios (now

### Banking sector liquidity and FX pressures
- TL loan-to-deposit ratio: at 145 percent.
- Effects noted:
  - Exerting pressure on Lira deposit rates.
  - Driving up swap costs when banks seek Lira with FX.
- NPL ratios: at 0.4 percent (noted as currently low, but loan vintages are too recent to show a deterioration in asset quality).

### Fiscal impact of the Credit Guarantee Fund (CGF)
- Government provided the CGF with an amount equivalent to 0.8 percent of GDP to cover a maximum exposure equivalent to 8 percent of GDP.
- From that envelope:
  - Government has paid out the equivalent of 0.02 percent of GDP in 2017.
  - Government budgeted 0.1 percent of GDP for 2018.

### Future of the CGF (as of February 2018 announcement)
- Unused and returned amounts:
  - Still-unused amount of 50 billion Lira.
  - 5 billion Lira in returned guarantees.
- New protocol envisages:
  - Up to 18 billion Lira loan guarantees to be granted for capital investment.
  - Up to 14 billion Lira to exporting firms.
  - Other specific beneficiaries: companies located in regions benefiting from an investment incentive package, agriculture, female and young entrepreneurs.
- Additional funds and rollover:
  - Additional funds expected as earlier loans are repaid under the previous protocol.
  - Possibility to roll over those was granted in December.
- Aggregate impact:
  - This would bring the maximum amount of guarantees in 2018 to 135 billion Lira (equivalent to 3¾ percent of GDP), with a smaller credit impulse than in 2017.

### Recommendations to improve CGF functioning and limit risks
- Scale down new guarantees and shift focus away from working capital toward investment (noted as steps in the right direction).
- Other specific measures:
  1. Revisit the possibility granted to roll-over loans for up to 36 months under the old protocol.
  2. Ensure support goes only to SMEs, and not to larger companies (currently a quarter of the usage) that do not suffer from market imperfections associated with the lack of collateral.
  3. Increase fees which would allow the funding of enhanced monitoring and a greater risk management capacity for the CGF.
  4. Revise downwards the level of guarantee coverage (e.g., for rolled over loans).

### Key statistics and projections (selected figures from adjacent tables and text)
- TL loan-to-deposit ratio (TL): 145 percent (text).
- NPL ratios: 0.4 percent (text).
- CGF fiscal envelope and usage:
  - 0.8 percent of GDP provided to CGF; maximum exposure equivalent to 8 percent of GDP.
  - Payouts: 0.02 percent of GDP in 2017; 0.1 percent of GDP budgeted for 2018.
- CGF balances and commitments (Feb 2018 protocol):
  - Unused: 50 billion Lira.
  - Returned guarantees: 5 billion Lira.
  - Envisaged guarantees: 18 billion Lira (capital investment), 14 billion Lira (exporting firms).
  - Maximum guarantees in 2018: 135 billion Lira (equivalent to 3¾ percent of GDP).
- Roll-over provision under old protocol: up to 36 months.
- Usage concentration: about a quarter of CGF usage currently goes to larger companies (not SMEs).

*Prepared by J. Vacher. International Monetary Fund.*

### Annex I. Re-Assessing Turkey’s Macroeconomic Performance

### Annex I. Re-Assessing Turkey’s Macroeconomic Performance

### Statistical revision and headline implications
- The December-2016 national accounts revision raised Turkey’s post-crisis growth profile:
  - Average growth of real GDP in 2011–2015 is 2.7 percentage points higher than the old estimate.
  - 2015 nominal GDP was revised up by 20 percent.
- Revisions increased estimates of both investment and saving rates, producing the largest external imbalance among G-20 and large EMs in the post-crisis years.
- Fund staff’s estimate of potential growth is in the range of 3.5 to 4 percent—modestly higher than the estimate based on the old series.
- The upward revision of real GDP growth over 2011–2015 was accompanied by an even bigger increase in the estimate of capital inputs, lowering estimated average productivity growth over 2007–17 to slightly negative territory.

### Saving, investment, and sectoral composition
- Post-2009 increase in the aggregate investment rate was driven by both households and corporates, with corporates contributing more.
- Turkey’s post-crisis household and corporate investment rates are the highest in Europe.
- Turkey’s household saving rate:
  - Falls in the mid-range of other European countries both pre- and post-crisis.
  - Is the highest among other emerging markets with similar or lower per capita incomes.
- Turkey’s corporate saving rate:
  - Broadly mid-range of European countries pre-crisis.
  - Post-crisis, among the lowest in the set of emerging markets with similar or lower per capita incomes.
- The post-crisis increase in the investment rate has been largely driven by construction.
  - Bank lending composition indicates a significant and rising share of construction activity is in the residential and retail trade sectors.

### Investment optimality and credit dynamics
- Benchmarking with the Ramsey-Cass-Koopmans model:
  - Investment rate was below the “golden rule” pre-global financial crisis.
  - Since 2012 it has been and is expected to remain higher than the optimal rate by about 2 percentage points over the medium term.
- Rapid credit growth financed the domestic demand boom:
  - Turkey ranks among the top countries by post-crisis growth of private indebtedness.
  - Rapid credit growth was in part financed by external borrowing, contributing to a deterioration of Turkey’s NIIP.
- Private credit gap assessments:
  - BIS H-P filter based estimates put Turkey’s private credit gap at around 10 percent of GDP since 2007.
  - An updated fundamentals-based benchmark suggests Turkey’s private credit gap has widened significantly since 2011, to more than 20 percent of GDP.

### Exchange rate, FX-debt burden, and NIIP
- Large Lira depreciation since the 2008 crisis increased FX-debt servicing burdens:
  - Until 2014, the Lira either appreciated or depreciated less than the growth of the GDP deflator, easing FX-debt serviceability; since then the opposite has become the norm.
- NIIP and reserve developments:
  - NIIP deteriorated from -42 percent of GDP in 2016 to -53 percent of GDP at end-2017.
  - Total foreign liabilities amount to 80 percent of GDP, dominated by debt.
  - Short-term debt and non-resident holdings of domestic portfolio debt amount to around 25 percent of GDP.
  - 40 percent of long-term private external debt is on adjustable interest rate terms.
- Reserves and FX liquidity:
  - Gross reserves remained low at around $108 billion USD at end-2017 (82 percent of the ARA metric).
  - Net international reserves declined to $31 billion USD.
  - Given low reserve coverage of external financing requirements (less than half) and low net international reserves, further reserve accumulation is needed.

### External position, current account, and REER assessments
- Current account developments:
  - CA deficit widened to 5.5 percent of GDP in 2017 (4.6 percent on a cyclically adjusted basis).
  - 1.1 percent of GDP of the 2017 CA deficit was due to increased demand for gold, treated as an one-off phenomenon.
  - High import growth underpinned by strong domestic demand offset export growth and tourism recovery.
  - The output gap turned positive in 2017 with signs of overheating.
- CA gap and norms:
  - EBA model estimates the 2017 cyclically-adjusted CA was some 3.5 percent of GDP weaker than the level implied by medium-term fundamentals and desirable policies.
  - The ES approach suggests the CA deficit is broadly in line with fundamentals.
  - Staff assesses the CA gap to be in the range of -0.5 to -2.5 percent of GDP, with the gap primarily driven by policy factors.
  - Staff’s midpoint estimate of the CA norm range is around 2 percent of GDP lower than the estimated EBA CA norm.
- Real exchange rate (REER) assessments:
  - In 2017 the average REER depreciated by 10 percent from the year before, standing 25 percent below its 2010 peak.
  - EBA REER level approach suggests REER was broadly fairly valued in 2017.
  - The REER index approach suggests the Lira was undervalued by around 9 percent.
  - The EBA CA approaches point to an REER overvaluation of around 17.5 percent, while the ES approach suggests an REER broadly in line with fundamentals.
  - Staff assesses the REER to be broadly in line with fundamentals, with the CA gap mainly driven by policy gaps and delays in adjustment to REER depreciation.

### Capital flows, financing quality, and vulnerabilities
- Financing composition and risks:
  - Quality of financing weakened in 2017 with a decline in FDI and higher reliance on portfolio inflows into government and bank debt securities.
  - Gross external financing needs are over 25 percent of GDP.
  - Financing has relied significantly on short-term and portfolio inflows, making Turkey vulnerable to shifts in investor sentiment.
  - Improvements in debt maturity over 2015–16 have been slightly reversed due to lower quality of inflows.
  - Debt service of the private sector is vulnerable to hikes in global rates given adjustable-rate composition and FX-denominated domestic debt exposure.
- FX interventions and policies:
  - The CBRT stopped selling foreign exchange to commercial banks in 2016 but continues direct sales of FX to energy-importing SOEs.
  - Measures to support FX liquidity include 1-week FX deposit auctions, changes to the Reserve Option Mechanism (ROM), and discounted Lira exchange rates for export rediscount credit repayments.
  - ROM balances are held at blocked accounts at CBRT for 14 days and may be fully substituted with Lira liquidity after this maintenance period.
  - Domestic banks may use FX deposits at the CBRT as collateral for Lira liquidity facilities, including swaps with maturities up to 1 month.
  - Turkey has not used capital controls on either inflows or outflows.

### Fiscal space, debt sustainability, and macroeconomic outlook
- Despite upward revisions lowering fiscal, current account and debt-to-GDP ratios, the revisions also imply more limited debt-servicing capacity because fiscal and export revenues are smaller relative to the revised economy size.
- External and fiscal debt continue to be sustainable over the medium term, but vulnerabilities from composition and financing remain significant.
- Potential output growth composition:
  - Capital inputs increased materially in the revised data, while TFP growth over 2007–17 is slightly negative.
  - Narrowing development margins and a lull in productivity-enhancing reforms imply low productivity likely to persist.

### Policy recommendations and priorities
- Tighten macroeconomic policy mix to address dual deficits (current account and fiscal):
  - Implement tighter fiscal, quasi-fiscal, and monetary policies to rein in domestic demand and imports.
  - Revisit macroprudential policies to improve external financing quality and lower FX exposure risks.
- Fiscal policy:
  - Center on a credible medium-term fiscal consolidation plan to restore the strong fiscal anchor for macroeconomic stability.
  - Unwind state loan guarantees over time and use them only where credit conditions are hampered by market failures.
  - Contain PPPs and direct them to critical economically viable projects.
- Monetary policy:
  - Aim at re-anchoring inflation expectations and building credibility of the inflation target.
  - Increase net international reserves and limit interventions to periods of excessive Lira volatility.
- Financial stability and credit:
  - Decelerate credit growth to address positive output and credit gaps and restore external sustainability.
  - Reduce FX-denominated domestic debt exposure to limit balance sheet risks for corporates and banks.

*Prepared by P. Iossifov; content drawn from Annex I, "Re-Assessing Turkey’s Macroeconomic Performance," as provided by the source PDF.*

### Annex III. Risk Assessment Matrix

### Annex III. Risk Assessment Matrix

### Global risks and assessments
- Retreat from cross-border integration
  - Likelihood: Medium
  - Time Horizon: Short to Medium Term
  - Impact: Low
  - Description: A fraying consensus about the benefits of globalization leads to protectionism and economic isolationism, resulting in reduced global and regional policy collaboration with negative consequences for trade, capital and labor flows, sentiment, and growth.
  - Policy response:
    - Efforts should continue to upgrade the Customs Union with the EU.

- Policy and geopolitical uncertainties
  - Likelihood: Medium
  - Time Horizon: Short to Medium Term
  - Impact: High
  - Description:
    - Policy uncertainty. Two-sided risks to U.S. growth with difficult-to-predict policies; uncertainty associated with negotiating post-Brexit arrangements and associated market fragmentation risks; and evolving political processes, including elections in several large advanced and emerging market economies weigh on global growth.
    - Intensification of the risks of fragmentation/security dislocation in part of the Middle East, Africa, Asia, and Europe, leading to socio-economic disruptions.
  - Policy response:
    - Preemptively increase FX reserves through sterilized intervention.
    - Use exchange rate as a shock absorber.
    - Allow automatic fiscal stabilizers to operate.

- Financial conditions: Tighter global financial conditions
  - Likelihood: High
  - Time Horizon: Short Term
  - Impact: High
  - Description: Against the backdrop of continued monetary policy normalization and increasingly stretched valuations across asset classes, an abrupt change in global risk appetite (e.g., due to higher-than-expected inflation in the U.S) could lead to sudden, sharp increases in interest rates and associated tightening of financial conditions. Higher debt service and refinancing risks could stress leveraged firms, households, and vulnerable sovereigns, including through capital account pressures in some cases.
  - Policy response:
    - Preemptively strengthen bank and NFC balance-sheets through restrictions on the structure of liabilities and higher risk weights and provisioning on lending to NFCs in FX.
    - Tighten monetary policy.
    - To the extent the NIR level allows, use FX reserves to smooth volatility under disorderly market conditions.
    - Use exchange rate as a shock absorber.
    - Allow automatic fiscal stabilizers to operate.

- Weaker-than-expected global growth (including significant China slowdown)
  - Likelihood: Low /Medium
  - Time Horizon: Short to Medium Term
  - Impact: Medium
  - Description: Ongoing efforts by the Chinese authorities to “de-risk” the financial system are welcome, but too fast an adjustment and improper sequencing of actions may adversely affect near-term growth (low likelihood). Over the medium term, overly ambitious growth targets, including by over reliance on credit stimulus and investment, lead to unsustainable policies, reducing fiscal space, further increasing financial imbalances. A sharp adjustment would weaken domestic demand, with adverse international spillovers, including a pullback in capital flows to EMs.
  - Policy response:
    - Use exchange rate as a shock absorber.
    - Allow automatic fiscal stabilizers to operate.
    - Structural reforms should aim at raising the economy’s competitiveness.
    - Diversify export destinations, increase high value-added exports, and improve competitiveness, thus boosting exports.

### Domestic risks and assessments
- Loose domestic policies leading to high inflation and deteriorating fiscal position
  - Likelihood: Medium
  - Time Horizon: Short to Medium Term
  - Impact: High
  - Description: High inflation and a deteriorating fiscal position, eroding confidence and leading to re-dollarization. This could occur if the government tries to spur growth through demand management, rather than long-term structural reform.
  - Policy response:
    - Tighten monetary policy and normalize the framework.
    - Tighten fiscal policy to bring it back into line with the medium-term program. Prioritize expenditure compression.
    - Structural reforms should aim at increasing underlying total factor productivity growth.

- Disorderly macro-financial cycle of deleveraging and income compression
  - Likelihood: Medium
  - Time Horizon: Short to Medium Term
  - Impact: High
  - Description: Turkey’s sizeable estimated credit gap—capturing deviations of private debt from fundamentals—is prone to unwinding. This can trigger a vicious cycle between deleveraging and lower domestic demand, incomes, and asset prices. Possible triggers include domestic policy mistakes and/or external financing pressures giving rise to rapid exchange rate depreciation, which weakens corporate balance sheets and worsens bank asset quality, triggering sharp deleveraging and slowdown of economic activity.
  - Policy response:
    - Use exchange rate as a shock absorber, while preemptively building reserves to give space for FX liquidity support in the event of disorderly market conditions.
    - Allow automatic fiscal stabilizers to operate.
    - Preemptively strengthen bank and NFC balance sheets through restrictions on the structure of liabilities and higher risk weights or provisioning on lending to NFCs in FX.
    - Some additional fiscal space could be used and monetary policy could assign a bigger weight on the output gap to the extent consistent with orderly FX market conditions.
    - Robust debt-restructuring framework needs to be put in place in the medium-term.

### Public debt and debt sustainability (Annex IV summary points relevant to risk)
- Current position and profile
  - Turkey’s public debt ratio: about 28 percent of GDP (measured as general government gross debt according to Maastricht criteria).
  - Central government debt accounts for over 90 percent of public debt and has an average remaining maturity of 6.4 years.
  - Fixed interest debt accounts for about 74 percent share of total public debt.
  - Around 39 percent of public debt is denominated in foreign currency.
  - Public gross financing needs have declined significantly and should remain low over the medium term.
  - External financing requirements exceed the EM benchmark level of 15 percent of GDP, indicating high risk with respect to external financing requirements.

- Baseline projections and risks
  - Debt levels: Debt-to-GDP ratio increased to around 28 percent at end-2016. Staff forecasts that the ratio will remain around this level over the medium term as the ongoing and projected fiscal expansion is broadly offset by the positive growth-interest rate differential.
  - Growth: Growth is expected to decelerate in 2018 but to continue to be strong in the run-up to the 2019 elections, before returning to its long-run potential of about 3.6 percent over the medium term. The output gap is estimated to remain positive throughout the projection period, driven by pro-cyclical policies.
  - Sovereign yields: The spread against US bonds in the last three months remained on average at 289 bps, compared to its lowest value of 163 bps observed in May 2013. The effective interest rate has been stable at around 8¼ percent in 2017, and is expected to increase in the near and medium term due to the normalization of monetary policies in advanced countries.
  - Fiscal adjustment: In the baseline, the general government structural primary deficit is projected to increase from 1.7 percent of potential GDP in 2017 to 2.0-2.1 percent in 2018-19. In the medium term, the general government structural primary deficit is projected to be around 0.6 percent of potential GDP.

- Stress test results (selected shocks)
  - Overall: The public DSA suggests that Turkey’s government debt is sustainable under the baseline and under various shocks. Primary balance and interest rate shocks do not affect debt dynamics substantially. Growth, combined macro-fiscal, and contingent liability shocks lead to a prolonged increase in public debt.
  - Primary balance shock:
    - Shock specification: A deterioration of 1.2 percentage points of GDP in the primary balance over the next two years.
    - Impact: Would raise the medium-term public debt level by around 1½ percentage points of GDP.
    - Additional effect: Under this scenario, sovereign borrowing costs are also raised by 25 basis points for each 1 percentage point of GDP worsening in the primary balance. The impact on the debt-to-GDP ratio and gross financing needs levels by 2022 is modest.
  - Growth shock:
    - Shock specification: Real output growth rates are lowered by 1 standard deviation, or 4.4 percentage points, for 2 years starting in 2018.
    - Impact (partial): The decline in growth leads to lower inflation. The primary balance deteriorates significantly compared to the baseline, as nominal revenues fall against unchanged expenditures, reaching -4¾ percent of GDP by [text truncated in source].

*Annex III. Risk Assessment Matrix (and connected Annex IV summary) — content as provided in the source.*

### 2019. This also leads to higher sovereign borrowing costs. The debt-to-GDP ratio increases

### cr18110 - 2019. This also leads to higher sovereign borrowing costs. The debt-to-GDP ratio increases

### Baseline projections and key debt indicators
- Nominal gross public debt: 37.1 (2015), 27.6 (2016), 28.3 (2017), 28.5 (2018), 27.8 (2019), 27.9 (2020), 27.9 (2021), 28.0 (2022), 28.1 (projection series).
- Public gross financing needs: 12.4 (2015), 4.7 (2016), 5.3 (2017), 5.1 (2018), 5.6 (2019), 5.1 (2020), 5.7 (2021), 5.0 (2022).
- Real GDP growth (in percent): 5.1 (2015), 6.1 (2016), 3.2 (2017), 7.0 (2018), 4.4 (2019), 4.0 (2020), 3.6 (2021), 3.6 (2022).
- Inflation (GDP deflator, in percent): 7.7 (2015), 7.8 (2016), 8.1 (2017), 11.0 (2018), 11.6 (2019), 11.1 (2020), 9.3 (2021), 8.2 (2022), 7.8 (2022 further entry).
- Effective interest rate (in percent): 11.9 (2015), 9.3 (2016), 8.2 (2017), 8.2 (2018), 8.4 (2019), 9.6 (2020), 10.5 (2021), 11.2 (2022).
- Primary balance (in percent of GDP): -1.2 (2015), -0.6 (2016), 1.0 (2017), 0.9 (2018), 1.3 (2019), 1.3 (2020), 0.7 (2021), 0.3 (2022) — identified flows table shows cumulative primary deficit contributions and levels consistent with projections.
- Change in gross public sector debt (cumulative): -2.4 (2015), -1.1 (2016), 0.7 (2017), 0.2 (2018), -0.7 (2019), 0.1 (2020), 0.1 (2021), 0.1 (2022), -0.2 (projection cumulative).

### Alternative scenarios and stress-test outcomes
- Growth shock scenario:
  - Debt-to-GDP ratio increases to about 37 percent during the growth shock and remains around this level in the medium term.
  - Gross public financing needs climb toward 9¼ percent of GDP before trending down to 7 percent of GDP by the end of the period.
- Interest rate shock:
  - Real effective rate reaches similar levels as in 2009, implying a permanent increase in spreads by about 845 basis points.
  - Government’s implicit average interest rate reaches 17¼ percent by 2022.
  - Debt-to-GDP ratio climbs to around 32 percent.
  - Gross public financing needs increase to around 7 percent of GDP by 2022.
- Combined macro-fiscal shock:
  - Public debt trends upward towards 46½ percent of GDP by 2022.
  - Gross financing needs increase to around 10¼ percent of GDP in the medium term.
- Contingent liability shock:
  - One-time contingent liabilities assumed to increase non-interest expenditures by a hypothetical 10 percent of GDP.
  - Combined with a real GDP growth shock (1 standard deviation for 2 years).
  - Sovereign borrowing costs pushed up (25 bps for each 1 percent of GDP worsening in the primary balance).
  - Inflation declines (0.25 percentage points per 1 percentage point decrease in GDP growth).
  - Debt rises to 40 percent of GDP in 2018 and gradually increases towards 44 percent of GDP by end-2022.
  - Gross public financing needs peak in 2018 before declining to about 8 percent of GDP in the medium term.

### Public DSA mechanics and contributions to debt dynamics
- Automatic debt dynamics components:
  - Interest rate/growth differential contributions and decomposition presented (real interest rate and real GDP growth contributions).
  - Example entries: interest rate/growth differential contribution row shows -0.4 (2015), -1.3 (2016), -0.8 (2017), -2.5 (2018), -2.0 (2019), -1.4 (2020), -0.7 (2021), -0.2 (2022), 0.0 (projection).
  - Of which: real interest rate contributions and real GDP growth contributions listed explicitly (e.g., real interest rate: 1.4 (2015), 0.3 (2016), 0.0 (2017), -0.9 (2018), -0.9 (2019), -0.5 (2020), 0.2 (2021), 0.7 (2022), 0.9 (further), -0.5; real GDP growth: -1.8 (2015), -1.5 (2016), -0.8 (2017), -1.7 (2018), -1.1 (2019), -1.0 (2020), -0.9 (2021), -0.9 (2022), -0.9 (projection)).
- Other identified debt-creating flows and residuals:
  - Other identified debt-creating flows entries: 0.4 (2015), 0.3 (2016), 0.0 (2017), 1.6 (2018), -0.5 (2019), -0.1 (2020), -0.1 (2021), -0.1 (2022), -0.2 (projection), 0.5 (cumulative).
  - Deposit build-up: 0.9 (2015), 0.8 (2016), 0.6 (2017), 1.2 (2018), -0.2 (2019), 0.5 (2020), 0.4 (2021), 0.5 (2022), 0.5 etc.
  - Residual, including asset changes: -1.9 (2015), -1.9 (2016), -1.5 (2017), 0.2 (2018), 0.5 (2019), 0.3 (2020), 0.2 (2021), 0.1 (2022), 0.2, 1.5.

### Market perception, risk assessment, and heat-map indicators
- EMBIG (bp): 297 (as of 05-Mar-2018 three-month average 05-Dec-17 through 05-Mar-18).
- 5-year CDS (bp): 171 (reported).
- Risk-assessment benchmarks and commentary:
  - External financing requirements benchmark: 5 and 15 percent of GDP (EMs high risk when above 15 percent of GDP).
  - Debt profile risk thresholds: EMBIG global spread between 200 and 600 basis points, and/or share of public debt in foreign currency between 20 and 60 percent considered moderate for EMs.
  - Market perception snapshot entries: Bond spread 289 bp, External Financing Requirement 12 (percent of GDP), Annual Change in Short-Term Public Debt 0.1 (percent), Public Debt in Foreign Currency 41% (in percent of total), Public Debt Held by Non-Residents 23% (in percent of total).
- Heat-map outcomes:
  - Cells highlighted by benchmarks (green/yellow/red/white) according to whether debt burden or gross financing needs benchmarks are exceeded under shocks or baseline.

### External debt sustainability (Annex V)
- Baseline external debt trajectory:
  - External debt: 38.9 (2012), 41.0 (2013), 43.0 (2014), 46.1 (2015), 46.9 (2016), 53.2 (2017), 54.1 (2018), 54.6 (2019), 54.3 (2020), 53.6 (2021), 52.9 (2022), 52.1 (2023).
  - Debt-stabilizing non-interest current account: -2.5 (long-run constant balance that stabilizes the debt ratio given last projection year assumptions).
- Key vulnerabilities and exposures:
  - External debt estimated to reach 53 percent of GDP in 2017.
  - Private sector external debt: 37 percent of GDP (bulk of external debt); banks: about 16 percent of GDP; non-financial corporates: 16 percent of GDP (around a third short-term trade credits).
  - Private creditors, including bondholders, hold close to 90 percent of debt.
  - Short-term rollover and liquidity risk: annual rollover needs around 20 percent of GDP.
  - Currency composition risk: over 90 percent of Turkish external debt denominated in foreign currency.
- Stress-test outcomes for external debt:
  - Permanent Lira depreciation of 30 percent would push external debt stock to 83 percent of GDP by 2023, including about 60 percent of GDP of private debt (analysis does not account for potential contraction of the current account deficit associated with such sharp currency movements).
  - A steeper recovery of fuel prices leading to a non-interest current account of about 5 percent of GDP would push the debt ratio above 60 percent of GDP over the medium term.
- Baseline components and projections (selected entries):
  - Change in external debt: 2.4 (2012), 2.2 (2013), 2.0 (2014), 3.1 (2015), 0.8 (2016), 6.3 (2017), 0.8 (2018), 0.6 (2019), -0.4 (2020), -0.6 (2021), -0.8 (2022), -0.8 (2023).
  - Current account deficit, excluding interest payments: 4.8 (2012), 6.1 (2013), 4.1 (2014), 3.1 (2015), 3.2 (2016), 4.8 (2017), 4.3 (2018), 3.2 (2019), 2.6 (2020), 2.1 (2021), 1.6 (2022), 1.3 (2023).
  - Net non-debt creating capital inflows (negative): -1.8 (2012), -1.1 (2013), -0.9 (2014), -1.2 (2015), -1.3 (2016), -1.3 (2017), -1.2 (2018), -1.2 (2019), -1.2 (2020), -1.2 (2021), -1.3 (2022), -1.3 (2023).
  - Automatic debt dynamics contribution: -1.2 (2012), -2.7 (2013), 0.9 (2014), 3.7 (2015), 0.1 (2016), -2.6 (2017), -1.1 (2018), -0.5 (2019), 0.0 (2020), 0.1 (2021), 0.1 (2022), 0.3 (2023).
  - External debt-to-exports ratio (in percent): 165.5 (2012), 186.1 (2013), 182.1 (2014), 199.6 (2015), 216.0 (2016), 215.7 (2017), 207.7 (2018), 208.7 (2019), 209.5 (2020), 208.5 (2021), 207.9 (2022), 207.3 (2023).
  - Gross external financing need (in billions of US dollars): 173.7 (2012), 211.6 (2013), 215.1 (2014), 203.9 (2015), 197.4 (2016), 211.3 (2017), 228.8 (2018), 252.5 (2019), 271.4 (2020), 284.1 (2021), 292.6 (2022), 292.7 (2023).
  - Gross external financing need (in percent of GDP): 19.9 (2012), 22.3 (2013), 23.0 (2014), 23.7 (2015), 22.9 (2016), 24.9 (2017), 25.1 (2018), 26.3 (2019), 26.5 (2020), 26.1 (2021), 25.3 (2022), 23.9 (2023).
- Stress-test charts and bound tests:
  - Interest rate shock, permanent 1 standard deviation increase, and combined shocks depicted; historical scenario and one-time real depreciation of 30 percent (2016 example) push external debt substantially higher in bound tests (e.g., real depreciation shock shows external debt reaching 82 (percent of GDP) under that scenario per figure notes).

*Source: IMF staff (Turkey Public Sector DSA and Annex V: External Debt Sustainability Analysis, as of March 05, 2018).*

### Annex VI. Implementation of Past Fund Advice

### Annex VI. Implementation of Past Fund Advice

### Traction of Fund advice and technical assistance
- Authorities have increased traction on Fund advice over the past year to address risks from the large, negative FX position.
- Technical assistance commitments:
  - Monetary and Capital Markets Department: bank and corporate risk analysis.
  - Fiscal Affairs Department: assessing fiscal costs and risks of Public-Private Partnerships (PPP).
- Areas with less traction:
  - Advice on building up reserves and savings, and on reducing uncertainty and improving the design of the private pension auto-enrollment.
- Progress in normalizing the monetary framework was derailed by the large post-coup attempt depreciation bouts.

### Progress on 2017 FSAP recommendations (Table 1) — key findings by theme
- Banking supervision
  - Revise legislation to further strengthen BRSA independence (Timing: MT): Not done.
  - Deepen and broaden risk assessment nature of banking inspection and follow up (MT): In progress. Actions:
    - Supervisory approach and manuals revised in 2016; associated guidelines implemented in 2017.
    - Risk assessment of banks strengthened in examination reports.
    - Forward-looking component included in the CAMELS methodology.
    - Coordination between on-site and off-site functions enhanced.
  - Strengthen corporate governance rules and enforcement (MT): In progress. Actions:
    - Revision of internal system regulations to take into account IOSCO and Basel principles planned.
    - Corporate governance assessment aspect of supervisory process strengthened.
  - Evaluate and revise the definition of credit classifications and strengthen enforcement (ST): In progress. Actions:
    - IFRS 9 implementation started in January 2018.
    - New credit classifications and provisioning rules more in line with international standards came into force.

- Insurance supervision
  - Improve independence, governance and accountability of supervisor; increase resources for internal control functions; integrate offsite, onsite and enforcement activities; develop risk-based, group supervision (ST/MT): In progress. Actions:
    - Revision of regulation on internal systems of insurance, reinsurance and pension companies and other related regulations being prepared.
    - Steps for establishing a compliance function within insurance companies and strengthening their risk management are being assessed.
    - A qualitative supervisory assessment tool is being developed to assess insurers' risk management and internal control systems.

- Systemic risk oversight
  - Strengthen macro prudential measures to lower foreign exchange risk in the economy (I): In progress. Actions and scope:
    - Measures to restrict new FX borrowing by SMEs: introducing FX debt to FX income limits and banning new FX-indexed corporate loans starting in May 2018.
    - The new framework contains a number of exemptions and covers just 16 percent of FX borrowers.
    - Authorities plan to extend and tailor scope to the rest of corporate FX borrowers in 2018 based on Q1 2018 corporate data and surveys.
  - Strengthen FSC's governance and powers, provide explicit financial stability objective to all members, and limit Council of Minister’s role (ST): Not done.
  - Develop procedures for improved systemic risk assessment and coordination of macroprudential policies (ST/MT): In progress. Actions:
    - Systemic risk monitoring working group established under the FSC, responsible for identification of systemic risks including through stress tests.
    - Efforts to coordinate stress tests of CBRT and BRSA are ongoing.
    - CBRT aims to incorporate liquidity and corporate stress tests in its current framework with forthcoming IMF technical assistance.
  - Base choice of policy tools on integrated assessment of systemic risk and cost-benefit analysis of alternative options (ST): In progress. Actions:
    - Two working sub-groups established in 2017 under systemic risk assessment group: (i) systemic risk monitoring working group; (ii) crisis management and resolution working group.
    - A heat map system put in place to facilitate a more integrated risk assessment system.
  - Strengthen transparency (including FSC publishing an Annual Report) (ST): Not done.

- Managing systemic liquidity
  - Orient liquidity provision towards a single key policy rate (I): Not done. Observation:
    - CBRT shifted liquidity provision from the policy rate facility to the more expensive late liquidity window (LLW).
  - Increase net reserves such that gross reserves are within the range of 100-150 percent of the ARA metric (MT): In progress. Status and measures:
    - Gross reserves are at 82 percent of the Assessment of Reserves Adequacy (ARA) metric.
    - In November 2017, the CBRT introduced the use of non-deliverable forwards to manage demand for FX and hedging by banks and corporates to manage volatility without depleting reserves.
  - Improve ELA capacity; redefine CBRT FX lending facility as ELA and increase conditionality (ST): In progress. Actions:
    - Following technical cooperation with other central banks and the ECB, regulation on liquidity support credit and best country practices will be discussed by the crisis management and resolution working group.

- Financial crisis management
  - Strengthen recovery and resolution planning and enhance resolution powers by: (i) Strengthening the banking law; (ii) Developing guidance (MT): In progress. Actions:
    - Recovery and resolution amendments being prepared by SDIF and BRSA in a joint task force, which received technical assistance from the World Bank.
    - Draft legislation has been prepared.
  - Strengthen domestic and cross-border coordination arrangements (ST): In progress. Actions:
    - Domestic crisis management and resolution working group established in 2017 under the systemic risk assessment group operating under the FSC.
    - No significant progress reported on cross border coordination arrangements.

- AML/CFT
  - Determine reason for low money laundering (ML) conviction rates and plan to address them (MT): In progress. Actions:
    - Financial Crimes Investigation Board (MASAK) has increased staff and undergone a National Risk Assessment Project since 2016.
  - Introduce customer due diligence requirements for politically exposed persons (ST): In progress. Actions:
    - Draft legislation prepared to cover the PEP concept more fully.
  - Ensure compliance with requirements of the United Nations Security Council Resolution (UNSCRs), and strengthen border controls on currency transportation (MT): In progress. Actions:
    - Turkish authorities awaiting National Risk Assessment results for UNSCR compliance.
    - Circular on passenger accompanied outgoing cash movements prepared; training of customs personnel increased.
    - Turkish customs working on further IT and operational capacity improvements.

### Fund relations — key data (as of March 5, 2018)
- Stand-By Arrangement history:
  - A three-year SDR 6,662.04 million (691.1 percent of quota) Stand-By Arrangement approved in May 2005 and expired on May 10, 2008. Cumulative purchases amounted to SDR 4,413,601,500.
  - No outstanding Fund credit as of March 5, 2018.
- Membership Status:
  - Turkey became a member of the Fund on March 11, 1947.
  - Accepted obligations of Article VIII, Sections 2, 3, and 4 as of March 22, 1990.
- General Resources Account:
  - Quota: 4,658.60 SDR Million (100.00 percent Quota)
  - Fund holdings of currency: 4,545.83 SDR Million (97.58 percent Quota)
  - Reserve position in Fund: 112.78 SDR Million (2.42 percent Quota)
- SDR Department:
  - Net cumulative allocation: 1,071.33 SDR Million (100.00 percent Allocation)
  - Holdings: 965.89 SDR Million (90.16 percent Allocation)
- Latest Financial Arrangements (selected):
  - Stand-By 05/11/05–05/10/08: Amount Approved 6,662.04; Amount Drawn 6,662.04 (In millions of SDRs)
  - Stand-By 02/04/02–02/03/05: Amount Approved 12,821.20; Amount Drawn 11,914.00
  - Stand-By 12/22/99–02/04/02: Amount Approved 15,038.40; Amount Drawn 11,738.96
  - Of Which: SRF 12/21/00–12/20/01: Amount Approved 5,784.00; Amount Drawn 5,784.00
- Projected Payments to the Fund (based on existing use of resources and present holdings of SDRs):
  - For forthcoming years 2018–2022: Principal --; Charges/Interest 0.83 each year; Total 0.83 each year.
- Safeguard Assessments:
  - Central bank safeguards assessment completed June 29, 2005; no material weaknesses; recommendations implemented.
- Exchange Rate Arrangement:
  - Currency: Turkish lira (replaced the new Turkish lira on January 1, 2009).
  - De jure exchange rate arrangement: free floating; de facto exchange rate arrangement: floating.
- Article IV Consultations:
  - Board discussion of last Article IV staff report took place on January 11, 2017.
  - Article IV staff report published on February 3, 2017 (IMF Country Report No. 17/32).
- FSAP:
  - Financial System Stability Assessment issued on February 3, 2017 (IMF Country Report No. 17/35).
- Resident Representative:
  - Resident representative office in Ankara. Mr. Srikant Seshadri has been the senior resident representative since August 2014.

### Recent IMF technical assistance (selected)
- FAD/MFD February 2005: Treasury cash management and state bank reform
- MFD 2005–06 (several missions): Inflation targeting and monetary policy implementation
- ICM May 2005: Investor relations office
- FAD July 2005: Income tax reform
- FAD 2005–08 (several missions): Revenue administration reforms
- FAD February 2007: Health spending
- STA June 2007, November 2007: Revision of national accounts statistics and communication strategy
- STA November 3–17, 2008: DATA ROSC
- FAD June 2009: Tax administration
- MCM February 2012: Stress testing framework for the financial sector supervisor
- FAD September 2012: G–20 budget institutions
- MCM October 2012: Early warning system and stress testing
- FAD November 2012: Measurement of structural fiscal balances
- STA January 2013: National account statistics
- MCM December 2013: Stress testing
- STA December 2013: Monetary and financial statistics
- STA March 2014: Government finance statistics
- STA March 2014: National accounts statistics
- FAD April 2014: Performance-based budgeting
- FAD May 2014: Tax revenue modeling
- STA May 2014: Financial sector accounts
- STA July 2014: Government finance statistics – public sector debt statistics
- STA April 2015: National accounts statistics
- FAD June 2015: Fiscal transparency evaluation
- STA January 2016: Compilation system for independent annual estimates of GDP
- STA April 2016: Government finance statistics – GFSM2014 and ESA10
- FAD December 2017: Public-Private Partnerships (PPP)
- FAD January 2018: VAT Policy Issues

### World Bank Group relations — key points and figures
- Partnership: WBG Country Partnership Framework (CPF) aligned with Turkey’s 10th National Development Plan and WBG’s 2016 Systematic Country Diagnostic (SCD); CPF outlines WBG strategy for FY18–21.
- Instrument mix: IBRD, IFC, and MIGA engagement.
- International Bank for Reconstruction and Development (IBRD):
  - Turkey is IBRD’s sixth-largest borrower in terms of debt outstanding, representing 6.85% of all IBRD loan outstanding.
  - Active investment portfolio includes 13 projects with total net commitments of US$3.9 billion (as of January 2018).
  - IBRD financing for FY18-21 is estimated at $5-7.5 billion.
- International Finance Corporation (IFC):
  - Turkey is the second largest country in IFC’s global portfolio after India.
  - During the previous CPS, IFC invested a record of US$ 4.55 billion—of which US$ 3.58 billion was for IFC’s own account and US$ 973 million in mobilization—in 84 projects across sectors.

*Source: Annex VI. Implementation of Past Fund Advice; Staff Report for the 2018 Article IV Consultation — Informational Annex (March 16, 2018).*

### 8.      Turkey is MIGA’s largest country by gross exposure, representing almost 14 percent of

### 8.      Turkey is MIGA’s largest country by gross exposure, representing almost 14 percent of 

### MIGA exposure and portfolio
- MIGA’s portfolio in Turkey comprises projects in the infrastructure, financial, and services sectors with gross exposure of US$2.7 billion (as of January 2018).
- MIGA intervention helped mobilize foreign private financing in support of healthcare, the financial sector, and the transport sector.
- MIGA’s product mix includes traditional political risk insurance and the non-honoring credit guarantee product.

### Assessment of data adequacy for surveillance (As of March 5, 2018)
- General: Data provision to the Fund is broadly adequate for surveillance purposes, despite shortcomings especially in national accounts and government finance statistics.
- National Accounts:
  - Published data for 2009 onwards adheres to 2008 SNA/ESA 2010.
  - TURKSTAT compiles quarterly GDP at current prices and in chain-linked volume terms (production and expenditure approaches); quarterly and annual GDP at current prices (income approach); financial and non-financial sectoral accounts; regional accounts; and supply and use tables.
  - In December 2016 TURKSTAT published a new series of national accounts, with reference year 2009 and base year 2012.
  - Quarterly national accounts are published with a 2-3 month lag.
  - Since the end-2016 revision, annual GDP is estimated independently from quarterly estimates and is published with a 9-12 month lag.
  - The end-2016 rebased national accounts led to a significant upward revision of GDP; IMF Statistics Department continues to work with TURKSTAT to clarify questions raised on the rebased series.
  - TURKSTAT plans to disseminate rebased high frequency indicators using new data sources.
- Price Statistics:
  - CPI base year: 2003; weights based on Household Budget Survey conducted yearly by TURKSTAT.
  - PPI compiled for mining, manufacturing, and utilities; separate PPI for agriculture.
- Government Finance Statistics:
  - Coverage of the budget is largely complete; some fiscal operations through extra budgetary funds available only with lags.
  - Fiscal analysis complicated by quasi-fiscal operations by state banks, SEEs, and consolidation issues between cash-based government accounts and accrual-based SEEs.
  - Difficult to reconcile fiscal data with monetary and BOP data, especially external debt flows and central government deposits.
  - Latest GFS Yearbook data cover 2016, general government sector with stocks and flows, including a full general government balance sheet.
  - Quarterly general government accrual data (revenue, expenditure, financing, balance sheet) are reported for publication in IFS.
- Monetary and Financial Statistics:
  - CBRT reports monetary statistics for central bank, other depository corporations, and other financial corporations using SRFs consistent with the IMF’s Monetary and Financial Statistics Manual.
  - BRSA reports all 12 core FSIs and nearly all encouraged FSIs quarterly.
- External sector statistics:
  - CBRT compiles and disseminates BOP and IIP quarterly in broad conformity with BPM6.
  - CBRT participates in IMF surveys on direct and portfolio investments and reports international reserves and foreign currency liquidity templates regularly.
  - CBRT recently started reporting the currency composition of IIP to STA.
- Data Standards and Quality:
  - Turkey subscribed to the SDDS since 1996.
  - Latest Data ROSC published in September 2009.

### Table of common indicators (selected publication/frequency notes)
- Exchange Rates: Mar. 2018; Date received 03/05/2018; Frequency D; Frequency of reporting D; Frequency of publication D.
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Feb. 2018; Date received 03/01/2018; Frequency W; Frequency of reporting W; Frequency of publication W.
- Reserve/Base Money (narrow definition): Feb. 2018; Date received 03/01/2018; Frequency W and M; Frequency of reporting W and M; Frequency of publication W and M.
- Broad Money: Feb. 2018; Date received 03/01/2018; Frequency W and M; Frequency of reporting W and M; Frequency of publication W and M.
- Consumer Price Index: Feb. 2018; Date received 03/05/2018; Frequency M; Frequency of reporting M; Frequency of publication M.
- Revenue, Expenditure, Balance and Composition of Financing – General Government: 2017Q3; Date received Jan. 2018; Frequency Q; Frequency of reporting Q; Frequency of publication Q.
- Revenue, Expenditure, Balance and Composition of Financing – Central Government: Jan. 2018; Date received Feb. 2018; Frequency M; Frequency of reporting M; Frequency of publication M.
- External Current Account Balance: Dec. 2017; Date received 02/14/2018; Frequency M; Frequency of reporting M; Frequency of publication M.
- GDP/GNP: 2017Q3; Date received 12/11/2017; Frequency Q; Frequency of reporting Q; Frequency of publication Q.
- Gross External Debt: 2017Q3/2017Q4; Frequency Q.

### Macroeconomic context and 2017 outcomes (statements by Turkish authorities, March 30, 2018)
- Policy mix and fiscal:
  - Fiscal policy was used judiciously and on a strictly measured basis to preserve production and employment via targeted transfers, investment and employment incentive schemes, temporary tax breaks, and emphasis on key public investment programs including PPPs.
  - General government debt to GDP ratio expected to remain at around 28.5 percent as of end-2017.
- Credit Guarantee Fund (CGF):
  - Restructured and scaled up to provide Treasury guarantees to a portfolio of TL 250 billion (about USD 65 billion) for 3 years.
  - CGF design: support credit market while retaining market dynamics in banks; contain contingent fiscal liabilities via a 7 percent ceiling on possible Treasury assumptions of problematic loans, limiting maximum fiscal burden to about USD 4.5 billion over three years.
- 2017 growth and employment:
  - Turkish economy rebounded with an estimated growth of around 7 percent in 2017.
  - Employment: 1.6 million new jobs added in 2017.
  - Authorities’ growth targets: initial MTP (2017–2019) target 4.4 percent; revised MTP (2018–2020) target 5.5 percent.
- External sector and trade:
  - Current account deficit widened from 3.8 percent in 2016 to an estimated 5.5 percent of GDP in 2017.
  - Exports (fob) increased by 10.2 percent.
  - Net tourism receipts increased by 26 percent.
  - Imports (cif) increased by 17.7 percent.
  - Net gold imports reached USD 10 billion (more than 1.1 percent of GDP) in 2017.
- Inflation and monetary tightening:
  - Consumer prices (y-o-y / end-2017) rose by 11.9 percent.
  - Headline CPI y-o-y receded to 10.3 percent in February 2018.
  - CBRT tightened monetary stance; weighted average funding cost rose by almost 500 bps throughout 2017.

### Outlook and policy positioning
- Medium-Term Program (MTP) 2018-2020:
  - Aimed at promoting strong and inclusive growth while ensuring macroeconomic stability, taming inflation, and reducing external imbalances.
  - Authorities expect GDP growth to moderate to 5.5 percent in 2018 and onwards (authorities view), slightly higher than staff’s forecast.
  - Authorities set MTP official target for the current account deficit at 4.3 percent of GDP in 2018 under assumptions:
    - moderation of growth from current levels;
    - reversion of net gold trade towards historical averages (USD 1.5billion);
    - no material terms of trade shock;
    - continued recovery of tourism sector and shuttle trade;
    - continued export performance supported by trading partner growth and increased competitiveness.
  - Authorities concur with staff on need to accumulate international reserves as financing conditions permit.
- Views on potential growth:
  - Staff’s potential growth range estimate: 3.5 – 4.0 percent (staff).
  - Authorities consider staff estimate too conservative and argue for higher potential based on:
    - historical average real growth about 4.8 percent per annum since the Republic;
    - 2011–2016 average growth above 6.4 percent per annum;
    - belief that subdued Solow residual is transitory and TFP could revert to past 15 years’ average (close to 1 percent per annum);
    - higher female labor force participation and educational trends raising labor contribution to long-run output.

### Monetary policy details
- Authorities’ inflation outlook and policy stance:
  - Authorities expect gradual easing of inflation to single-digit levels in 2018 with current end-year inflation estimate standing at 6.5 – 9.3 percent.
  - Monetary policy maintains a tightening bias and is prepared to tighten further if needed.
  - Authorities pursuing shift towards a simpler policy framework with all funding executed from a single facility, implying an effective policy rate of 12.75 percent.
  - Interbank rates have converged to CBRT funding rate.
- Structural measures to address supply-side inflation:
  - Measures to reduce structural dependence on energy imports; share of renewable sources (including hydro) in electricity generation has surpassed 30 percent of the energy mix.
  - Food and Agricultural Products Markets Monitoring and Evaluation Committee monitors food prices and can take measures, including selective relaxation of import quotas.

### Fiscal policy stance
- Growth-friendly fiscal policy while maintaining fiscal prudence.
- 2017 fiscal outcomes:
  - Time-bound fiscal stimulus elements expired in second half of 2017.
  - Steps to restrain expenditure growth and windfall revenue gains improved year-end central government budget deficit expected to be realized as 1.5 percent of GDP (below revised MTP estimate of 2 percent).
  - Public debt-to-GDP ratio in EU definition estimated to remain broadly stable at around 28.5 percent.
- Contingent liabilities and quasi-fiscal activities:
  - Authorities monitor state loan guarantees including CGF and do not expect material impact on fiscal balances.
  - Under CGF, loan assumption ceiling of 7 percent of the portfolio considered prudent.
  - Contingency budgeted of about 0.1 percent of GDP for fiscal year 2018 to cover potential Treasury assumptions.
  - Authorities will continue to improve assessment, monitoring, reporting and management of PPP portfolio; will adhere to international best practices in accounting of Sovereign Wealth Fund (once operational).

### Financial sector resilience and policies
- Banking system indicators:
  - Capital adequacy ratio: 16.8 percent (latest data - as of January 2018).
  - Total non-performing loan ratio: around 3 percent.
  - NPL ratio for CGF-backed loans: currently less than 0.5 percent.
  - 13-week annualized rate of credit growth slowed to 12.9 percent recently.
- FX and corporate sector:
  - Mitigants to corporate FX risk:
    - Many firms with FX liabilities are hedged or have natural hedges via FX revenues or intra-group receipts.
    - FX loans concentrated in large companies capable of absorbing depreciation impacts.
    - Corporate sector has net FX long position in the short term.
    - Offshore FX assets held by firms act as a buffer.
    - Share of FX loans in corporate loan volume fell as companies shifted to TL financing.
- Macroprudential measures:
  - New regulation effective May 2, 2018 to introduce a ceiling (equivalent to the total of preceding 3 years’ FX receipts) on FX borrowings of small- and medium-sized enterprises.
  - SMEs account for less than 20 percent of FX-denominated loan stock.
  - Authorities working on a comprehensive prudential framework for containing large corporates’ FX exposures to be announced in 2018.
  - Macroprudential framework will cover banks, households, and non-financial corporates.

### Structural reform priorities
- Identified reform areas include:
  - Labor Market: Severance pay reform, enhancing active labor market programs, boosting on-the-job training.
  - Public Finance: Income Tax Code, Tax Procedures Code, VAT reform, extending Treasury single account coverage, public expenditures reform.
  - Capital Markets: Capital Markets Law, Istanbul Finance Center reform, restructuring private pension system, new savings/investment instruments (e.g. housing accounts, and gold lease certificates).
  - Public Personnel Reform: Civil Service Code.
  - Education: Increase private sector role, lifelong education centers, prioritization of foreign language learning, academy for teachers, compulsory pre-school education, improving vocational and technical education.
  - Investment Climate and Competitiveness: Boost R&D and innovation, ease regulatory burden, improve access to finance, improve logistics, establish Localization Board, restructure TÜBİTAK and the state-owned development bank.

### International development efforts and refugees
- Development assistance:
  - Total development assistance reached USD 7.9 billion in 2016.
- Refugee hosting and support:
  - Turkey hosts about 4 million refugees and caters to more than 600,000 beyond its borders, making it the largest refugee-hosting and supporting country.
  - Significant funding mobilized for refugee camps and essential public services including education and health.
  - Authorities take measures to integrate refugees into social and economic life, including granting work permits.
  - Authorities view Syrian refugees’ labor market challenges as largely stemming from market dynamics rather than administrative restrictions.
  - Turkey and the EU continue to cooperate on refugee matters.

### Final remarks (authorities’ view)
- Authorities appreciate the Article IV consultation analyses and will carefully assess policy advice.
- Authorities will continue cooperation with the Fund, including targeted Technical Assistance to support key policy and reform initiatives.

*Source: IMF staff report text (selected extracts) as presented in the provided content.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18110.pdf_