## 1turea2019001 — TURKEY: STAFF REPORT FOR THE 2019 ARTICLE IV CONSULTATION

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### Executive summary and main policy challenge
- Context:
  - Following the sharp lira depreciation and associated recession in late-2018, growth improved, helped by policy stimulus and favorable market conditions.
  - The lira recovered and the current account saw a remarkable adjustment.
  - Turkey remains susceptible to external and domestic risks; prospects for strong and sustainable medium-term growth are challenging without reforms to address vulnerabilities, strengthen policy credibility, and boost productivity.
- Main policy challenge:
  - Move focus from short-run growth to higher and more resilient medium-term growth through a comprehensive reform package emphasizing monetary credibility, fiscal discipline, financial-sector repair, insolvency frameworks, and structural reforms.

### Recent developments — stimulus, recovery, exchange rate, and inflation
- Growth:
  - Growth resumed in 1H 2019 aided by expansionary fiscal policy, rapid credit expansion by state-owned banks, and more favorable market sentiment.
  - Growth should be slightly positive for 2019 as a whole—about ¼ percent—despite large negative carryover effects from the 2018 recession.
- External adjustment:
  - Import compression and strong tourism receipts produced a major current account adjustment; only a small deficit expected for 2019.
  - Improved external financing conditions and tight monetary policy reduced pressure on the lira.
- Inflation and monetary policy:
  - Inflation reached about 25 percent—five times the target—in October 2018, largely due to high exchange rate passthrough and rising inflation expectations.
  - Disinflation since then driven by strong negative base effects, relative lira stability, and a negative output gap; inflation expectations remain well above target.
  - The CBRT has cut policy rates by 1,000 basis points since July 2019, bringing the official repo lending rate to 14 percent.
  - The CBRT provided lira liquidity to primary dealers at 100 basis points below the official policy rate and to participating banks at rates settled under longer-term FX swaps.
- Reserves and unconventional policies:
  - Reserves remain low despite recent increases.
  - Authorities used measures on repatriation/conversion of export proceeds and BRSA capped banks’ swap positions.
  - Reports of large FX interventions through state-owned banks and questions over CBRT net reserve position; shift to longer-maturity FX swaps complicates reserve assessment.
  - CBRT started to rebuild reserves, including through the export rediscount credit facility (credit provided in lira, typically repaid in FX).

### Financial sector, state-owned banks, and corporate balance sheets
- State-owned banks and credit growth:
  - Private banks cut back lending, while state-owned banks engaged in major credit expansion which picked up pace in early-2019.
  - State-owned banks provided credit "at rates well below the cost of funding from the CBRT," weakening monetary transmission.
  - Value of TL loans by state-owned banks more than doubled over the last three years; share of state-owned banks in total TL loan market reached 44 percent, up from 32 percent in early 2016.
  - Staff analysis suggests Turkey’s state-owned bank credit gap remains wide, at around 15 percent of GDP.
  - TL loan to deposit (LTD) ratio for state-owned banks peaked at more than 156 percent in May 2019, 30 percentage points higher than in 2016.
  - State-owned banks’ dollarization ratio close to 46 percent, up 16 percentage points from three years earlier.
- Asset quality and regulatory treatment:
  - Reported metrics as of mid-October 2019: NPL ratio "5.5 percent for all deposit-taking institutions and 3.9 percent for state-owned banks."
  - BRSA note: "On September 17, 2019, the BRSA announced that the impact analysis conducted on the July 2019 financial statements of the banks would increase the level of NPLs to 6.3 percent."
  - Stage 2 loans climbed steadily to about 11½ percent of total loans as of June 2019.
  - Combined NPL and stage 2 loan ratio in construction "is approaching 25 percent."
- Corporate sector:
  - Balance sheets weakened due to lira depreciation, higher interest rates, and lower growth; large open FX position increased leverage; interest coverage ratios fell.
  - Authorities abolished bankruptcy postponement and set up an out-of-court debt restructuring mechanism; announced plans for centralized asset management companies for NPLs in energy and construction sectors.
  - Recent decree allows Treasury to acquire holdings in companies by presidential decree.
- Recommended diagnostics and reforms:
  - Comprehensive third-party asset quality review and new stress tests to better understand bank health.
  - Tighter loan classification and provisioning rules; strengthen resolution framework; monitor restructuring agreements to ensure durable repayment capacity.

### Outlook, projections, and key macro-fiscal metrics (selected staff baseline)
- Real GDP growth rate: 7.5 (2017), 2.8 (2018), 0.2 (2019), 3.0 (2020), 3.0 (2021), 3.0 (2022), 3.5 (2023), 3.5 (2024)
- Output gap: 2.2 (2017), 1.5 (2018), -1.1 (2019), -0.8 (2020), -0.5 (2021), -0.5 (2022), -0.2 (2023), -0.1 (2024)
- Inflation (period-average): 11.1 (2017), 16.3 (2018), 15.7 (2019), 12.6 (2020), 12.4 (2021), 11.4 (2022), 11.0 (2023), 11.0 (2024)
- Inflation (end-year): 11.9 (2017), 20.3 (2018), 13.5 (2019), 12.0 (2020), 12.0 (2021), 11.0 (2022), 11.0 (2023), 11.0 (2024)
- Unemployment rate: 10.9 (2017), 11.0 (2018), 13.8 (2019), 13.7 (2020), 12.9 (2021), 12.3 (2022), 11.8 (2023), 11.8 (2024)
- Nonfinancial public sector overall balance (Percent of GDP): -2.2 (2017), -3.8 (2018), -5.2 (2019), -4.9 (2020), -5.3 (2021), -5.3 (2022), -5.3 (2023), -5.2 (2024)
- General government overall balance (headline, Percent of GDP): -1.5 (2017), -2.4 (2018), -3.0 (2019), -3.9 (2020), -4.6 (2021), -4.6 (2022), -4.6 (2023), -4.5 (2024)
- General government gross debt (EU definition, Percent of GDP): 28.2 (2017), 30.1 (2018), 32.2 (2019), 33.1 (2020), 34.1 (2021), 35.4 (2022), 36.6 (2023), 37.3 (2024)
- Current account balance (Percent of GDP): -5.6 (2017), -3.5 (2018), -0.1 (2019), -0.6 (2020), -1.3 (2021), -1.7 (2022), -1.8 (2023), -1.8 (2024)
- Gross external debt (Percent of GDP): 53.4 (2017), 57.6 (2018), 61.3 (2019), 55.7 (2020), 50.7 (2021), 47.7 (2022), 46.0 (2023), 44.2 (2024)
- Gross financing requirement (Percent of GDP): 25.0 (2017), 26.8 (2018), 23.5 (2019), 23.5 (2020), 22.3 (2021), 21.5 (2022), 21.0 (2023), 20.2 (2024)

### Policy package proposed by IMF staff (five-part response)
- 1) Tight monetary policy to:
  - Boost central bank credibility;
  - Underpin the lira;
  - Durably lower inflation; and
  - Strengthen reserves.
- 2) Broadly neutral fiscal policy in the near term and steps to strengthen fiscal position over the medium term.
- 3) Comprehensive third-party assessment of bank assets, new stress tests, and follow-up measures as needed; rein in rapid credit growth by state-owned banks.
- 4) Additional steps to reinforce insolvency and corporate restructuring framework.
- 5) Focused structural reforms to support productivity growth (product and labor market reforms, human capital, female labor force participation, governance).

### Fiscal policy guidance and recommended medium-term measures
- Near term:
  - Fiscal policy should remain a key anchor.
  - A broadly neutral fiscal stance in 2020, combined with tight monetary and quasi-fiscal policies, would help support the nascent recovery while containing financing needs.
  - Maintaining the headline overall balance for 2020 at 2019 levels, despite the expected loss of one-off CBRT transfers equivalent to about 1½ percent of GDP, would require expenditure cuts or revenue increases and would imply a negative fiscal impulse.
  - Postponing some planned spending cuts, particularly on investment, would allow a central government overall balance of around 4 percent of GDP in 2020.
- Medium term:
  - Without credible medium-term consolidation measures, Turkey’s debt will continue to rise, and exceed 37 percent of GDP by 2024 (Annex III).
  - Measures yielding about 1½ percent of GDP would help stabilize the debt burden around current levels and reduce gross financing needs.
- Turkey: Recommended Medium-Term Fiscal Measures (Percent of GDP)
  - Recommended medium-term adjustment to structural primary balance: 1.5
  - Consolidation measures total: 2.0
    - Revenue options:
      - i) Personal Income Tax reform: 0.1
      - ii) VAT reform and streamlining VAT exemptions (net of arrears clearance): 0.9
    - Expenditure options:
      - iii) Wage bill controls: 0.3
      - iv) Contain net lending: 0.2
      - v) Rationalization of transfers/subsidies: 0.5
  - Additional spending:
    - Increase in social spending to support implementation of structural reforms (provided overall adjustment need met): -0.5
- Fiscal structural priorities:
  - Increase publicly-available information on contingent liabilities and fiscal risks; integrate Turkey Wealth Fund investments/borrowing into budget; strengthen PPP oversight; publish a fiscal risk statement; return debt management to transparency and predictability and seek opportunities to lengthen maturities.

### Debt dynamics, stress tests, and vulnerabilities (public DSA highlights)
- Baseline: public debt remains below vulnerability benchmarks through projection period but does not stabilize by 2024 absent policy adjustment.
- Individual shock outcomes:
  - Primary balance shock: worsening by 1 standard deviation over 2020–21 would raise medium-term public debt by around 1.3 percent of GDP.
  - Growth shock: real output growth lowered by 4½ percentage points for 2 years would raise debt-to-GDP to 42 percent during the shock and to over 45 percent by end-2024; gross public financing needs climb to 13 percent of GDP.
  - Interest rate shock: spreads rise about 850 basis points; government's implicit average interest rate rises to over 18 percent; debt-to-GDP climbs to around 43 percent; gross financing needs around 13 percent of GDP.
  - Contingent liability shock: one-time increase in non-interest expenditures by 10 percent of GDP in 2020 combined with negative GDP shock raises debt to 45 percent of GDP in 2020 and to 54 percent in the medium term.
  - Combined macro-fiscal shock: public debt reaches 62 percent of GDP; gross financing needs rise to 18 percent of GDP.
  - Combined macro-fiscal-contingent liability shock: public debt breaches 70 percent of GDP by 2024; gross financing needs increase to above 20 percent of GDP.
- Baseline trajectory and key metrics (selected):
  - Nominal gross public debt: 34.2 (2017), 28.2 (2018), 30.1 (2019), 32.2 (2020), 33.1 (2021), 34.1 (2022), 35.4 (2023), 36.6 (2024), 37.6 (projection units: percent of GDP).
  - Public gross financing needs: 9.9 (2017), 5.0 (2018), 6.5 (2019), 7.5 (2020), 9.2 (2021), 10.2 (2022), 10.4 (2023), 10.6 (2024), 10.0 (projection units: percent of GDP).
  - Gross external financing needs estimated at about US$191 billion (about 23.5 percent of GDP) in 2020.

### Risks and contingency (Annex I risk assessment matrix)
- Global risks (examples):
  - Sharp rise in risk premia — Likelihood: High; Time Horizon: Short Term; Impact: High. Policy response: Tighten monetary policy; use FX reserves as conditions allow; allow automatic fiscal stabilizers; use exchange rate as shock absorber.
  - Further build-up of financial vulnerabilities — Likelihood: High; Time Horizon: Medium Term; Impact: Medium. Policy response: Increase FX reserves; strengthen bank and corporate balance-sheets; undertake third-party asset quality review; structural reforms.
- Domestic risks (examples):
  - Premature easing of overall macroeconomic stance — Likelihood: High; Time Horizon: Short to Medium Term; Impact: High. Policy response: Restore tight monetary policy; adopt credible medium-term fiscal plan; use FX reserves as conditions allow.
  - Disorderly macro-financial cycle of deleveraging and income compression — Likelihood: High; Time Horizon: Short to Medium Term; Impact: High. Policy response: Tighten monetary policy; promote out-of-court workouts; undertake asset quality review and stress tests; adopt medium-term fiscal plan.

### Structural reform agenda to boost productivity and reallocate resources
- Priority areas:
  - Product and business environment reforms: simplify business entry and exit; reduce administrative and regulatory barriers to competition; ensure energy prices follow automatic pricing to improve efficiency.
  - Labor market reforms: eliminate backward-looking public wage indexation; align minimum wage increases with expected inflation and productivity; review employment incentive schemes; reform severance pay; sequence reforms to limit short-term costs.
  - Human capital and female labor force participation: upgrade education and on-the-job training; extend universal pre-school education; expand early childhood education and childcare; introduce flexible working arrangements for women.
  - Governance and resilience: improve regulatory predictability; simplify administrative procedures; reduce corruption vulnerabilities; enhance fiscal transparency; minimize regulatory forbearance and direct support to selected sectors.
- Rationale:
  - Structural reforms increase manufacturing export responsiveness to real exchange rate and magnify payoffs to other reforms; cleaning up financial sector and improving policy credibility strengthen the expenditure-switching effect following depreciation.

### Empirical evidence on inflation expectations and passthrough (Box 4 highlights)
- Key regression findings (dependent variable: core inflation; N = 55):
  - L.Core inflation coefficients across specifications: 0.291**, 0.597***, 0.460***, 0.754***, 0.304**, 0.305**, 0.339** (standard errors reported in source).
  - Inflation expectations 1-year ahead: 0.139***, 0.122***, 0.134***, 0.134*** in respective columns (standard errors reported).
  - Interaction term IE*ER: 0.906** (standard error reported).
  - Evidence suggests strong inflation inertia (coefficient on past inflation around 0.3 in some specifications) and that inflation expectations are a major contributor to recent inflation.
- Policy implication:
  - Lowering inflation expectations would help lower inflation and reduce the output costs of disinflation; reining in expectations allows sustainably lower interest rates.

### Authorities’ views and selected authorities' data/claims
- Authorities emphasize:
  - Policies are on the right track, citing mitigation of "speculative exchange rate attacks," support for activity, falling inflation and inflation expectations, fiscal discipline, and supervisory strength.
  - They agree on the need to accumulate international reserves as conditions permit and to publish reserve data timely and transparently.
  - NEP 2020–2022 projects strong growth and low inflation; authorities expect 5 percent real growth over the planning horizon and unemployment to decline to 9.8 percent by end-2022.
  - Authorities report headline CPI forecasts and targets: headline CPI forecast 12 percent as of end-2019; projected to decline to 8.2 percent in 2020, 5.4 percent in 2021, and stabilize around the target by 2022. CBRT medium-term inflation target retained at 5 percent with interim targets.
  - Authorities dispute staff’s assessment of a continued positive credit gap and argue the credit gap is still in negative territory.
  - Banking system indicators cited by authorities: capital adequacy ratio above 18 percent (latest data as of October 2019); total non-performing loan ratio at 5.15 percent.

### Implementation priorities and sequencing
- Immediate priorities:
  - Tighten monetary policy to rebuild credibility and lower inflation expectations.
  - Limit further credit expansion by state-owned banks; drop measures that lower reserve requirements tied to loan growth incentives.
  - Undertake third-party asset quality review and rigorous stress tests.
  - Maintain broadly neutral fiscal stance in near term while preparing medium-term consolidation measures.
- Medium-term priorities:
  - Implement measures yielding about 1½ percent of GDP to stabilize debt dynamics.
  - Advance insolvency and out-of-court restructuring reforms; strengthen bank resolution framework.
  - Implement focused structural reforms to improve product markets, labor markets, human capital, female labor participation, and governance.

*Source: IMF staff report for the 2019 Article IV Consultation (Turkey), content unit 1turea2019001.*

### 2019. Inflation peaked at around 25 percent—five times the target—in October 2018 due, in

### TURKEY: STAFF REPORT FOR THE 2019 ARTICLE IV CONSULTATION

### Executive Summary and Key Issues
- Context: Following the sharp lira depreciation and associated recession in late-2018, growth improved, helped by policy stimulus and favorable market conditions. The lira recovered and the current account saw a remarkable adjustment. Turkey remains susceptible to external and domestic risks; prospects for strong and sustainable medium-term growth are challenging without reforms to address vulnerabilities, strengthen policy credibility, and boost productivity.
- Main policy challenge: Move focus from short-run growth to higher and more resilient medium-term growth through a comprehensive reform package emphasizing monetary credibility, fiscal discipline, financial-sector repair, insolvency frameworks, and structural reforms.

### Executive Board Assessment (selected findings and recommendations)
- Directors noted stimulus-driven growth in previous years contributed to large economic imbalances.
- Vulnerabilities noted: low reserve buffers, large external financing needs, and stressed bank and corporate balance sheets.
- Policy recommendations (high level):
  - Fiscal policy should remain a key anchor; recommend a broadly neutral fiscal stance in 2020 combined with tight monetary and quasi-fiscal policies.
  - Modest consolidation over the medium term to ensure public debt remains low and stable.
  - Monetary policy should focus on durably lowering inflation and rebuilding central bank credibility; recent easing was judged to have gone too far.
  - Rebuild international reserves as conditions allow and clarify monetary and intervention policy to bolster transparency.
  - Rein in rapid credit growth of state-owned banks; undertake a third-party asset quality review and new stress tests.
  - Improve insolvency regime and out-of-court restructuring to release resources and restart productive lending.
  - Focused, carefully sequenced structural reforms to improve product market efficiency, labor market flexibility, human capital quality, female labor force participation, and governance to improve the investment climate.

### Recent Developments — Stimulus and Recovery
- Growth dynamics:
  - Growth resumed in 1H 2019 aided by expansionary fiscal policy, rapid credit expansion by state-owned banks, and more favorable market sentiment.
  - Growth should be slightly positive for 2019 as a whole—about ¼ percent—despite large negative carryover effects from the 2018 recession.
- Exchange rate, current account, and external adjustment:
  - Import compression and strong tourism receipts produced a major current account adjustment; only a small deficit expected for 2019.
  - Improved external financing conditions and tight monetary policy reduced pressure on the lira.
- Inflation and monetary policy:
  - Inflation reached about 25 percent—five times the target—in October 2018, largely due to high exchange rate passthrough and rising inflation expectations.
  - Disinflation since then driven by strong negative base effects, relative lira stability, and a negative output gap; inflation expectations remain well above target.
  - The CBRT has cut policy rates by 1,000 basis points since July 2019, bringing the official repo lending rate to 14 percent.
  - The CBRT provided lira liquidity to primary dealers at 100 basis points below the official policy rate and to participating banks at rates settled under longer-term FX swaps.
- Reserves and unconventional policies:
  - Reserves remain low despite recent increases; authorities used measures on repatriation/conversion of export proceeds and BRSA capped banks’ swap positions—these are capital flow management measures under the Fund’s Institutional View.
  - Reports emerged of large FX interventions through state-owned banks and questions over CBRT net reserve position; shift to longer-maturity FX swaps complicates reserve assessment.
  - CBRT started to rebuild reserves, including through the export rediscount credit facility (credit provided in lira, typically repaid in FX).
- Fiscal stance and developments:
  - Fiscal discipline has been weakening. After declining for several years, the central government primary balance recorded a deficit in 2018, the first time in almost a decade.
  - Fiscal stimulus continued in 1H 2019, contrary to the consolidation planned in the late-2018 New Economy Program; the central government primary deficit widened to 0.7 percent of GDP through end-June 2019.
  - Revenue weakness driven by low net VAT collection and cuts in Special Consumption Tax rates; spending growth driven by overruns on wages and current transfers.
  - Weak tax revenues in 2H 2019 were offset by a large transfer from the central bank, counted by the authorities as revenues.

### Financial Sector and State-Owned Banks
- State-owned banks are supporting rapid credit growth:
  - Private banks cut back lending, while state-owned banks engaged in major credit expansion which picked up pace in early-2019.
  - Directors urged vigilance, steps to rein in credit growth by state-owned banks, and cleaning up bank and corporate balance sheets to support financial stability.
- Recommended assessments and reforms:
  - A third-party asset quality review and new stress tests are needed to better understand underlying bank health.
  - Additional reforms to improve the insolvency regime and out-of-court restructuring would help release resources and restart productive lending.

### Outlook, Risks, and Macroeconomic Projections (selected table highlights)
- Real GDP growth rate: 7.5 (2017), 2.8 (2018), 0.2 (2019), 3.0 (2020), 3.0 (2021), 3.0 (2022), 3.5 (2023), 3.5 (2024)
- Output gap: 2.2 (2017), 1.5 (2018), -1.1 (2019), -0.8 (2020), -0.5 (2021), -0.5 (2022), -0.2 (2023), -0.1 (2024)
- Inflation (period-average): 11.1 (2017), 16.3 (2018), 15.7 (2019), 12.6 (2020), 12.4 (2021), 11.4 (2022), 11.0 (2023), 11.0 (2024)
- Inflation (end-year): 11.9 (2017), 20.3 (2018), 13.5 (2019), 12.0 (2020), 12.0 (2021), 11.0 (2022), 11.0 (2023), 11.0 (2024)
- Unemployment rate: 10.9 (2017), 11.0 (2018), 13.8 (2019), 13.7 (2020), 12.9 (2021), 12.3 (2022), 11.8 (2023), 11.8 (2024)
- Nonfinancial public sector overall balance (Percent of GDP): -2.2 (2017), -3.8 (2018), -5.2 (2019), -4.9 (2020), -5.3 (2021), -5.3 (2022), -5.3 (2023), -5.2 (2024)
- General government overall balance (headline, Percent of GDP): -1.5 (2017), -2.4 (2018), -3.0 (2019), -3.9 (2020), -4.6 (2021), -4.6 (2022), -4.6 (2023), -4.5 (2024)
- General government gross debt (EU definition, Percent of GDP): 28.2 (2017), 30.1 (2018), 32.2 (2019), 33.1 (2020), 34.1 (2021), 35.4 (2022), 36.6 (2023), 37.3 (2024)
- Current account balance (Percent of GDP): -5.6 (2017), -3.5 (2018), -0.1 (2019), -0.6 (2020), -1.3 (2021), -1.7 (2022), -1.8 (2023), -1.8 (2024)
- Gross external debt (Percent of GDP): 53.4 (2017), 57.6 (2018), 61.3 (2019), 55.7 (2020), 50.7 (2021), 47.7 (2022), 46.0 (2023), 44.2 (2024)
- Gross financing requirement (Percent of GDP): 25.0 (2017), 26.8 (2018), 23.5 (2019), 23.5 (2020), 22.3 (2021), 21.5 (2022), 21.0 (2023), 20.2 (2024)

### Policy Package Proposed by IMF Staff (five-part response)
- Tight monetary policy to:
  - Boost central bank credibility;
  - Underpin the lira;
  - Durably lower inflation; and
  - Strengthen reserves.
- Broadly neutral fiscal policy in the near term and steps to strengthen fiscal position over the medium term.
- Comprehensive third-party assessment of bank assets, new stress tests, and follow-up measures as needed; rein in rapid credit growth by state-owned banks.
- Additional steps to reinforce the insolvency and corporate restructuring framework.
- Focused structural reforms to support productivity growth, including product and labor market reforms, improvements in human capital, higher female labor force participation, and governance reforms.

### Background and Structural Concerns
- Long-term growth pattern: Turkey achieved strong growth over two decades, but dependence on demand stimulus and externally-funded credit increased as reforms waned, slowing productivity growth.
- Resulting imbalances: internal and external imbalances increased, with the economy entering 2018 above potential, a positive credit gap, high inflation, large current account deficits financed by debt, weak net international investment position, and large private-sector currency mismatches.
- 2018 shock: imbalances contributed to a sharp lira depreciation (around 40 percent in TL/US$ terms in early August 2018), a necessary but belated monetary policy reaction (625 basis points hike mid-September 2018), recession in 2H 2018, and a sharp rise in unemployment.

*Source: IMF staff report for the 2019 Article IV Consultation (Turkey).*

### 9.       The authorities adapted their debt

### 9.       The authorities adapted their debt management approach to contain borrowing costs

### Debt management and fiscal financing
- Authorities increased Eurobond issuance: "US$11.2 billion by mid-November, above the full-year target."
- Other financing actions: increased domestic FX debt issuance, drew down Treasury deposits, and shortened borrowing maturities.
- Unconventional measures used: "a large transfer to Treasury of CBRT reserves (around 1 percent of GDP)" in addition to dividend payments.
- Domestic issuance deviated significantly from original borrowing plans, "reducing predictability for market participants."

### Non-financial corporate sector health
- Balance sheets weakened due to lira depreciation, higher interest rates, and lower growth.
- Effects on corporates: large open FX position increased leverage; interest coverage ratios fell.
- Authorities' response:
  - Abolished bankruptcy postponement.
  - Set up and gradually refined an out-of-court debt restructuring mechanism.
  - Announced plans to establish centralized asset management companies for NPLs in the energy and construction sectors.
  - Recent decree allows Treasury to acquire holdings in companies by presidential decree.

### Banking sector: asset quality, capitalization, and regulatory treatment
- Reported metrics as of mid-October 2019: NPL ratio "5.5 percent for all deposit-taking institutions and 3.9 percent for state-owned banks."
- BRSA note: "On September 17, 2019, the BRSA announced that the impact analysis conducted on the July 2019 financial statements of the banks would increase the level of NPLs to 6.3 percent."
- Regulatory framework allows discretion in recognizing impairment, enabling banks "to deal with their problematic loans over time."
- Credit risk indicators: "Stage 2 loans have climbed steadily to about 11½ percent of total loans as of June 2019."
- Sectoral pressure: combined NPL and stage 2 loan ratio in construction "is approaching 25 percent."

### State-owned banks and credit expansion
- State-owned banks supported rapid credit growth while private banks cut lending.
- State-owned banks provided credit "at rates well below the cost of funding from the CBRT," weakening monetary transmission.
- CBRT policy in August: introduced lower TL reserve requirements for banks with credit growth in a higher range; for banks whose loan growth is "between 10 percent and 20 percent, TL reserve were set at 2 percent."
- Balance sheet effects and recapitalization: TL 28 billion "(0.7 percent of GDP) was injected into state-owned banks in April 2019."
- Funding and dollarization: state-owned banks kept lira deposit rates low and borrowed heavily in FX, contributing to a "sharp increase in deposit dollarization."
- Liquidity concerns: funding increasingly short term and concentrated in FX deposits against declining liquid assets, worsening liquidity conditions.
- Definition note: Liquid assets include cash; receivables from CBRT, money market, banks, securities interbank and reverse repo; as well as securities held at fair value and required reserves.

### External flows, stock imbalances, and the current account
- Improvement in external flows driven by lira depreciation and weak domestic demand: import compression, "strong tourism receipts and a normalization of gold imports."
- Real effective exchange rate: "estimated to have been undervalued by about 10 to 20 percent," and the effective exchange rate "stood at about the 2018 average at end-September 2019."
- External debt and financing composition:
  - Private banks reduced external debt, while other sectors increased external borrowing.
  - Non-financial corporates shifted trade financing abroad.
  - State-owned banks used external financing to support credit expansion.
  - Government relied on external financing to help fund the growing fiscal deficit.
- Financing quality deterioration: external debt rolled over at shorter tenors and higher rates; "errors and omissions have been an important financing source and net FDI remains subdued, with much of it in real estate."

### Outlook and risks
- Fragile calm: reserves remain low and private sector FX debt and external financing needs remain high.
- Balance sheet stresses: non-financial corporates stressed by lira depreciation, higher interest rates, and lower growth.
- Bank-sector dynamics: banks report adequate capitalization and moderate NPLs, but "loan restructuring has increased" and asset quality strains are expected to continue with lag.
- Dollarization remains high, reflecting weaker domestic sentiment and state-owned bank funding needs.
- Public debt: "public debt is low" but the fiscal deficit has increased and uncertainty over contingent liabilities and potential debt rollover pressures limit fiscal space.
- Growth prospects: a return to the pre-2019 output trend (when growth averaged "5½ percent") appears unlikely; cross-country experience suggests Turkey could follow "a shallow L-shaped recovery from its balance sheet recession."
- Domestic risks: possible policy implementation and political developments.
- External risks: deterioration in sentiment towards emerging markets and adverse geopolitical developments.
- Spillover channels: trade links and financial exposures (direct investment, portfolio investment, bank stakes) could transmit outward effects; most observers view Turkey’s difficulties as "largely idiosyncratic" but a severe dislocation could affect vulnerable emerging markets.

### Policy recommendations (five-part response)
- Overarching aim: move focus from short-run stimulus to higher and more resilient medium-term growth through a comprehensive reform package to repair private balance sheets, strengthen public balance sheets, and restore credibility, independence and rules-based functioning of economic institutions.
- The five-part policy response:
  1. Tight monetary policy to boost the credibility of the central bank, underpin the lira, durably lower inflation, and strengthen reserves.
  2. Broadly neutral fiscal policy in the near term and steps to strengthen the fiscal position over the medium term.
  3. A comprehensive third-party assessment of bank assets, new stress tests, and follow-up measures as needed to enhance confidence in banks, and efforts to rein in rapid credit growth by state-owned banks.
  4. Additional steps, building on existing reforms, to reinforce the insolvency and corporate restructuring framework.
  5. Focused structural reforms to support productivity growth.
- Trade-offs acknowledged: likely near-term sacrifice of growth for stronger medium-term prospects; tight monetary and quasi-fiscal policies would accelerate deleveraging and reduce near-term demand, partly offset by a less contractionary near-term fiscal stance.
- Expected medium- and long-term benefits: lower downside risks, faster and more durable disinflation, stronger bank and corporate balance sheets, higher reserve buffers, stronger external position, lower fiscal contingent liabilities, and higher and more sustainable growth.
- Timing window: a political-economy window of opportunity exists given that "the next major elections are scheduled for 2023."
- Authorities’ views: authorities believe policies are on the right track, citing mitigation of "speculative exchange rate attacks," support for activity, falling inflation and inflation expectations, fiscal discipline, and supervisory strength; they see justification for a third-party review but emphasize supervisory competency. Their program is set out in the "New Economy Program."

### Monetary policy actions detailed
- Assessment: "Rates are too low to strengthen monetary policy credibility and lower inflation durably."
- Policy instruments and clarity:
  - Official instrument: one-week repo facility, but most liquidity is provided via other facilities including subsidized lending to primary dealers, FX swap instruments, and longer-term export rediscount credits.
  - Recommendation: reduce the many instruments and rates through which liquidity is provided and publish high-frequency amounts and rates for all instruments used by the CBRT to clarify the policy stance.
- FX intervention framework:
  - Recommendation: replace the export rediscount credit facility with "a transparent framework for pre-announced and sterilized FX purchases from a broader set of market participants."
  - Recommendation: phase out remaining measures aimed at containing excessive volatility in capital flows (e.g., limit on banks' swap transactions with foreign investors and export surrender/repatriation requirements) as conditions improve.

*Source: IMF staff report excerpt provided in the content unit.*

### 27.      The authorities agreed with the need to strengthen monetary policy credibility and

### 1turea2019001 - 27.      The authorities agreed with the need to strengthen monetary policy credibility and

### Monetary policy and reserves
- Authorities agreed on the need to strengthen monetary policy credibility and lower inflation durably.
- Authorities viewed the trajectory of monetary policy as sufficiently tight to restore price stability while also considering the need to support economic growth and credit expansion.
- Authorities agreed on the need to rebuild reserves, as economic and financial conditions permit, but saw merit in continuing with export rediscount credits.

### Fiscal Policy—Preserving the Anchor
- Fiscal policy should remain a key policy anchor.
- Near term: a broadly neutral fiscal stance, combined with tight monetary and quasi-fiscal policies, would help support the nascent recovery while containing financing needs.
- Medium term: focus should shift to stabilizing debt and enhancing fiscal space, calling for a modest fiscal consolidation, supported by more transparency and control of quasi-fiscal activity.

Key near-term and medium-term points
- A broadly neutral stance in 2020 would help contain rising debt and financing needs without undermining the nascent recovery.
- The authorities’ announced fiscal plan for 2020 appears to be contractionary.
- Maintaining the headline overall balance for 2020 at 2019 levels, despite the expected loss of one-off CBRT transfers equivalent to about 1½ percent of GDP, would require expenditure cuts or revenue increases and would imply a negative fiscal impulse for the real economy.
- Postponing some planned spending cuts, particularly on investment, would allow a central government overall balance of around 4 percent of GDP in 2020.
- The structural primary balance has deteriorated by around 1½ percentage points over the past two years.

Medium-term consolidation rationale
- Without credible medium-term consolidation measures, Turkey’s debt will continue to rise, and exceed 37 percent of GDP by 2024 (Annex III).
- Measures yielding about 1½ percent of GDP would help stabilize the debt burden around current levels and reduce gross financing needs.

Turkey: Recommended Medium-Term Fiscal Measures (Percent of GDP)
- Recommended medium-term adjustment to structural primary balance: 1.5
- Consolidation measures total: 2.0
  - Revenue options
    - i) Personal Income Tax reform: 0.1
    - ii) VAT reform and streamlining VAT exemptions (net of arrears clearance): 0.9
  - Expenditure options
    - iii) Wage bill controls: 0.3
    - iv) Contain net lending: 0.2
    - v) Rationalization of transfers/subsidies: 0.5
- Additional spending
  - Increase in social spending to support implementation of structural reforms (provided overall adjustment need met): -0.5

Fiscal structural reform priorities
- Increase publicly-available information regarding contingent liabilities and fiscal risks.
- Define and monitor the scope and role of all non-central government entities.
- Integrate investments and borrowing by the Turkey Wealth Fund into the budget and refine the Wealth Fund’s governance to limit potential conflicts of interest.
- Strengthen oversight and management of public-private partnerships; ensure PPPs are fully integrated with the budget, including authorization and appraisal.
- Publish a fiscal risk statement.
- Return debt management practices to a focus on transparency and predictability and seek opportunities to lengthen maturities to help reduce near-term financing needs.

Authorities’ views on fiscal policy
- Authorities underscored the importance of fiscal discipline.
- They noted fiscal policy successfully supported economic activity in 2019 and agreed with goals of fiscal consolidation and maintaining public debt at low and stable levels.
- As they expected relatively high growth in 2020, they viewed an unchanged overall balance as an appropriate fiscal stance.
- They underlined the importance of revenue mobilization, including through revenue administration improvements.
- Authorities agreed that greater transparency for contingent liabilities, primarily for public-private partnerships, would enhance fiscal credibility.

### Financial and Corporate Sector Policies—Stability and Rebalancing

Financial sector challenges and recommendations
- Efforts to boost credit, including through state-owned banks and the Credit Guarantee Fund, have hampered needed deleveraging.
- A third-party asset quality review is needed to get a better sense of bank balance sheet health.
- Further moves to strengthen bank regulation, resolution and AML/CFT frameworks are needed.
- Improvements to the insolvency regime and out-of-court debt restructuring mechanisms are welcome and should continue.

State-owned banks and credit
- Rapid credit growth by state-owned banks should be reined in to permit needed deleveraging and balance sheet cleanup.
- State-owned banks are already stretched, with a large positive credit gap and emerging balance sheet and liquidity strains, including lower profit margins, increased dollarization, and high lira loan-to-deposit ratios.
- Credit to overleveraged corporates is likely to be used mainly for refinancing, limiting resource allocation to more productive firms.
- More cautious lending by state-owned banks would contain contingent liabilities for the sovereign.
- Efforts to expand lending through the Credit Guarantee Fund and financial incentives should be limited.
- Example recommendation: the recent move that lowered TL reserve requirements for banks with credit growth in a higher range should be dropped.

Asset quality review and stress testing
- A comprehensive third-party assessment of bank assets, new stress tests, and follow-up measures as needed would strengthen confidence in banks.
- Any identified actual or potential capital needs should be addressed in line with international best practice.

Regulation, provisioning, and resolution
- Tighter loan classification and provisioning rules should be put in place to encourage timely recognition of loan losses and minimize evergreening.
- Restructuring agreements should be monitored closely to ensure durable repayment capacity.
- The BRSA should prioritize financial sector stability over financial sector development.
- Strengthen the bank resolution framework; draft legislation to clarify resolution agency responsibilities, supervisory legal protections and coordination across agencies and with foreign supervisors is helpful and should be implemented timely.

AML/CFT
- Continue to strengthen the AML/CFT framework, including legislation on money laundering offenses, staffing, and training for enforcement.
- Further actions to ensure compliance with relevant UN Security Council Resolutions, strengthen border controls on currency transportation, and mitigate financial integrity risks related to virtual assets.
- Turkey’s comprehensive AML/CFT assessment was discussed at the FATF October 2019 Plenary and the publication of the FATF report is expected for December 2019.

Authorities’ views on the financial sector
- Authorities believe the financial system is sufficiently strong to support further credit growth and disagreed with staff’s assessment of a continued positive credit gap.
- They acknowledged potential positive effects of an asset quality review for market confidence but stressed that supervision is already strong, helped by recent alignment with IFRS9.
- They noted regular onsite examinations and an effective stress test framework are operational.
- On AML/CFT, draft legislation is being prepared, including to address requirements for politically exposed persons.

Non-financial corporate sector: insolvency and restructuring
- The 2018 repeal of bankruptcy postponement is helpful; however, the composition procedure (konkordato) continues to allow debtors to stay enforcement proceedings for around two years.
- Insolvency resolution indicators are weak and have deteriorated; the insolvency legislation, revised piecemeal since 2004, should be reviewed in its entirety.
- The framework for out-of-court restructuring is improving: Restructuring Framework Agreements by the Banks Association of Turkey have been made more practicable by allowing foreign creditor participation, granting tax exemptions, and providing stronger legal protection for bank officials writing down debt.
- Further improvements could include lower hurdles for write-downs and debt-for-equity swaps, greater foreign expert participation, and use of hybrid mechanisms with court involvement.
- The authorities’ reluctance to use public funds beyond tax incentives as part of loan restructurings is warranted.
- Focus on out-of-court restructuring rather than centralized asset management companies is appropriate given concerns about transfer pricing and governance difficulties.
- Financial restructuring alone may be insufficient; greater focus on operational restructurings should be supported by structural reforms.

Preventing future lending excesses
- Policy options to reduce recurrence:
  - Extend limits on FX loans beyond small and medium-sized enterprises and reduce exemptions.
  - Improve corporate governance and transparency, including through stronger auditing standards.
  - Develop a home-grown investor base and domestic financial markets (encourage equity financing, promote the voluntary pension system, deepen insurance and asset management sectors) to foster increased domestic savings over time.

Authorities’ views on corporate reforms
- Authorities noted progress on insolvency regime and out-of-court restructuring and signaled further improvements.
- Amendments under review aim to better balance debtor and creditor rights, speed up insolvency proceedings, and reduce costs.
- Specialized courts and judicial reforms aim to speed resolution of commercial disputes and enhance efficiency.
- Development of domestic financial markets will be fostered through changes to the legal and institutional infrastructure of capital markets.

### Structural Reforms—Boosting Productivity
- Focused structural and governance reforms would help foster stronger sustainable growth and increase resilience to shocks.
- Switching to a productivity-led growth model requires carefully-sequenced structural reforms with an initial emphasis on product markets.
- Staff analysis indicates largest long-run gains likely from improving:
  - The business and regulatory environment,
  - Labor market flexibility,
  - The quality of human capital (Selected Issues Paper).

Product and business environment reforms
- Simplify business entry and exit and address administrative and regulatory barriers to competition.
- Product market reforms would help resolve the corporate debt overhang.
- Example: delayed energy price adjustments have aggravated financial strain in some energy-generation companies; energy prices should follow an automatic pricing mechanism to improve efficiency and help contain contingent sovereign liabilities.

Labor market reforms
- Eliminate backward-looking public wage indexation and align minimum wage increases with expected inflation and productivity.
- Review and streamline employment incentive schemes.
- Reform severance pay to reduce burden on formal sector employers and discourage labor mobility constraints caused by non-transferable built-up rights.
- Sequence labor market reforms carefully to alleviate short-term trade-offs and factor in budgetary implications; priority should be given to reforms with little or no fiscal costs.

Human capital and female labor force participation
- Improve quality of human capital by upgrading education and on-the-job training; ongoing curriculum review is an opportunity to strengthen education outcomes.
- Female labor force participation has been gradually improving from a low base compared to G20 peers.
- Staff welcomes initiatives to expand early childhood education and childcare, and to introduce flexible working arrangements for women.

Resilience and governance
- Focused structural reforms would increase the economy’s resilience to shocks; staff analysis shows manufacturing export responsiveness to the real exchange rate should increase with structural reforms.
- Governance reforms—improving regulatory predictability, simplifying administrative procedures, reducing corruption vulnerabilities, and enhancing fiscal transparency—would improve investment climate and economic efficiency.
- Minimizing regulatory forbearance and direct government support to selected sectors would help.
- Improvements in governance could magnify payoffs to other structural reforms.

*Source: IMF staff report content provided in the supplied PDF excerpt.*

### 45.      The authorities acknowledged the importance of improving productivity. They

### 1turea2019001 - 45.      The authorities acknowledged the importance of improving productivity. They

### Productivity and structural policies
- Authorities highlighted policy initiatives and targeted subsidies for strategic projects aimed at diversifying the economy into high value-added tradable sectors to help reduce external imbalances.
- Recognized needs and reforms:
  - Upgrade the quality of human capital via an overhaul of the curriculum and an expansion of vocational training.
  - Plans to extend universal education to pre-school grades to help foster female labor force participation.
  - Intention to reform severance pay as labor market conditions permit; potential solutions are being discussed with stakeholders.
  - Ongoing judicial reform to strengthen judicial independence and increase transparency and efficiency in legal procedures, including in commercial dispute resolution.

### Staff appraisal — macroeconomic assessment and risks
- Recent developments and vulnerabilities:
  - Turkey’s stimulus-driven growth contributed to large economic imbalances, increasing susceptibility to shocks; an adverse shift in market sentiment triggered sizeable lira depreciation and a recession in late-2018.
  - Since 2018 currency shock and recession, growth resumed aided by expansionary fiscal policy, rapid credit provision by state-owned banks, and more favorable external financing; the lira recovered as market pressures abated.
  - Remarkable current account adjustment attributed to import compression and a strong tourism season.
- Remaining fragility and constraints:
  - Reserves are low and external financing needs are high.
  - Non-financial corporate and bank balance sheets stressed by lira depreciation, higher interest rates, and the recession.
  - Public debt is low but the fiscal deficit has increased; uncertainty over contingent liabilities and potential debt rollover pressures limits fiscal space.
- Growth outlook and risks:
  - Prospects for strong sustainable growth have weakened; without comprehensive reforms medium-term growth likely subdued and volatile.
  - Risks: deterioration in sentiment towards emerging markets, policy implementation risks, adverse domestic or geopolitical developments.
- Main policy challenge:
  - Secure stronger and more resilient medium-term growth rather than boosting short-term growth; reforms may have short-term output tradeoffs but large medium- and long-term payoffs including faster disinflation, stronger balance sheets, higher reserve buffers, stronger external position, lower fiscal contingent liabilities, and higher sustainable growth.

### Monetary policy recommendations
- Monetary policy should focus on strengthening credibility and durably lowering inflation to help permanently lower interest rates.
- Assessment and guidance:
  - CBRT easing cycle deemed too aggressive given the need to lower still-high inflation expectations and mitigate macro-financial risks.
  - Real policy rates are now well below levels that would underpin the lira, durably reduce inflation and inflation expectations, allow reserves to be rebuilt, and support de-dollarization.
  - Need for clearer monetary and intervention policy to strengthen central bank credibility.
  - Remaining measures aimed at containing excessive volatility in capital flows should be phased out as macroeconomic and financial conditions improve.

### Fiscal policy guidance
- Fiscal policy should remain a key policy anchor.
- Recent fiscal stimulus helped recovery but underlying deficit increased significantly.
- Recommended stance:
  - A broadly neutral fiscal stance in 2020, combined with tight monetary and quasi-fiscal policies, to support the nascent recovery while containing financing needs and enhancing fiscal space.
  - Over the medium term, a modest consolidation is needed to keep public debt low and dynamics stable, supported by increased transparency and control of quasi-fiscal activity.

### Financial sector and state-owned bank policies
- Reign in policies that boost lending and clean up bank and corporate balance sheets to support financial stability and resilient growth.
  - Limit further lending expansion—including through state-owned banks and the Credit Guarantee Fund—to allow deleveraging and strengthen financial soundness of state-owned banks.
  - Conduct a third-party asset quality review and new stress tests to better understand underlying bank health.
  - Further strengthen regulatory, resolution and AML/CFT frameworks.
- Insolvency and restructuring:
  - Reforms to improve the insolvency regime and out-of-court restructuring would help release resources and restart productive lending.
  - Comprehensive review of existing insolvency legislation could incentivize out-of-court debt restructuring by making the insolvency regime more creditor friendly.
  - Tighter NPL classification and enforcement would inform better pricing of NPLs, increase attractiveness of out-of-court solutions, and encourage more durable restructurings.
- Structural reforms:
  - Improve product market efficiency, labor market flexibility, quality of human capital, and female labor force participation to reallocate resources to productive sectors and support higher, more resilient growth.
  - Increase regulatory predictability, simplify administrative procedures, and reduce corruption vulnerabilities to improve business environment and investment climate.
  - Improvements in governance could magnify structural reform payoffs.

### Box 1 — State-Owned Bank Balance Sheet Expansion: key findings
- State-owned bank credit growth has contributed to the recovery but increased economic imbalances; associated with a persistent positive credit gap, increasing reliance on FX deposits, and shorter-term funding against declining liquid assets.
- TL loan market dynamics:
  - Value of TL loans by state-owned banks more than doubled over the last three years; share of state-owned banks in total TL loan market reached 44 percent, up from 32 percent in early 2016.
- Credit gap and dollarization:
  - Staff analysis suggests Turkey’s state-owned bank credit gap remains wide, at around 15 percent of GDP.
  - Share of TL deposits in total liabilities declined from 40 percent in January 2016 to 29 percent in August 2019, largely offset by a rise in FX deposits.
  - TL loan to deposit (LTD) ratio for state-owned banks peaked at more than 156 percent in May 2019, 30 percentage points higher than in 2016.
  - State-owned banks’ dollarization ratio close to 46 percent, up 16 percentage points from three years earlier.
- FX exposure and liquid assets:
  - On-balance sheet open FX position climbed from TL 20 billion in November 2018 to close to TL 100 billion in April 2019.
  - TL liquid assets declined to a low of 15 percent of total liabilities in May 2018 and recovered only marginally since then; FX liquid asset coverage saw an even steeper decline.

### Box 2 — Benchmarking medium-term GDP projections against banking crisis episodes
- Rationale:
  - Past banking crisis experiences used as a benchmark for medium-term projections given uncertainty; Turkey’s 2019 output and credit developments resemble first-year developments in typical banking crises.
- Findings and projections:
  - A banking crisis typically produces an L-shaped recovery with output not reverting to pre-crisis trend; higher pre-crisis growth associated with larger drop in post-crisis growth rate.
  - Applied to Turkey, findings suggest 2023 output could be 17 to 20 percent below the pre-crisis trend.
  - Main explanatory factors for Turkey’s output loss: (i) scale of 2019 shock (an output loss, relative to trend, of around 8 percent of 2018 GDP), and (ii) rapid pre-crisis trend growth rate of 5½ percent.
  - Analysis suggests average output growth of between 2.0 and 2.9 percent for 2020–23 (staff opts for higher medium-term growth rates under its baseline).

### Box 3 — Macroeconomic scenario under the New Economy Program (NEP) 2020–22
- NEP published by authorities on September 30 forecasts strong near- and medium-term growth, low inflation, and a broadly balanced current account based on assumptions:
  - Deleveraging largely completed and further rebalancing achieved through high productivity growth in the tradable sector, mostly via policy initiatives including further credit expansion.
  - Tradable sector growth to yield strong import substitution; expansion of domestic food production and shift to renewable energy to lower food and energy price inflation.
- Fiscal consolidation in NEP:
  - NEP envisages a modest consolidation of 0.3 percent of GDP in the central government headline balance, but nearly 2 percent of GDP in terms of impact on the real economy once one-off central bank revenues are stripped out.
  - One-off revenues from the CBRT in 2019 amounted to around 1½ percent of GDP, comprising TL40 bn in precautionary reserves transfers and around TL 20 bn in above-normal profit transfer.
  - Consolidation expected to come from tax revenue increases (0.5 percent of GDP) and spending cuts (1.2 percent of GDP), including unspecified current expenditure-side measures.

### Box 4 — Importance of managing inflation expectations
- Managing inflation expectations is critical to bringing inflation under control and lowering disinflation costs; reining in expectations would allow sustainably lower interest rates.
- Recent observations:
  - Despite recent drop in inflation, inflation expectations remain high; late-2018 inflation exceeded 25 percent and expectations rose to over 17 percent; inflation has fallen but expectations remain elevated.
- Empirical evidence (reduced-form Phillips curve):
  - Model decomposes seasonally-adjusted core (B-index) inflation into contributions from past inflation, one-year ahead inflation expectations, output gap, exchange rate, petroleum spot price, and nonfuel import price deflator.
  - Results suggest strong inflation inertia with coefficient on past inflation around 0.3.
  - Inflation expectations coefficient around 0.1; largest contribution to recent inflation comes from inflation expectations.
  - Interaction of inflation expectations with exchange rate suggests each percentage point increase in inflation expectations increases exchange rate passthrough by 0.9 percentage points (with large uncertainty).
  - Evidence of higher passthrough during depreciation episodes and non-linearities between output gap and inflation (small output gaps may have no significant effect).

*TURKEY — INTERNATIONAL MONETARY FUND (excerpt).*

### Box 4. The Importance of Managing Inflation Expectations (Continued)

### Box 4. The Importance of Managing Inflation Expectations (Concluded)

### Key findings and implications
- Lower inflation expectations would help lower inflation and reduce the output costs of disinflation.
- Reducing inflation expectations is an important way of sustainably lowering interest rates.

### Model-based simulation results (figures and notes)
- Box Figure 4. Expectations and Passthrough (Percentage points)
  - Results based on model 6 of Table 1.
- Box Figure 5. Exchange Rate Passthrough (Percent)
  - Source: IMF staff calculations.
  - Note: Long-term passthrough. Based on models 1 and 5.
- Box Figure 6. Output Gap (Percentage points)
  - Source: IMF staff calculations.
  - Note: Results based on model 6 of Table 1. Represents inflation effect of expectations reverting to the inflation target (5 percent).
- Box Figure 7. Inflation Benefit of Lower Expectations (Percentage points)
  - Source: IMF staff calculations.
  - Note: Results based on model 6 of Table 1. Represents the reduced output costs of disinflation with expectations reverting to target.
- Box Figure 8. Output Benefit of Lower Expectations (Percentage of potential GDP)
  - Source: IMF staff calculations.

### Regression evidence (Box Table 1 — Dependent Variable: Core Inflation)
- Estimation columns: (1) (2) (3) (4) (5) (6) (7)
- L.Core inflation
  - Column (1): 0.291**
  - Column (2): 0.597***
  - Column (3): 0.460***
  - Column (4): 0.754***
  - Column (5): 0.304**
  - Column (6): 0.305**
  - Column (7): 0.339**
  - Standard errors: (0.119)(0.068)(0.108)(0.052)(0.118)(0.115)(0.132)
- Inflation expectations 1-year ahead
  - Column (2): 0.139***
  - Column (3): 0.122***
  - Column (4): 0.134***
  - Column (5): 0.134***
  - Standard errors: (0.033)(0.036)(0.032)(0.039)
- L.Economic Policy Uncertainty Index
  - Coefficient (in included column): 0.013***
  - Standard error: (0.004)
- Standard deviation of inflation expectations
  - Coefficient: 0.749***
  - Standard error: (0.244)
- D.Inflation expectations 1-year ahead
  - Coefficient: 0.073
  - Standard error: (0.120)
- Output Gap
  - Coefficients across columns: 0.103***, 0.060*, 0.093***, 0.051, 0.102***, 0.105***
  - Standard errors: (0.030)(0.030)(0.033)(0.033)(0.030)(0.029)
- Fuel import inflation
  - Column coefficients: 0.017***, 0.023***, 0.020***, 0.025***, 0.018***, 0.014**, 0.018***
  - Standard errors: (0.006)(0.006)(0.006)(0.006)(0.006)(0.006)(0.006)
- L.Nonfuel import inflation
  - Column coefficients: 0.077**, 0.097***, 0.070**, 0.081**, 0.076**, 0.074**, 0.091***
  - Standard errors: (0.030)(0.032)(0.032)(0.035)(0.030)(0.029)(0.031)
- Exchange rate (avg., LTL/US$)
  - Coefficients shown: 0.059***, 0.068***, 0.062***, 0.081***, -0.028, 0.061***
  - Standard errors: (0.014)(0.015)(0.016)(0.016) (0.044)(0.016)
- L.Exchange rate (avg., LTL/US$)
  - Coefficients: 0.058***, 0.052***, 0.054***, 0.047***, 0.059***, 0.050***
  - Standard errors: (0.014)(0.015)(0.015)(0.017) (0.014)(0.015)
- Appreciation (TL/US$)
  - Coefficient: 0.070
  - Standard error: (0.049)
- Depreciation (TL/US$)
  - Coefficient: 0.058***
  - Standard error: (0.018)
- L.Depreciation (TL/US$)
  - Coefficient: 0.072***
  - Standard error: (0.017)
- IE*ER (interaction term)
  - Coefficient: 0.906**
  - Standard error: (0.439)
- Large Output Gap
  - Coefficient: 0.091**
  - Standard error: (0.040)
- Small Output Gap
  - Coefficient: -0.051
  - Standard error: (0.249)
- Adjusted R-sq (by column): 0.93 0.92 0.92 0.91 0.93 0.94 0.92
- N: 55 55 55 55 55 55 55
- Note: Standard errors in parentheses, * p<0.10, ** p<0.05, *** p<0.01

*Source: IMF staff calculations.*

### Box 5. How to Maximize Economic Gains After a Large Currency Depreciation

### Box 5. How to Maximize Economic Gains After a Large Currency Depreciation

### Conditions required to take full advantage of expenditure switching
- To take full advantage of the expenditure switching effect of a large depreciation, countries need to meet several conditions:
  - (i) the economy needs to be sufficiently flexible to facilitate timely resource reallocation,
  - (ii) the financial sector needs to be strong enough to finance the expansion of the tradable sector, and
  - (iii) policies should provide a clear outlook for the economy, fostering needed new investments.

### Transmission channels and timing
- Large depreciations affect output through negative balance sheet and positive expenditure-switching effects.
- Expenditure switching is weak at the outset; external adjustment typically comes initially from import compression (IMF Crisis Program Review 2015, Tressel et al., 2014).
- The expenditure switching effect gains strength over the years following large depreciations (Culiuc, forthcoming).

### Constraints limiting the expenditure-switching response
- Structural rigidities can slow resource reallocation to the tradable sector:
  - Culiuc and Kyobe (2017) find that elasticity of exports with respect to the real effective exchange rate increases with improvements in certain structural indicators.
  - Moving from the 25th to the 75th percentile of the distribution in terms of hiring and firing regulations is associated with a doubling in the export response to a given real exchange rate depreciation.
  - Improvements in the legal enforcement of contracts are associated with even larger effects.
  - Turkey is in the second quintile on both indicators.
  - With resource reallocation hindered by rigidities, depreciations tend to benefit incumbent exporters, while the Schumpeterian growth (creative destruction) channel (à la Melitz, 2003) remains muted.
  - This suggests large possible export gains from implementing structural reforms.
- Financial stress blunts the competitiveness effect:
  - Depreciation typically hits banks’ balance sheets, limiting credit to exporters, especially entrants, that are willing to capitalize on improved competitiveness.
  - Iacovone and Zavacka (2009) find a significant negative effect of banking crises on export growth, as sectors reliant on external financing are hit harder by credit contraction.
- Uncertainty can delay the export response:
  - Baldwin and Krugman (1989) invoke the sunk cost of exporting to explain sluggish export reactions to large and volatile real exchange rate movements.
  - Uncertainty, including that related to policy, about the exchange rate tends to delay decisions to incur fixed costs associated with exporting — particularly important for potential new entrants.

### Policy measures to strengthen the positive expenditure-switching effect
- Structural reforms, a cleanup of the financial sector, and improved policy credibility could help strengthen the positive expenditure-switching effect.
- Strengthening the export response to the large real depreciation Turkey has experienced would support a sustainable external position with less compression of domestic absorption and GDP.

### Box Figure 1 (summary)
- Box Figure 1 illustrates how measured elasticities of Manufacturing Export with respect to Real Effective Exchange Rate change across the distribution (percentiles) of two structural indicators for around 100 advanced and emerging market countries:
  - Hiring and firing regulations (horizontal axis: percentiles of countries for each indicator).
  - Legal enforcement of contracts (horizontal axis: percentiles of countries for each indicator).
- Key observations from the figure:
  - Elasticities increase across percentiles for both indicators.
  - Turkey is shown at the second quintile on both indicators.

*Source: IMF staff calculations.*

### Annex I. Risk Assessment Matrix

### Annex I. Risk Assessment Matrix

### Global Risks — Likelihood, Time Horizon, Impact, and Policy Responses
- Sharp rise in risk premia
  - Likelihood: High
  - Time Horizon: Short Term
  - Impact: High
  - Description: Abrupt deterioration in market sentiment (e.g., policy surprises, renewed stresses in emerging markets, or a disorderly Brexit) could trigger risk-off events, higher debt service and refinancing risks, stress on leveraged firms/households/vulnerable sovereigns, disruptive corrections to stretched asset valuations, and capital account pressures—all depressing growth.
  - Policy Response:
    - Tighten monetary policy.
    - To the extent net international reserves allow, use FX reserves to smooth volatility in disorderly market conditions.
    - Allow automatic fiscal stabilizers to operate and provide targeted, temporary support.
    - Use exchange rate as a shock absorber.
- Rising protectionism and retreat from multilateralism
  - Likelihood: High
  - Time Horizon: Short to Medium Term
  - Impact: Low
  - Description: Escalating/unpredictable trade actions and a threatened WTO dispute settlement system imperil the global trade system; additional barriers and technology-sector investment/trade restrictions reduce growth directly and via confidence and financial market volatility; medium-term risk of economic fragmentation undermining investment, growth, and stability.
  - Policy Response:
    - Further diversify export destinations, increase high value-added exports, and improve competitiveness, thus boosting exports.
- Further build-up of financial vulnerabilities
  - Likelihood: High
  - Time Horizon: Medium Term
  - Impact: Medium
  - Description: Easing in the monetary policy cycle encourages risk taking through underpricing of risk and reduces financial resilience to shocks and risk-off events.
  - Policy Response:
    - Preemptively increase FX reserves through pre-announced and sterilized intervention, as appropriate.
    - Preemptively strengthen bank and non-financial corporate balance-sheets through restrictions on the composition of liabilities and higher risk weights and provisioning on lending to such corporates in FX.
    - Undertake third-party asset quality review, followed by rigorous stress tests and follow up measures as needed.
    - Structural reforms aimed at raising the economy’s competitiveness.
    - Diversify export destinations, increase high value-added exports, and improve competitiveness, thus boosting exports.
- Intensification of geopolitical tensions and security risks (e.g., in the Middle East)
  - Likelihood: High
  - Time Horizon: Short Term
  - Impact: High
  - Description: Socio-economic and political disruption, disorderly migration, volatile commodity prices, and lower confidence.
  - Policy Response:
    - Tighten monetary policy.
    - Use exchange rate as a shock absorber.
    - To the extent net international reserves allow, use FX reserves to smooth volatility in disorderly market conditions.
    - Allow automatic fiscal stabilizers to operate and provide targeted, temporary support.
- Weaker-than-expected global growth (regions and channels)
  - Likelihood: High
  - Time Horizon: Short to Medium Term
  - Impact: Medium
  - Description:
    - Europe: Weak foreign demand, Brexit, or concerns about high-debt countries lead to delayed investment, lower private consumption, drifting inflation expectations, prolonged anemic growth and low inflation.
    - U.S.: Waning confidence amid stretched asset valuations and rising leverage leads to weaker investment and abrupt closure of the output gap.
    - China: Escalation in trade tensions reduces external demand, disrupts supply chains, depresses confidence and investment, potentially triggers tighter financial conditions, sharp property downturn, renewed PPI deflation, and commodity price drops; medium-term risks from reversal of globalization and increasing role of the state; excessive policy easing could reverse deleveraging progress and increase risk of disruptive adjustment or marked slowdown.
  - Policy Response:
    - Use exchange rate as a shock absorber.
    - Allow automatic fiscal stabilizers to operate and provide targeted, temporary support.
    - Structural reforms aimed at raising the economy’s competitiveness.
    - Diversify export destinations, increase high value-added exports, and improve competitiveness, thus boosting exports.

### Domestic Risks — Likelihood, Time Horizon, Impact, and Policy Responses
- Premature easing of overall macroeconomic stance
  - Likelihood: High
  - Time Horizon: Short to Medium Term
  - Impact: High
  - Description:
    - Premature easing of monetary policy could further erode confidence, weaken the currency, and exacerbate currency mismatches on private balance sheets.
    - Large fiscal expansion could encounter financing constraints as foreign appetite diminishes and banks cannot raise necessary funding.
  - Policy Response:
    - Restore tight monetary policy and normalize the framework.
    - Adopt a credible medium-term fiscal plan that is growth-friendly and enhances fiscal space to mitigate the slowdown and protect the most vulnerable.
    - To the extent net international reserves allow, use FX reserves to smooth volatility in disorderly market conditions.
- Disorderly macro-financial cycle of deleveraging and income compression
  - Likelihood: High
  - Time Horizon: Short to Medium Term
  - Impact: High
  - Description: Sharp unwinding of lending practices could create a vicious cycle between deleveraging and lower domestic demand/incomes/asset prices. Triggers include domestic policy mistakes and/or external financing pressures causing rapid exchange rate depreciation, weakening corporate balance sheets and bank asset quality, leading to sharp deleveraging and economic slowdown.
  - Policy Response:
    - Tighten monetary policy.
    - Use exchange rate as a shock absorber.
    - Allow automatic fiscal stabilizers to operate and provide targeted, temporary support.
    - Undertake third-party asset quality review, followed by rigorous stress tests and follow-up measures as needed.
    - Promote out of court debt workouts.
    - Adopt a medium-term fiscal plan that creates additional fiscal space to help with the fallout from the private sector.

*Annex I. Risk Assessment Matrix — sourced from the IMF staff report content provided.*

### 6. The public DSA suggests that Turkey’s government debt will remain below vulnerability

### 6. The public DSA suggests that Turkey’s government debt will remain below vulnerability benchmarks under the baseline and under various individual shock scenarios

### Summary findings on debt dynamics and vulnerabilities
- Under the baseline, public debt remains below vulnerability benchmarks through the projection period but does not stabilize by 2024 absent policy adjustment.
- Among individual shock scenarios, interest rate, growth, and contingent liability shocks produce relatively larger increases in debt and gross financing needs than primary balance and exchange rate shocks.
- Under a combined macro-fiscal shock, public debt would exceed 60 percent of GDP by end-2024.
- Under a combined macro-fiscal-contingent liability shock, public debt would breach the 70 percent of GDP threshold in the medium term and gross financing needs would rise above 20 percent of GDP.

### Individual stress-test scenarios and quantified impacts
- Primary balance shock
  - A worsening of the primary balance by 1 standard deviation over 2020–21 would raise medium-term public debt by around 1.3 percent of GDP.
  - Sovereign borrowing costs rise by 25 basis points for each 1 percentage point of GDP worsening in the primary balance.
  - Impact on gross financing needs levels by 2024 is modest.
- Growth shock
  - Real output growth rates lowered by 1 standard deviation, or 4½ percentage points, for 2 years starting in 2020.
  - Primary balance deteriorates to close to -6 percent of GDP by 2021.
  - Debt-to-GDP ratio increases to 42 percent during the growth shock and to over 45 percent by the end of 2024.
  - Gross public financing needs climb to 13 percent of GDP before gradually declining.
- Interest rate shock
  - Real effective rate assumed to reach similar levels to 2009, implying a permanent increase in spreads by about 850 basis points.
  - Government’s implicit average interest rate rises to over 18 percent in the medium term.
  - Debt-to-GDP ratio climbs to around 43 percent.
  - Gross public financing needs increase to around 13 percent of GDP in the medium term.
- Contingent liability shock
  - One-time assumption increases non-interest expenditures by 10 percent of GDP in 2020.
  - Combined with a negative real GDP growth shock (1 standard deviation for 2 years).
  - Sovereign borrowing costs increase by 25 basis points for each 1 percent of GDP worsening in the primary balance; inflation declines by ¼ percentage points for each percentage point decrease in GDP growth.
  - Debt rises to 45 percent of GDP in 2020 and gradually rises to 54 percent in the medium term.
  - Gross public financing needs peak in 2020 before declining to about 14 percent of GDP over the medium term.
- Combined macro-fiscal shock (excludes contingent liability shock)
  - Incorporates largest effects of individual macro-fiscal shocks on real GDP growth, inflation, primary balance, exchange rate, and interest rate.
  - Public debt reaches 62 percent of GDP over the medium term.
  - Gross financing needs rise to 18 percent of GDP over the medium term.
- Combined macro-fiscal-contingent liability shock (extreme)
  - Incorporates largest effects of macro-fiscal and contingent liability shocks.
  - Public debt breaches 70 percent of GDP by 2024.
  - Gross financing needs increase to above 20 percent of GDP.

### Baseline trajectory and key metrics (selected)
- Nominal gross public debt: 34.2 (2017), 28.2 (2018), 30.1 (2019), 32.2 (2020), 33.1 (2021), 34.1 (2022), 35.4 (2023), 36.6 (2024), 37.6 (projection units: percent of GDP as in source).
- Public gross financing needs: 9.9 (2017), 5.0 (2018), 6.5 (2019), 7.5 (2020), 9.2 (2021), 10.2 (2022), 10.4 (2023), 10.6 (2024), 10.0 (projection units: percent of GDP).
- Real GDP growth (in percent): 4.8 (2017), 7.5 (2018), 2.8 (2019), 0.2 (2020), 3.0 (2021), 3.0 (2022), 3.0 (2023), 3.5 (2024), 3.5 (projection).
- Inflation (GDP deflator, in percent): 7.7 (2017), 11.0 (2018), 16.4 (2019), 14.4 (2020), 11.8 (2021), 11.6 (2022), 10.9 (2023), 11.0 (2024).
- Effective interest rate (in percent, defined as interest payments divided by debt stock at end of previous year): 10.8 (2017), 8.1 (2018), 9.0 (2019), 9.6 (2020), 11.9 (2021), 13.1 (2022), 12.0 (2023), 12.0 (2024).
- Cumulative change in gross public sector debt over 2008–2024: listed as cumulative 7.5 (final cumulative figure in table).

### Stress-test outcomes (selected scenario snapshots from Figure 4)
- Real GDP growth shock scenario: real GDP growth falls to -1.4 (2020 and 2021) before recovering; primary balance deteriorates to -5.7 in 2021; effective interest rate reaches 13.3 (2021) and stabilizes around 12.3 (2024).
- Real interest rate shock scenario: effective interest rate rises to 15.3 (2021), 16.5 (2022), 17.4 (2023), 18.4 (2024).
- Contingent liability shock scenario: primary balance falls to -12.3 (2020) in the scenario table; effective interest rate is 13.9 (2020) and 14.7 (2021) before moderating.
- Macro-fiscal + CL shock scenario: primary balance shown as -12.6 (2020) and -6.0 (2021); effective interest rate rises to 15.9 (2021), 17.5 (2022), 18.1 (2023), 18.8 (2024).

### Public sector debt composition and market indicators (high-level)
- Share of short-term external debt projected to increase from 26 percent in 2018 to 32 percent in 2024.
- Around 21 percent of GDP of external debt is owed by banks; external debt owed by nonfinancial corporations rose from 15 percent (end-2008) to 20 percent of GDP (end-2018).
- Gross external financing needs estimated at about US$191 billion (about 23.5 percent of GDP) in 2020.

### Annex IV — External debt sustainability (key points)
- External debt increased sharply to nearly 58 percent of GDP in 2018.
- Under the baseline, external debt declines to around 44 percent of GDP over the medium term, assuming continued lower current account deficits and modest rollover rates.
- A permanent lira depreciation of 30 percent over the baseline would push external debt temporarily to around 90 percent of GDP by end-2020 before subsequently falling.
- A steep increase in fuel prices, widening the oil trade deficit by around 1 percent of GDP, would increase external debt relative to the baseline, leaving external debt around 50 percent of GDP by end-2024.
- Liquidity risk is significant: about one quarter of external debt is short term, implying gross external financing needs of about US$191 billion (about 23.5 percent of GDP) in 2020, which exposes the economy to liquidity risks given low international reserves relative to the Fund’s ARA metric.

*Source: IMF staff (Turkey Public Sector Debt Sustainability Analysis chapter).*

### Annex Box 1. External Debt and Balance Sheet Issues

### Annex Box 1. External Debt and Balance Sheet Issues

### Debtor composition and recent trends
- External public debt (general government plus CBRT) fell from 36 to 11 percent of GDP between the 2002 peak and the global financial crisis, and increased to 15 percent of GDP recently.
- External private sector debt rose to about 45 percent of GDP in 2019:Q2, up over 20 percentage points since end-2008.
- Financial sector (mainly banks) external debt reached 22 percent of GDP in 2019:Q2, up 15 percentage points since end-2008.
- Wholesale funding accounted for 10 percent of GDP of the increase in financial sector external debt; about a fifth of this wholesale funding is from parents/branches abroad.
- Corporate FX loans extended by domestic banks amounted to 23 percent of GDP in 2019:Q2, up from 11 percent in 2010.
- Non-financial corporates’ external borrowing was 14 percent of GDP as of 2019:Q2, contributing to total FX debt of 37 percent of GDP (USD 267 billion), excluding trade credits.
- The negative open net FX position widened to 26 percent of GDP as FX assets did not rise as much as FX liabilities.

### Banks' external liabilities and FX liquidity position
- Components of banks’ external liabilities shown include: Head offices/branches; Interbank deposits; Loans from banks; Debt securities; Other.
- FX liquid assets plus CBRT reserves and FX liquid assets are presented in the source figures (no additional numerical breakdown beyond those labels in the text).

### External Debt Sustainability and Stress Tests (bound tests and scenarios)
- Baseline external debt level shown as 44 percent of GDP in figures.
- Individual shocks are permanent one-half standard deviation shocks; the interest rate shock was increased to 1 standard deviation.
- Historical scenarios use ten-year historical averages to project debt dynamics five years ahead.
- Combined shock scenario applies permanent 1/4 standard deviation shocks to real interest rate, growth rate, and current account balance.
- One-time real depreciation shock of 30 percent occurs in 2018 in scenario specification.
- Figures in scenario boxes represent average projections for the respective variables in the baseline and scenario being presented.

### Table 1: Key projections and identified debt-creating flows (2014–24)
- Baseline: External debt: 2014: 43.5; 2015: 46.6; 2016: 47.5; 2017: 53.4; 2018: 57.6; 2019: 61.3; 2020: 55.7; 2021: 50.7; 2022: 47.7; 2023: 46.0; 2024: 44.2 (percent of GDP).
- Change in external debt: 2.1; 3.1; 0.9; 5.9; 4.3; 3.6; -5.5; -5.0; -3.0; -1.7; -1.8 (percent of GDP by year).
- Identified external debt-creating flows (4+8+9): 4.1; 5.5; 2.0; 4.2; 7.0; -0.9; -2.0; -1.0; -0.5; -0.5; -0.4 (percent of GDP by year).
- Current account deficit, excluding interest payments: 4.1; 3.1; 3.2; 4.8; 2.5; -0.9; -0.3; 0.3; 0.8; 0.9; 1.0 (percent of GDP by year).
- Deficit in balance of goods and services: 4.0; 2.8; 3.0; 4.6; 2.1; -1.3; -0.5; 0.1; 0.5; 0.7; 0.7 (percent of GDP by year).
- Exports (percent of GDP): 2014: 23.6; 2015: 23.1; 2016: 21.7; 2017: 24.6; 2018: 28.9; 2019: 31.8; 2020: 30.0; 2021: 28.2; 2022: 27.5; 2023: 27.7; 2024: 28.1.
- Imports (percent of GDP): 27.6; 25.9; 24.7; 29.2; 31.0; 30.5; 29.5; 28.3; 28.1; 28.4; 28.7 (percent of GDP by year).
- Net non-debt creating capital inflows (negative): -0.9; -1.4; -1.3; -1.4; -1.1; -0.8; -0.9; -0.7; -0.8; -0.8; -0.8 (percent of GDP by year).
- Automatic debt dynamics: 0.9; 3.7; 0.1; 0.8; 5.6; 0.9; -0.8; -0.5; -0.5; -0.7; -0.7 (percent of GDP by year).
  - Contribution from nominal interest rate: 0.6; 0.6; 0.6; 0.7; 1.0; 1.0; 0.9; 1.0; 0.9; 0.9; 0.8.
  - Contribution from real GDP growth: -2.2; -2.9; -1.5; -3.6; -1.7; -0.1; -1.7; -1.5; -1.4; -1.6; -1.5.
  - Contribution from price and exchange rate changes: 2/ 2.5; 6.0; 0.9; 3.6; 6.3; .................. (as reported).
- Residual, including change in gross foreign assets (2-3): -1.9; -2.4; -1.1; 1.8; -2.8; 4.5; -3.6; -4.0; -2.5; -1.2; -1.4 (percent of GDP by year).
- External debt-to-exports ratio (in percent): 184.0; 201.7; 218.5; 216.9; 199.2; 192.4; 185.7; 179.8; 173.3; 165.8; 157.2.
- Gross external financing need (in billions of US dollars): 214.9; 204.0; 198.0; 213.1; 206.7; 174.8; 191.2; 201.5; 210.4; 217.6; 221.9.
- Gross external financing need (in percent of GDP): 23.0; 23.7; 22.9; 25.0; 26.8; 23.5; 23.5; 22.3; 21.5; 21.0; 20.2.
- Debt-stabilizing non-interest current account (long-run constant balance) reported as -2.8 (percent of GDP).

### Key macroeconomic assumptions underlying the baseline (selected)
- Nominal GDP (US dollars): 934.1; 859.4; 863.4; 852.6; 771.3; 743.7; 813.8; 904.6; 978.8; 1,036.1; 1,099.5 (levels by year as listed).
- Real GDP growth (in percent): 5.2; 6.1; 3.2; 7.5; 2.8; 5.3; 4.4; 0.2; 3.0; 3.0; 3.0; 3.5; 3.5 (as presented in table; exact alignment with years in source table).
- GDP deflator (change in domestic currency): 7.4; 7.8; 8.1; 11.0; 16.4; 8.5; 3.1; 14.4; 11.8; 11.6; 10.9; 10.8; 11.0 (as presented).
- GDP deflator in US dollars (change in percent): -6.5; -13.3; -2.6; -8.1; -12.0; -4.6; 7.3; -3.8; 6.3; 7.9; 5.0; 2.3; 2.5.
- Nominal external interest rate (in percent): 1.4; 1.3; 1.4; 1.5; 1.7; 1.7; 0.4; 1.7; 1.6; 1.9; 1.9; 1.9; 1.9.
- Growth of exports (US dollar terms, in percent): 5.4; -10.0; -5.6; 11.9; 6.4; 2.9; 11.0; 6.0; 3.1; 4.5; 5.6; 6.6; 7.5.
- Growth of imports (US dollar terms, in percent): -3.1; -13.6; -4.2; 16.7; -3.8; 2.7; 18.2; -5.1; 5.7; 6.6; 7.3; 7.1; 7.5.
- Current account balance, excluding interest payments (percent of GDP): -4.1; -3.1; -3.2; -4.8; -2.5; -4.3; 2.1; 0.9; 0.3; -0.3; -0.8; -0.9; -1.0.
- Net non-debt creating capital inflows: 0.9; 1.4; 1.3; 1.4; 1.1; 1.4; 0.3; 0.8; 0.9; 0.7; 0.8; 0.8; 0.8.

### Implementation of past Fund advice and FSAP recommendations (selected progress)
- 2018 Article IV staff report advised rein in domestic demand to reduce imbalances; Turkey experienced a large exchange rate shock in late 2018 that, with a belated monetary policy rate hike, sharply curtailed domestic demand.
- Banking supervision:
  - Revise legislation to strengthen BRSA independence: MT — Not done.
  - Deepen and broaden risk assessment in banking inspection: MT — BRSA revised supervisory approaches and implemented them in 2017; strengthened risk assessments and coordination between on-site and off-site functions.
  - Strengthen corporate governance rules and enforcement: MT — Revision planned; corporate governance assessment in supervision strengthened.
  - Evaluate and revise credit classifications and strengthen enforcement: ST — In January 2018, new credit classification and provisioning rules were developed in conjunction with IFRS 9; new rules have come into force.
- Insurance supervision:
  - Improve independence, governance, accountability, resources, integrate offsite/onsite/enforcement, develop risk-based group supervision: ST/MT — Supervisor revised regulations on internal systems; established compliance function requirement; developed early warning assessment tool SEUS; developing stress testing approaches.
- Systemic risk oversight:
  - Strengthen macroprudential measures to lower FX risk: I — May 2018 legislation restricted FX lending to borrowers with less than US$15 million of loan exposures through FX debt to FX income limits and banned new FX-indexed corporate loans; rules under development for exposures >= US$15 million.
  - Strengthen FSC governance and powers; assign explicit financial stability objective: ST — January 2019 law no. 4059 restructured FSC into Financial Stability and Development Committee (FSDC) with more robust macro-prudential responsibilities.
  - Develop procedures for improved systemic risk assessment and coordination: ST/MT — Ministry of Treasury and Finance working on rules and procedures; systemic risk monitoring working group established.
  - Base policy-tool choice on integrated assessment and cost-benefit analysis: ST — Working sub-groups and heat map system in place; CBRT participates in ex-ante/ex-post impact analyses; Capital Markets Board adopted a risk-based supervision program for derivatives.
  - Strengthen transparency, including Annual Report publication: ST — To be taken up by FSDC.
- Managing systemic liquidity:
  - Orient liquidity provision towards a single key policy rate: I — CBRT shifted main instruments from late liquidity window to one-week repo auction rate.
  - Increase net reserves toward 100-150 percent of ARA: MT — CBRT reports gross reserves at 76.2 percent of ARA as of June 2019; introduced NDF auctions in BIST derivatives market; rediscount credits contributed about USD 15 billion in 2018 and projected to contribute USD 22.5 billion in 2019.
  - Improve ELA capacity; redefine CBRT FX lending facility as ELA and increase conditionality: ST — CBRT conducting studies on amendments to central bank regulation for ELA provision of TL liquidity only.
- Financial crisis management:
  - Strengthen recovery and resolution planning and resolution powers: MT — Draft legislation prepared jointly by SDIF and BRSA with World Bank technical assistance.
  - Strengthen domestic and cross-border coordination arrangements: ST — Domestic crisis management and resolution working group established in 2017; cross-border coordination addressed by forthcoming legislation.
- AML/CFT:
  - Determine reason for low ML conviction rates and plan to address them: MT — MASAK increased staff by more than 10 percent, strengthened training, improved IT tools; staffing/training increased at other agencies; National Risk Assessment completed as part of FATF mutual evaluation in 2018.
  - Introduce customer due diligence requirements for politically exposed persons: ST — Draft legislation prepared to align with FATF recommendations.
  - Ensure compliance with UNSCRs and strengthen border controls on currency transportation: MT — Compliance with UNSCR requirements remains incomplete; circular on passenger accompanied outgoing cash movements prepared; customs training increased; Customs Agency working on IT and operational improvements.

*Source: IMF staff calculations.*

### 1. The Performance and Learning Review (PLR) of the Country Partnership Framework

### 1. The Performance and Learning Review (PLR) of the Country Partnership Framework

### CPF implementation and portfolio performance
- The PLR of the Country Partnership Framework (CPF, FY18–21) is under preparation for Board discussion in January 2020.
- All planned IBRD lending in the CPF pipeline has been fully delivered, totaling US$3.7 billion.
- Current portfolio composition:
  - 13 IBRD operations
  - 2 Global Environment Facility (GEF)-financed projects
  - 6 trust-funded (recipient-executed trust funds, RETFs) projects
  - Combined total of US$4.77 billion
- Portfolio indicators:
  - Consistently strong with a low-level of risk
  - High disbursements
  - Satisfactory closing of seven lending operations (including RETFs)
  - No disconnect with Independent Evaluation Group reviews

### Strategic alignment and adjustments with Turkey’s 11th National Development Plan
- Turkey’s 11th National Development Plan, released in July 2019, reaffirmed the three major CPF focus areas: Growth, Inclusion, and Sustainability.
- Strategic orientation remains valid, but adjustments are needed:
  - Some CPF objectives and revision of indicators will be needed to reflect evolutions in government demand for World Bank Group (WBG) support.
- The CPF is designed as a flexible program; WBG and the government are discussing support options to meet the 11th Plan goals.
- WBG program maintains a long-term focus on supporting Turkey's progression to high-income country status.

### IBRD lending envelope, utilization, and demand
- CPF proposed IBRD financing for FY17–21: US$5-7.5 billion.
- To date, US$3.9 billion of this envelope has been used.
- Demand for additional lending:
  - FY20 demand is about US$1.13 billion
  - Indicative lending for FY21 is US$1.1 billion
- Conclusion: Turkey still has space in the IBRD lending envelope of the CPF to deliver new operations in FY20–21.

### EU Facility for Refugees in Turkey (FRiT) managed by WBG
- WBG entrusted with managing a total of €205 million of EU-funded FRiT as part of the EU response to the Syrian refugee crisis.
- First tranche agreed in 2016 targeted three projects:
  - €150 million for “Education Infrastructure for Resilience Activities” to help Turkey respond to growing demand for access to education among Syrian refugee children
  - €50 million to cover socio-economic support for refugees and host communities to finance employment services and active labor market programs
  - €5 million to support creation of entrepreneurship and employment opportunities for refugees and host communities
- Second tranche agreed in June 2019 allocated approximately US$283 million to the WBG for socio-economic projects and a further US$150 million for municipal services.

### Trust Fund portfolio
- Trust Fund portfolio has increased to US$250 million with 8 active operations.
- Notable trust funds and facilities included:
  - Clean Technology Fund (CTF)
  - EU Instrument for Pre-Accession Assistance (IPA) funds
  - Global Environmental Facility (GEF) funds
  - Swedish International Development Cooperation Agency (SIDA) Gender Funds
  - Grant Facility for Disaster Risk Reduction (GFDRR)

### International Finance Corporation (IFC) implementation
- IFC portfolio implementation continued to perform satisfactorily.
- IFC’s own-account investment program delivery since the beginning of the CPF totaled US$3,250 million, broken down by fiscal year:
  - FY17: US$1,348m
  - FY18: US$1,127m
  - FY19: US$275m
  - FY20 to date: US$500m
- IFC committed US$938 million to Turkish banks under its Global Trade Finance Program (GTFP) to broaden access to finance for companies.
- FY19 experienced a significantly reduced program of US$275 million, reflecting:
  - IFC’s current level of exposure to Turkey (2nd largest exposure globally)
  - Elevated economic and political risks
  - Increased global risk aversion

*Source: 1turea2019001 - 1. The Performance and Learning Review (PLR) of the Country Partnership Framework*

### 7. Turkey continued to be Multilateral Investment Guarantee Agency’s (MIGA) largest

### 7. Turkey continued to be Multilateral Investment Guarantee Agency’s (MIGA) largest country by gross exposure, representing about 13 percent of MIGA’s gross portfolio.

### MIGA exposure and activities
- MIGA’s gross exposure in Turkey totaled about US$3 billion across 15 projects as of end-FY19.
- Sectoral composition of the 15 projects:
  - five in the infrastructure sector,
  - four in the financial sector,
  - six in the services sector.
- Two-thirds of the portfolio stems from MIGA non-honoring guarantees: state-owned enterprises and sub-sovereigns.
- The remainder of the portfolio comprises political risk insurance guarantees (largely in support of PPPs in the healthcare sector).
- Over the past fiscal year:
  - MIGA underwrote new guarantees of US$618 million in the financial sector.
  - MIGA conducted a Project Evaluation Report, validated by the IEG, on the non-honoring transaction with TurkExim I (guarantees issued in 2015), which achieved a Satisfactory development outcome.

### I. Assessment of Data Adequacy for Surveillance (As of November 4, 2019)
- General:
  - Data provision to the Fund is broadly adequate for surveillance purposes, despite some shortcomings especially in national accounts and government finance statistics.
- National Accounts:
  - Published data for 1998 onwards adheres to the standards of the System of National Accounts 2008 (2008 SNA)/ European System of Accounts 2010 (ESA 2010).
  - TURKSTAT compiles and disseminates a comprehensive set of national accounts series, including:
    - quarterly Gross Domestic Product (GDP) at current prices and in chain-linked volume terms (production approach and expenditure approach);
    - quarterly and annual GDP at current prices (income approach);
    - financial and non-financial sectoral accounts;
    - government accounts;
    - regional accounts; and
    - supply and use tables.
  - In December 2016, TURKSTAT published a new series of national accounts, with reference year 2009 and benchmark year 2012.
  - Quarterly national accounts are published within 2 months after the reference period.
  - Since the end-2016 revision, annual GDP is estimated independently from the quarterly estimates and is published within 9 months after the reference period.
  - The end-2016 dissemination of rebased national accounts led to a significant upward revision of GDP, with many changes introduced, including improvements in methodology, the adoption of the 2008 SNA/ESA 2010, and the use of new data sources.
- Price Statistics:
  - The consumer price index (CPI) and the producer price index (PPI) generally conform to international standards.
  - The CPI has 2003 as base year and the weights are based in the Household Budget Survey conducted yearly by TURKSTAT.
  - The PPI is compiled for mining, manufacturing, and utilities. A separate PPI is disseminated for agriculture.
- Government Finance Statistics:
  - Coverage of the budget is largely complete.
  - Data for some fiscal operations conducted through extra budgetary funds are available only with some lags.
  - Fiscal analysis is further complicated by some quasi-fiscal operations carried out by state banks, state economic enterprises (SEEs), and other public entities; and technical problems associated with consolidating the cash-based accounts of governmental entities with the accrual-based accounting of SEEs.
  - It is difficult to reconcile fiscal data with monetary and BOP data, especially in the accounting of external debt flows and central government deposits.
  - Data available for publication in the Government Finance Statistics Yearbook cover the general government sector and its subsectors with coverage of both stocks and flows, including a full general government balance sheet.
  - Quarterly general government data on an accrual basis, including revenue, expenditure, financing, and balance sheet data, are reported for publication in International Financial Statistics (IFS).
- Monetary and Financial Statistics:
  - The Central Bank of Turkey (CBRT) reports monetary statistics for the central bank, other depository corporations, and other financial corporations, using the standardized report forms (SRFs), which accord with the concepts and definitions set out in the IMF’s Monetary and Financial Statistics Manual.
- Financial Sector Surveillance:
  - The Banking Regulatory and Supervision Agency (BRSA) reports all 12 core FSIs and nearly all the encouraged FSIs on a quarterly basis.
  - Turkey reports data on some key series and indicators of the Financial Access Survey (FAS), including the two indicators (commercial bank branches per 100,000 adults and ATMs per 100,000 adults) adopted by the UN to monitor Target 8.10 of the Sustainable Development Goals (SDGs).
- External Sector Statistics:
  - The CBRT compiles and disseminates balance of payments and international investment positions (IIP) statistics on monthly basis in broad conformity with the conceptual framework of BPM6.
  - The CBRT participates in the IMF’s surveys on direct and portfolio investments, and reports data template on international reserves and foreign currency liquidity regularly.
  - The CBRT started reporting the currency composition of IIP (beginning with 2016 data) to STA recently.

### II. Data Standards and Quality
- Turkey has subscribed to the Special Data Dissemination Standard (SDDS) since 1996.
- The latest Data ROSC was published in September 2009.

### Turkey: Table of Common Indicators Required for Surveillance (As of November 4, 2019)
- Selected dated entries (preserve exact entries and dates as presented):
  - Exchange Rates: Sep. 2019; Date received 10/11/2019; Frequency of data M; Frequency of reporting M; Frequency of publication M.
  - International Reserve Assets and Reserve Liabilities of the Monetary Authorities 1/: Aug. 2019; Date received 10/07/2019; Frequency of data W; Frequency of reporting W; Frequency of publication W.
  - Reserve/Base Money (narrow definition): Aug. 2019; Date received 10/07/2019; Frequency of data W and M; Frequency of reporting W and M; Frequency of publication W and M; Memo Items Data Quality – Methodological soundness O, O, LO, O; Data Quality Accuracy and reliability O, O, O, O, O.
  - Reserve/Base Money (broad definition): Aug. 2019; Date received 10/04/2019; Frequency of data W and M; Frequency of reporting W and M; Frequency of publication W and M.
  - Broad Money: Aug. 2019; Date received 10/04/2019; Frequency of data W and M; Frequency of reporting W and M; Frequency of publication W and M.
  - Central Bank Balance Sheet: Aug. 2019; Date received 10/07/2019; Frequency of data W and M; Frequency of reporting W and M; Frequency of publication W and M.
  - Consolidated Balance Sheet of the Banking System: Aug. 2019; Date received 10/04/2019; Frequency of data W and M; Frequency of reporting W and M; Frequency of publication W and M.
  - Interest Rates 2/: Sep. 2019; Date received 10/04/2019; Frequency of data D/W/M; Frequency of reporting D/W/M; Frequency of publication W/M.
  - Consumer Price Index: Sep. 2019; Date received 10/03/2019; Frequency of data M; Frequency of reporting M; Frequency of publication M; Memo Items Data Quality – Methodological soundness O, LO, O, LO; Data Quality Accuracy and reliability O, O, O, O, O.
  - Revenue, Expenditure, Balance and Composition of Financing 3/ – General Government 4/: 2019Q2; Date received Oct. 2019; Frequency of data Q; Frequency of reporting Q; Frequency of publication Q; Memo Items Data Quality – Methodological soundness O, LO, O, O; Data Quality Accuracy and reliability O, O, O, LO, O, LO.
  - Revenue, Expenditure, Balance and Composition of Financing 3/ – Central Government: Jan. 2018; Date received Feb. 2018; Frequency of data M; Frequency of reporting M; Frequency of publication M.
  - Stocks of Central Government and Central Government-Guaranteed Debt 5/: Jan. 2018; Date received Feb. 2018; Frequency of data M; Frequency of reporting M; Frequency of publication M.
  - External Current Account Balance: 2019Q2; Date received 10/11/2019; Frequency of data Q; Frequency of reporting Q; Frequency of publication Q; Memo Items Data Quality – Methodological soundness O, O, O, LO; Data Quality Accuracy and reliability O, O, O, O, O.
  - Exports and Imports of Goods and Services: Aug. 2018; Date received 10/11/2019; Frequency of data M; Frequency of reporting M; Frequency of publication M.
  - GDP/GNP: 2019Q2; Date received 09/02/2019; Frequency of data Q; Frequency of reporting Q; Frequency of publication Q; Memo Items Data Quality – Methodological soundness O, LO, O, O; Data Quality Accuracy and reliability LO, O, LO, O, LO.
  - Gross External Debt: 2017Q3; Date received 2017Q4; Frequency of data Q; Frequency of reporting Q; Frequency of publication Q.
  - International Investment Position 6/: 2019Q2; Date received 9/26/2019; Frequency of data Q; Frequency of reporting Q; Frequency of publication Q.

### Statement by Mr. Raci Kaya and Mr. Omer Ethem Bayar (December 9, 2019)
- Macroeconomic Context:
  - Second half of 2018: major bout of stress for the Turkish economy and financial markets due to deterioration in sentiment toward emerging market economies and adverse geopolitical developments.
  - Lira depreciated sharply; market valuations suffered; temporary spike in inflation and undermined confidence hampering private consumption and investment.
  - Authorities’ policy response included significant monetary tightening by the CBRT, targeted fiscal incentives, and restructuring of the Financial Stability and Development Committee.
  - Objectives of policy response: (i) reinstate monetary and financial stability, (ii) facilitate rebalancing of the economy, and (iii) avoid a sharp and protracted downturn in economic activity.
  - Recovery began Q1/2019; y-o-y growth returned to positive territory as of Q3/2019 after three quarters of negative rates.
  - Lira gained strength; inflation retreated from its peak of 25.2 percent in October 2018 to 10.56 percent (y-o-y, end-November 2019).
  - Current account adjusted by approximately US$ 63.8 bn (i.e. around 8.3 percent of GDP) to return to surplus.
  - Adjustment drivers: resilient exports, decreasing import demand, strong tourism performance.
  - Unemployment rose to 14 percent.
  - New Economy Program set year-end central government budget deficit target at 2.9 percent of GDP, implying a 0.9 percentage point widening relative to 2018.
  - EU-defined general government debt stock forecast at 32.8 percent of GDP as of end-2019.
- Outlook and Policies:
  - New Economy Program (NEP) 2020–2022 aims to uplift growth while enhancing price and financial stability and consolidating external balance gains.
  - Authorities expect 5 percent real growth over the planning horizon.
  - Authorities expect unemployment to decline to 9.8 percent by the end of 2022.
- Monetary Policy:
  - Inflation projected to decline to low single-digit levels; CBRT medium-term inflation target retained at 5 percent with interim targets.
  - Headline CPI forecast: 12 percent as of end-2019; projected to decline to 8.2 percent in 2020, 5.4 percent in 2021, and stabilize around the target by 2022.
  - CBRT cut interest rates by a cumulative of 1000 bps since July 2019.
  - Authorities agree on the need to accumulate international reserves as conditions permit and state reserve data is compiled and published timely and transparently.
- Fiscal Policy:
  - Fiscal policy will be growth-friendly and fiscal prudence will be preserved.
  - Overall fiscal stance broadly unchanged in 2020.
  - Budget deficit-to-GDP ratio targeted to remain below 3 percent in the outer years of the planning period.
  - Public debt set to remain broadly flat between 32–34 percent of GDP throughout the NEP period.
  - 2020 central government budget aims to balance buttressing activity and consolidating rebalancing gains.
  - On PPPs: a framework arrangement will be prepared to ensure efficiency, productivity, affordability, and integrity in PPP applications.
  - On the Sovereign Wealth Fund (SWF): authorities will adhere to international best practices in accounting of its activities.
- Current Account:
  - Current account expected to post a deficit of 1.2 percent of GDP in 2020.
  - Structural policies to increase exports of high value-added products, reduce import dependence in key sectors, and bolster tourism.
- Financial Sector:
  - Turkish banking system capital adequacy ratio above 18 percent (latest data as of October 2019).
  - Total non-performing loan ratio at 5.15 percent.
  - By regulation, banks are not allowed to carry net open FX positions beyond 20 percent of regulatory capital.
  - Authorities dispute staff’s assessment of a continued positive credit gap and argue the credit gap is still in negative territory.
  - Authorities consider supervisory framework robust, aided by on-site examinations and stress tests.
  - Authorities working on new insolvency legislation and encourage private-sector restructuring initiatives.
- Structural Reforms:
  - Opportunity to implement reforms to improve competitiveness, resilience, and address impediments to job creation and investments.
  - Policies underway to improve labor market, business environment, public financial management, capital markets, and judicial and education systems.
  - Targeted incentives to support renewable energy and technology-intensive sectors.
  - Turkey’s rank in World Bank Doing Business Indicators improved to 33 in 2019 from 60 in 2017.
- International Development Efforts and Refugees:
  - Turkey’s total development assistance reached USD 9.3 billion in 2017.
  - Turkey hosts more than 4 million refugees, the largest population of displaced people globally.
  - Significant efforts and funding mobilized to provide education and health services for refugees; measures to integrate refugees and pursue safe and voluntary return.
- Final Remarks:
  - Turkish authorities appreciate the Article IV consultations’ analytical depth and rigor and will carefully assess policy advice and continue to work closely with the Fund.

*Source: IMF content unit 1turea2019001 - 7. Turkey continued to be Multilateral Investment Guarantee Agency’s (MIGA) largest (PDF; As of November 4, 2019 / Statement dated December 9, 2019).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1turea2019001.pdf_