## _cr08272 ## Source details **Canonical URL:** [_cr08272](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08272.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08272.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08272.pdf.json) --- ### Executive summary - Macroeconomic backdrop and risks: - Macroeconomic developments less favorable since May 2007; supply-side shocks slowed growth and stoked inflation. - Global credit crunch weighing on the outlook; principal vulnerabilities: large current account deficit and private sector reliance on external financing. - Political developments distracted from the economic agenda and contributed to slippages in program conditionality and implementation. - Turkey’s GDP level revised upward by some 30 percent (March 2008 revision), lowering public debt and current account ratios relative to GDP but not altering assessment of vulnerabilities (notably high gross external financing requirements). - Key policy actions: - Passage of revised social security law, estimated savings around 75 percent of 2007 GDP in present value. - Average end-user electricity prices raised by 16½ percent; privatization of several electricity distribution companies launched. - Steps to enhance tax administration and reduce informality. - Strengthened bank provisioning and liquidity requirements. - Central bank halted easing and adopted a tightening bias. - Authorities target an unchanged primary surplus for 2008 and plan a medium-term fiscal framework targeting debt reduction. - Program performance under the SBA: - SBA overperformed on growth, public debt reduction, and international reserve accumulation. - Structural achievements: social security reform, large privatizations, new banking, mortgage, and insurance laws. - Requested SBA purchase amount: SDR 2.25 billion; staff supports completion of the seventh review and the associated purchase. ### Recent developments — growth, inflation, external, fiscal, and banking - Real sector and growth: - GDP growth: 2007 average 4.5 percent (one-half percentage point below authorities’ target); growth slowed from average 5.7 percent in H1 2007 to 3.4 percent in H2 2007. - Drought subtracted ¾ percentage point from 2007 growth; strong lira (up 19 percent in real effective terms in 2007) deteriorated net exports. - Domestic demand recovered in H2 2007; industrial production “kept up relatively well.” - Inflation and monetary policy: - CPI inflation (end-of-period): 2005 7.7; 2006 9.7; 2007 8.4 (actual outturn vs. original program 8.0, 5.0, 4.0). - Central bank policy rate fell from 17.5 percent (simple) in September 2007 to 15.25 percent by February 2008, then halted easing and adopted a tightening bias as inflation rose to 9.2 percent by March 2008. - Real policy rates were above 10 percent for most of 2007. - External sector and financing: - Current account deficit: 2007 −5.7 percent of GDP (down from −6.0 in 2006); widened in early 2008 amid higher import growth and oil prices. - External debt-to-GDP fell to 34 percent by end-2007 due to lira appreciation and nondebt inflows. - Net FDI (percent of GDP) actual outturns: 2005 1.9; 2006 3.6; 2007 3.0 (vs. original program 0.8, 0.8, 0.6). - Gross foreign reserves (billions of U.S. dollars): actual outturns 2005 52.2; 2006 63.3; 2007 76.5 (original program 39.7, 39.5, 40.2). - Fiscal developments: - Fiscal stance weakened in 2007; nonfinancial public sector primary surplus was 1½ percent of GDP less than programmed. - Main revenue weakness: VAT and excises deviation −0.5 percent of GDP; revolving funds deviation −0.1 percent of GDP. - Primary expenditure deviation +0.7 percent of GDP. - Public sector net debt (percent of GDP) actual outturns: 2005 41.7; 2006 34.2; 2007 29.1 (original program 45.0, 43.5, 40.4). - Banking sector and financial markets: - Banks resilient with ample capital buffers and sound liquidity; loan portfolios expanded at an annual rate over 30 percent in late 2007/early 2008; surge in FX-linked loans noted. - Financial markets outperformed in 2007 (equities +42 percent local currency); in 2008 equities down 22 percent year-to-date; external spreads up 210 basis points; domestic spreads up 55 basis points; lira down 12.5 percent against a euro-dollar basket. - Public debt managers temporarily shortened maturities; average domestic debt maturity remains around 2 years. ### Outlook, projections, and risks - Growth: - Authorities revised 2008 growth forecast from 5.5 percent to 4.5 percent. - IMF staff projection for 2008: 4 percent. - Staff notes risks slightly tilted to the downside due to global credit crunch and domestic political events. - Inflation: - Core inflation (HICP excluding energy and food) reached 5.9 percent in March. - HICP weights: energy 11½ percent; food 28½ percent. - Staff projects end-year inflation at 9¼ percent with upside risks. - Staff research: a 1 percentage point energy or food shock increases core inflation by around 0.2–0.25 percentage points and raises headline inflation by 0.3–0.4 percentage points. - Current account and external: - Current account deficit projected to widen in 2008; baseline projection for current account (percent of GDP): 2008 −6.4; 2009 −6.1 (Table 3 memorandum). - FDI projected to cover one-quarter of the current account shortfall in 2008. - External financing conditions expected to remain adequate but with increased risks. - Medium-term projections (selected): - Real GDP growth: 2008 4.0; 2009 4.3; 2010–2013 5.0 each year (baseline). - Current account (percent of GDP): 2008 −6.4; 2009 −6.1; projected to remain large in medium term. - Gross foreign reserves (CBT, billions of U.S. dollars): 2008 86.4; 2009 88.9. - Gross external debt (percent of GDP): 2008 41.1; 2009 42.9; projected to rise to 48.7 by 2013 under baseline. ### Fiscal policy, medium-term fiscal framework, and structural reforms - Medium-term fiscal framework (MTFF): - Authorities to announce MTFF targeting 2012 gross debt 30 percent of GDP (general government, Maastricht definition). - Policy mix: gradual reduction in primary surplus, mild restraint in personnel costs, reallocation toward infrastructure spending and cuts in labor and financial transaction taxes. - Authorities expect to study a fiscal rule embedded in a fiscal responsibility law and decide prior to the 2009 budget. - 2008 fiscal stance: - Authorities target a neutral fiscal stance with a primary surplus target of 3.5 percent of GDP for 2008 (revised from an earlier 4.2 percent). - Staff and authorities agree some tightening from the 2007 outturn is warranted. - Fiscal table entries (percent of GDP): primary revenue 2007 25.5; 2008 25.1; primary expenditure 2007 22.9; 2008 22.4. - Social security reform: - Parliament passed reform on April 17, 2008; raises retirement age to 65 gradually, reduces replacement rates, indexes pensions to consumer prices, adopts universal health insurance; staff estimate present value savings around 75 percent of 2007 GDP over 75 years. - Tax administration and labor market reforms: - Measures to combat VAT refund fraud, move to risk-based refunds, evaluate consolidation of tax auditing under Revenue Administration (RA). - Labor market package: reduce employer social security contributions by 5 percentage points; expected fiscal cost around 0.4 percent of GDP annually; effective in Q4 2008. - Energy sector: - Urgent reforms to restore financial viability; TEDAŞ losses estimated at 0.14 percent of GDP in 2007 due to tariffs unchanged 2002−07. - Tariffs increased on January 1, 2008 by 12.2 percent for industrial users and 19.4 percent for households and retail businesses. - Under current projections, a mid-year price increase of nearly 15 percent is needed to restore cost-recovery; automatic cost-based pricing mechanism planned by July 1, 2008. ### Debt sustainability and stress tests - Public debt outcomes: - General government gross debt (Maastricht): 2007 38.8 percent of GDP; projected 2012 30.2; 2013 29.2 (Appendix Table II.1). - NFPS net debt: 2007 34.0 percent of GDP; projected 2012 23.8; 2013 22.3. - Stress-test tailored scenarios (selected outcomes on NFPS net debt): - C1 (persistent global deterioration: 30 percent depreciation, +500 bps real rates, growth 2½ percent in 2008–09): debt rises by 8 percentage points in near term. - C2 (transient deterioration: 10 percentage point depreciation, +200 bps rates): debt increases by some 2 percentage points near term. - C3 (domestic policy complacency: primary surplus falls to ½ percent of GDP by 2012): debt plateaus about 4 percentage points above the 2012 baseline. - Debt-stabilizing primary surplus currently around 2 percent of GDP; authorities’ MTFF envisages near-term primary surplus for 2009 of 3 percent of GDP. ### Financial sector reforms and corporate FX risk - Financial sector measures: - New insurance law; strengthened provisioning rules distinguishing “standard” and “special mention” loans; BRSA raised liquidity requirements. - BRSA postponed full Basel II implementation until early 2009; will announce risk weightings soon. - CBT launched survey of corporate FX exposure; results to be published by end-2008. - Commercial Code to require IFRS-aligned financial statements. - Corporate sector FX exposure: - Large FX indebtedness in corporate sector is a potential risk; evidence of increased FX-linked borrowing and variable-rate debt; scarcity of hedging data hampers assessment. - Staff recommends close monitoring and ensuring bank loan policies account for FX risks. - State bank privatization: - Successful Halkbank IPO in May 2007; plans for a secondary equity offering of another 24 percent of Halkbank shares; commitment to privatize other state-owned banks including Ziraat. ### Program request, conditionality, and staff recommendation - Authorities request completion of the seventh review and purchase of SDR 2.25 billion under the Stand-By Arrangement; staff supports the request. - Program monitoring outcomes: - Several quantitative performance criteria for August 2007 and December 2007 were "Not observed"; other criteria were "Observed". - Structural benchmarks: mixed implementation. - Staff supports waivers of nonobservance of end-December 2007 fiscal performance criteria given recent measures and adoption of key fiscal reforms. - Staff appraisal: - SBA has overachieved many objectives (debt reduction, reserve accumulation); sustaining success requires unwavering commitment to reform. - Strategy: adapt monetary policy to low stable inflation, strengthen public balance sheets, increase banking system resilience, pursue structural reforms (privatization, tax and energy reforms, labor market liberalization), and maintain a floating exchange rate. ### Key policy recommendations (summary) - Monetary: tighten policy promptly to contain second-round inflation effects; consider raising interest rates to anchor expectations. - Fiscal: secure 2008 fiscal targets, restrain nonessential current spending, implement MTFF targeting gross debt 30 percent of GDP by 2012, and institutionalize with stronger fiscal frameworks. - Structural reforms: implement social security, tax administration consolidation (preferably under the RA), labor market reforms, and energy sector automatic cost-pass-through and privatization. - Financial sector: monitor corporate FX exposure, strengthen provisioning and liquidity buffers, and advance state bank privatization as conditions permit. - External: monitor gross external financing needs closely given high and rising requirements and sizeable current account deficits. *Source: IMF staff report excerpt and appendices from _cr08272.* ### Executive Summary ### Executive Summary ### Macroeconomic backdrop and recent developments - Macroeconomic developments have become less favorable since the last review in May 2007. - Supply-side shocks have slowed growth while stoking inflationary pressure. - The unfolding global credit crunch is weighing on the economic outlook and heightening risks stemming mainly from a large current account deficit and the private sector’s significant reliance on external financing. - Political developments have distracted attention from an ambitious economic agenda, contributing to slippages in program conditionality and implementation. - Turkey’s GDP level was revised upward by some 30 percent in March 2008 to reflect improved coverage of both formal and informal sectors. - The revision raises several ratios (e.g., public debt and current account deficit relative to GDP fall) but does not fundamentally alter staff’s assessment of Turkey’s vulnerabilities, particularly high gross external financing requirements. ### Key policy actions taken by the authorities - Passage of a revised social security law, estimated by staff at around 75 percent of 2007 GDP in present value (major step for long-term public finance sustainability). - Raised average end-user electricity prices by 16½ percent (first increase in over five years) and launched privatization of several electricity distribution companies. - Steps to enhance tax administration and reduce informality. - Strengthened bank provisioning and liquidity requirements to build additional buffers in bank balance sheets. - Central bank halted its easing cycle and moved to a clear tightening bias to reverse the recent surge in inflation. - On fiscal policy, authorities now target an unchanged primary surplus for 2008 while planning a soon-to-be-announced medium-term fiscal framework that targets continued debt reduction. - Authorities request completion of the seventh review and the purchase of the associated outstanding amount (SDR 2.25 billion) under the Stand-By Arrangement (SBA); staff supports this request. ### Program performance and outcomes under the SBA - Despite delays, the SBA has overperformed on several key objectives: economic growth, public debt reduction, and international reserve accumulation have all exceeded original program targets by wide margins. - Structural achievements during the SBA include social security reform, large privatizations, and new banking, mortgage, and insurance laws. - Base-broadening tax policy and revenue administration measures enabled tax rate reductions (example cited: corporate tax rate cut from 30 to 20 percent in 2006). ### Selected macroeconomic indicators (as presented) - GDP revision: upward by some 30 percent (March 2008 revision). - Staff estimate of social security reform savings: around 75 percent of 2007 GDP in present value. - Electricity price increase: 16½ percent. - Requested SBA purchase amount: SDR 2.25 billion. - Indicators comparing original program and actual outturns (2005–07, percent of GDP unless noted): - GDP growth (percent): Original program 5.0, 5.0, 5.0; Actual outturn 8.4, 6.9, 4.5 (for 2005, 2006, 2007). - CPI inflation (end-of-period, percent): Original program 8.0, 5.0, 4.0; Actual outturn 7.7, 9.7, 8.4 (for 2005, 2006, 2007). - Current account deficit (percent of GDP): Original program -3.3, -2.7, -2.1; Actual outturn -4.6, -6.0, -5.7 (for 2005, 2006, 2007). - Net FDI (percent of GDP): Original program 0.8, 0.8, 0.6; Actual outturn 1.9, 3.6, 3.0 (for 2005, 2006, 2007). - Nonfinancial public sector primary balance (percent of GDP): Original program 4.9, 4.9, 4.9; Actual outturn 5.1, 4.6, 3.5 (for 2005, 2006, 2007). - Nonfinancial public sector overall balance (percent of GDP): Original program -3.4, -1.7, -0.8; Actual outturn -0.2, -0.5, -1.4 (for 2005, 2006, 2007). - Public sector net debt (percent of GDP): Original program 45.0, 43.5, 40.4; Actual outturn 41.7, 34.2, 29.1 (for 2005, 2006, 2007). - Gross foreign reserves (billions of U.S. dollars): Original program 39.7, 39.5, 40.2; Actual outturn 52.2, 63.3, 76.5 (for 2005, 2006, 2007). ### Program monitoring and conditionality (high-level outcomes) - Quantitative performance criteria: several fiscal floors and ceilings were "Not observed" for August 2007 and December 2007 (including floors on primary balance of consolidated government sector and CGS excluding SEEs; ceiling on consolidated primary spending of central government and SSIs; floor on overall balance of SSIs). - Other quantitative criteria were "Observed" (ceilings on new external public debt with maturities exceeding one year; ceilings on new external public debt with maturities up to one year; floor on net international reserves of CBT and Treasury combined). - Inflation consultation clause: inner and outer bands were exceeded at various dates, prompting staff discussions and an open letter (Attachment II). - Structural benchmarks: mixed implementation—some "Observed", some "Observed with delay", some "Not observed". - New prior actions listed in the Supplementary Letter of Intent include adoption of a revised medium-term fiscal plan targeting a debt ratio of 30 percent of GDP (Maastricht definition) by 2012 (Pending), and legal framework requiring large employers to pay salaries through bank accounts (Done), among others. ### Risks, vulnerabilities, and policy priorities - Principal vulnerabilities stem from a large current account deficit and significant private sector reliance on external financing. - Global financial turbulence reduces growth prospects in Turkey’s main export markets and raises the risk of a disorderly external adjustment. - Oil and food import price surges have pushed inflation well above target; second-round inflation effects are a concern. - Domestic political tensions are weighing on investor and consumer confidence. - Policy priorities highlighted: - Steadfast macroeconomic policies to navigate the weaker external environment. - Continued structural reforms to reduce risks and sustain high growth. - Anchor expectations through a medium-term fiscal framework targeting continued debt reduction. ### Conclusion and staff recommendation - Completion of the seventh review would bring closure to the current SBA, under which Turkey has dramatically reduced public debt and built international reserves. - In light of recent progress, the authorities request, and staff support, completion of the seventh review and the purchase of the associated outstanding amount (SDR 2.25 billion) under the SBA. - Nonetheless, steadfast policies and reforms are still needed to successfully navigate the weaker external environment and sustain high growth. *Source: Executive Summary, _cr08272 - Executive Summary.* ### 7. Nonetheless, key economic challenges remain to be addressed. In the near term, ### _cr08272 - 7. Nonetheless, key economic challenges remain to be addressed. In the near term, ### Key challenges and policy message - Near-term risks: heightened global risks, domestic political tensions, and surging import prices amplify Turkey’s external vulnerabilities and the challenge of reducing inflation to its target. - Structural problems identified: still high tax rates, a large informal economy, energy supply bottlenecks, and shallow financial intermediation—all constraints on lifting potential growth. - Policy prescription: steadfast implementation of macroeconomic policies and structural reforms will help Turkey navigate the choppy waters, increase the resilience of the economy, and secure lasting prosperity. ### II. RECENT DEVELOPMENTS — Real sector and growth - Growth dynamics in 2007: - Growth slowed during 2007, from an average annual rate of 5.7 percent in the first half to 3.4 percent in the second half. - Average growth in 2007 reached 4.5 percent, one-half percentage point below the authorities’ target. - Key contributors to the slowdown: - a sharp drought-related drop in agricultural production, which subtracted ¾ percentage point from 2007 growth; - a deterioration in net exports, reflecting the strong lira in 2007 (up 19 percent in real effective terms). - Partial mitigants: declining real interest rates and a temporary rise in sentiment after the July elections. - Near-term outlook: the flaring up of political tensions, higher prices of food and energy, and the worsening global outlook have weighed on consumer sentiment, portending continued weakness in economic activity into 2008. - Domestic demand and production: - Domestic demand recovered in the second half of 2007, with higher durable goods purchases. - On the production side, the slowdown was driven by weaker construction and a drop in agricultural output. - Industrial production growth moderated but “kept up relatively well.” - Confidence indicators were depressed and portend a renewed weakening of private consumption in 2008. ### II. RECENT DEVELOPMENTS — Inflation and monetary policy - Inflation path: - Inflation fell through most of 2007, with headline and core inflation down to historic lows (below 7 percent) by mid-2007. - The central bank started a gradual easing cycle: policy rate fell from 17.5 percent (simple) in September 2007 to 15.25 percent by February 2008. - Supply-side shocks (surging food and oil prices, excise increases, and administered price hikes) pushed inflation up to 9.2 percent by March 2008, just above the upper limit of the central bank’s inflation band. - Lira weakness has further added to inflationary pressures. - Policy response: the central bank halted its easing cycle and introduced a tightening bias in its monetary policy stance. - Real policy rates: real policy rates were above 10 percent for most of 2007. ### II. RECENT DEVELOPMENTS — External sector and financing - Current account and external balances: - The current account deficit stabilized temporarily in 2007 despite an appreciating lira. - The current account deficit was 5.7 percent of GDP for the full 2007, down from 6.0 percent in 2006. - The deficit widened again in recent months (early 2008) amid higher import growth and sharply higher oil prices. - External debt-to-GDP ratio fell to 34 percent of GDP by end-2007 due to the lira’s sharp appreciation and strong nondebt-creating inflows. - External financing conditions: - External financing was ample during 2007: FDI inflows were buoyant and covered half of last year’s current account deficit; equity market inflows and long-term corporate loans were robust. - Abundant inflows allowed the central bank to increase international reserves well above the 2007 program floor. - Since late 2007 and into 2008, turmoil in global markets tightened financing conditions: foreign investors scaled back portfolio holdings, securitized bank lending ground to a halt, and spreads on syndicated loans widened. - Trade and imports: - Import growth was weak in early 2007 but gradually regained strength as domestic demand recovered and oil prices surged. - In volume terms, import growth outpaced export growth since the middle of 2007. - Import composition (shares in 2007): intermediate imports (74%), consumption imports (12%), capital imports (14%). - Export composition (shares in 2007): intermediate exports (50%), consumption exports (37%), capital exports (13%). ### II. RECENT DEVELOPMENTS — Fiscal developments - Fiscal stance and performance: - Fiscal resolve weakened considerably in 2007. Fiscal policy had been programmed to tighten by over 1 percent of GDP in 2007. - The 2007 nonfinancial public sector primary surplus was 1½ percent of GDP less than programmed, largely due to policy-induced factors. - Main revenue weakness: tax collections linked to consumption were weak (VAT and excises deviation -0.5 percent of GDP) reflecting slow spending for durable goods, compliance issues, and arrears from ailing state energy enterprises (around ¼ percent of GDP). - Nontax revenue deviation: -0.1 percent of GDP (Revolving Funds transferred less than expected). - Primary expenditure was higher than programmed (deviation 0.7 percent of GDP), led by central government current and capital (each 0.3 percent of GDP), and social security deviations (0.2 percent of GDP) partly due to an H2 pension increase and health spending overruns. - Despite weaker fiscal performance, debt ratios continued to decline rapidly in 2007, helped by lira appreciation and privatization receipts. ### II. RECENT DEVELOPMENTS — Banking sector and credit - Banking sector resilience: - Turkish banks have so far weathered the global credit crunch: ample capital buffers, strong profitability, sound liquidity, and no known direct exposure to the U.S. subprime mortgage market. - Banks expanded loan portfolios at an annual rate of over 30 percent in recent months (late 2007/early 2008). - Consumer lending grew the fastest, though still below record rates seen until mid-2006. - A noteworthy feature: a recent surge in foreign-currency (FX)-linked loans, possibly indicating demand from corporates facing a decline in external borrowing sources. - Tighter global credit conditions have reduced Turkish banks’ access to external funding (notably through securitized loans), which is likely to slow credit growth going forward. - Banking indicators cited: - Capital adequacy ratios: “capital cushions remained solid, despite their trend decline.” - Nonperforming loan ratios stayed at moderate levels, with high provisioning rates backing them. ### II. RECENT DEVELOPMENTS — Financial markets and investor sentiment - 2007 outperformance and 2008 reversal: - Financial markets outperformed most comparators in 2007: equities rose 42 percent in local currency last year; the benchmark bond yield fell by 460 basis points. - Turkey was a profitable “carry trade” destination in 2007 due to high interest rates and an appreciating currency, increasing exposure to global investor sentiment. - In 2008, markets fell back significantly: - Equities have fallen 22 percent this year (2008). - External spreads and domestic spreads: external spreads up 210 basis points and domestic spreads up 55 basis points (as of timeframe in text). - The lira is down 12.5 percent against a euro-dollar basket. - Market effects and policy response: - Faced with rising spreads, a steepening yield curve, and reduced foreign participation in domestic debt markets, public debt managers temporarily shortened maturities of new borrowing (the average maturity of domestic debt remains short at around 2 years). - Credit market details: syndicated and securitized loans to the Turkish banking sector declined (stock of external loans charted, 2004–07). *Source: IMF staff text in the provided content unit.* ### 12. Economic growth is expected to continue at a moderate pace (¶4–5). ### 12. Economic growth is expected to continue at a moderate pace (¶4–5) ### Outlook: growth and risks - Authorities revised their 2008 growth forecast down from 5.5 percent to 4.5 percent. - IMF staff projection for 2008 growth: 4 percent (Table 2), in line with the latest market consensus. - Growth drivers and constraints: - Expected benefits from recoveries in agricultural production and net export volume growth, the latter hinging on the weaker lira and at least modest growth among major trading partners. - Outlook for private domestic demand has dimmed significantly due to a sharp recent weakening in consumer confidence. - Risk balance: Risks around the staff growth forecast are slightly tilted to the downside, with further downside if the global credit crunch sharply contracts external demand and financing. Domestic political events could also weigh significantly on sentiment. ### Expenditure and production contributions (contribution to GDP growth) - Expenditure-side components shown for 2004–2008 include: Net exports, Public expenditure, Private investment, Private consumption, with GDP growth series reported. - Production-side components shown for 2004–2008 include: Construction, Agriculture, Industry, Services, with GDP growth series reported. - Source note: Difference between GDP growth and sum of components accounted for by taxes minus subsidies (1/). ### External spillovers and financing (Box 2) - Staff estimate: each 1 percentage point reduction in industrial country growth reduces Turkey’s growth by a cumulative 0.8 percentage points. - Decomposition: the trade channel accounts for about half of the cumulative growth response; financial factors play a significant role, especially in the first quarter after the shock. - Historical indicator: measures of industrial country liquidity have been strong leading indicators of private non-FDI flows into Turkey; over the last two years industrial country liquidity contracted while private capital flows into Turkey remained strong. - External financing assessment for 2008: - FDI is projected to cover one-quarter of the current account shortfall in 2008 (privatization transactions and M&A pipeline). - Key risks: tight global credit conditions; political uncertainty in Turkey; reliance of banks and especially corporates on external loans; substantial stock of portfolio investment by nonresidents. ### Inflation outlook and second-round effects (Box 3) - Core inflation (HICP excluding energy and food) reached 5.9 percent in March (annual HICP excluding energy and food). - HICP basket weights: energy represents 11½ percent of the HICP basket; food represents 28½ percent of the basket. - Recent shocks: surge in oil prices and continued upward pressure from food prices have manifested in domestic inflation. - Virtual inflation exercise: applying Turkey’s basket weights to average EU-27 inflation shows EU-wide trends explain most of very recent inflation dynamics, but the general level of inflation remains essentially a domestic phenomenon. - Staff research on second-round effects: - An initial one percentage point shock to energy or food inflation tends to increase core inflation by around 0.2–0.25 percentage points in simple bivariate models. - As a result, headline inflation rises by 0.3–0.4 percentage points—or by a factor of 1½ (for food) and 2 (for energy) times the mechanical impact of the shocks on headline inflation. - The adjustment has typically been fast, unfolding on average within one year from the original shock, with a relatively persistent, if contained, effect on inflation expectations. - Recent developments: - Inflation expectations have increased sharply in recent weeks. - Monthly numbers on core inflation point to a problematic broadening of price pressures, partly related to the lira depreciation early this year. - Staff projects end-year inflation at 9¼ percent with risks somewhat tilted to the upside (Section B). ### Current account and external outlook - Current account deficit projected to widen again in 2008 (Table 3). - Lagged effects of 2007’s strong lira and surging oil prices have weighed on net export values in early 2008; the lira’s recent reversal should help volume performance in the second half of the year, but the full-year current account deficit will widen in value terms due to unfavorable terms of trade movements. - Risks to exports: uncertain prospects for growth in major trading partners (downside); offset by risk that the lira may weaken and boost net exports. - External financing conditions are expected to remain adequate but with considerably increased risks (Table 4). ### Monetary and exchange rate policies (Section B) - Central bank response to surge in inflation (¶6): - Adopted a tightening bias in its interest rate policy; halted its easing cycle and announced that monetary policy will be more responsive to adverse developments than favorable developments in the inflation outlook. - Staff advice: consider raising interest rates in the period ahead to anchor inflation expectations and ensure progress in reducing inflation to target over the medium term. Supporting fiscal and income policies are key to achieve further disinflation without aggravating external imbalances. - Reserve accumulation (¶7): - Central bank doubled its daily foreign currency auction purchases in October 2007 to a minimum US$30 million plus an additional optional amount of up to US$60 million. - It reduced the purchase amounts back to the previous level in March 2008 in the face of greater exchange market volatility. - The central bank is prepared to adjust its pace of predictable and moderate reserve accumulation as conditions permit to meet its goal of building reserves without adding to market volatility. ### Fiscal policy stance and composition (Section C) - Authorities target a neutral fiscal stance for 2008 (Tables 5-6; ¶10). - Primary surplus history and targets: - Primary surplus target of the last five years: 5 percent of GDP (viewed as cornerstone of past macro success). - Gross public debt down to 39 percent of GDP (Appendix II). - With gross public debt at 39 percent of GDP, a primary surplus of 5 percent is viewed as no longer necessary from a debt dynamics perspective. - Authorities’ original 2008 budget targeted a higher primary surplus of 4.2 percent of GDP, relying in part on significant compression of investment spending. - Authorities later reduced the target back to 3.5 percent of GDP to create additional fiscal space for infrastructure investment, labor market reform, and higher transfers to subnational governments. - Staff and authorities agree that some tightening from the 2007 outturn (3.5 percent of GDP) is warranted by high real interest rates, above-target inflation, the large current account deficit, and Turkey’s below-investment-grade rating. - Fiscal composition changes (¶10, ¶16): - Tentative distribution in staff projection incorporates potential effects of upward inflation revisions on revenue and on wage and pension increases. - Revenue projected to fall somewhat as a share of GDP relative to 2007, in part due to an expected revenue loss of 0.2 percent of GDP from a reduction in the VAT rate on tourism (hotels and restaurants) from 18 to 8 percent in the original budget. - Staff view: lowering VAT on tourism is undesirable (administration complications, revenue erosion, fraud opportunities, artificial activity distortions), though authorities cite comparator European treatment and competitiveness concerns. - On expenditure: current spending is compressed to safeguard capital spending. - Budget risks (¶17): - Downside risks: further electricity price increases may be insufficient to ensure state enterprises’ targeted contribution to the primary surplus; VAT reduction on tourism could prove more costly than expected. - Offsetting factors: nominal revenue projections somewhat conservative relative to upward inflation adjustment and improved revenue compliance in Q1. - Fiscal tables and projections (selected figures preserved as presented): - Reported nonfinancial public sector primary balance: 2004 5.5; 2005 5.0; 2006 4.6; 2007 3.5; 2008 3.5; Change 2007–08: 0.0. - Structural balance (percent of potential GDP) nonfinancial public sector primary balance: 2004 6.2; 2005 5.2; 2006 3.3; 2007 3.4; 2008 3.6; Change 2007–08: 0.3. - Memorandum: Potential GDP (billions of lira): 2004 577.3; 2005 655.2; 2006 759.4; 2007 862.0; 2008 989.9; Output gap (percent of potential): 2004 3.2; 2005 1.0; 2006 0.1; 2007 0.7; 2008 1.2; Change 2007–08: 0.5. - Turkey: Fiscal Program, 2008 (percent of GDP, unless otherwise indicated) selected entries: - Nonfinancial public sector primary balance: 2007 3.5; 2008 3.5; Change 2007–08 0.0. - Primary revenue: 2007 25.5; 2008 25.1; Change -0.4. - Tax revenue: 2007 17.8; 2008 17.7; Change -0.1. - VAT and excises: 2007 9.6; 2008 9.4; Change -0.2 (in part due to VAT cut on tourism). - Primary expenditure: 2007 22.9; 2008 22.4; Change -0.5. - Central government current: 2007 11.2; 2008 10.8; Change -0.4. - Central government capital: 2007 1.5; 2008 1.5; Change 0.0. - Social security: 2007 10.1; 2008 10.0; Change -0.1. *Source: IMF staff summary of paragraphs 4–5 and associated boxes and sections from the cited IMF chapter.* ### 18. The authorities will soon announce a medium-term fiscal framework to help ### _cr08272 - 18. The authorities will soon announce a medium-term fiscal framework to help ### Medium-term fiscal framework and fiscal objectives - Authorities will soon announce a medium-term fiscal framework to guide policies and expectations (¶12). - Main medium-term fiscal policy objective: lower debt further to safer levels (Turkey’s gross debt-to-GDP ratio is still high relative to European countries with similar levels of per capita income). - Framework targets 2012 gross debt at 30 percent of GDP (general government, Maastricht definition) and paths for key fiscal variables that support this objective (likely outcomes and risks under this fiscal framework and staff’s medium-term macroeconomic assumptions are in Appendix II and Table 13). - Policy mix under the scenario: - Gradual reduction in the primary surplus. - Mild restraint of the growth of personnel costs (supported by civil service reform). - Reallocation of fiscal space to increased infrastructure spending and cuts in labor and financial transaction taxes. - Institutional underpinning under study: a fiscal rule embedded in a fiscal responsibility law; authorities expect to decide prior to the 2009 budget. ### Subnational transfers and safeguards - Government considering increasing transfers to provincial and local governments by enacting legislation as early as mid-2008. - Some proposals would increase the share of central government revenue transferred to subnational governments by 0.4 percent of GDP without corresponding transfer of spending responsibilities or an attempt to claw back subnational governments’ substantial tax and other arrears. - Staff recommendation: include safeguards so the proposal is implemented in a broadly deficit-neutral and gradual manner to avoid: - Significant reduction in budget flexibility. - Rapid transfer of resources to localities with limited absorptive capacity. - Reduced space for other pressing priorities. ### Structural fiscal reform — Social security - Parliament passed a major reform on April 17, 2008 to place social security finances on a sustainable path (¶15). - Key features of the revised reform: - Gradually raises the retirement age to 65 (will eventually reach 65 for most new retirees around 2060−70; an individual’s exact retirement age will depend on several factors other than age). - Reduces replacement rates closer to internationally standard levels (Turkey will still have some of the highest replacement rates among OECD-member countries). - Indexes pension increases to consumer prices. - Officially adopts a universal health insurance system allowing flexibility in setting medical copayments to reorient demand toward primary care. - Creates a unified system once all grandfathering is phased out (currently private sector employees, the self-employed, and civil servants are covered by separate systems). - Fiscal impact estimates (World Bank staff): - Reform brings the pension system close to balance in the long run, compared to deficits in excess of 4.5 percent of GDP in the absence of reform. - In present value, staff estimate savings over the next 75 years to be around 75 percent of 2007 GDP. - Risks and uncertainty: - Large uncertainty surrounding long-run estimates. - Opposition announced it will again challenge the reform in the courts; depending on outcomes, further adjustments may be needed. ### Structural fiscal reform — Tax administration - Strengthening tax administration is a priority (¶16–17), with emphasis on VAT compliance following weak VAT collections in 2007, including from a spike in refunds. - Measures taken/planned: - Combat VAT refund fraud and move toward a risk-based refund system, reducing compliance burden for low-risk taxpayers. - Authorities evaluating consolidating all tax auditing under the Revenue Administration (RA) or alternatively merging auditing under the Ministry of Finance. - Staff advice: - Recommend consolidating all tax auditing under the RA to promote efficiency and coordination. - Advise against moving audit resources out of the RA to the Ministry of Finance as this would hamper coordination. - Measures on social security contributions: - Legislation requiring large employers to pay wages through bank accounts. - Introduction of a unified tax declaration form covering taxes due to both the RA and the Social Security Institution to facilitate cross-checking and ease administrative burden. ### Structural fiscal reform — Labor market - Authorities preparing a package of labor market reforms (¶11) aimed at encouraging employment and reducing rigidities. - Proposed measures include: - Reducing employer social security contributions by 5 percentage points (total social security contributions are currently 33.5–39 percent of wages). - Providing additional targeted incentives for youth employment. - Raising spending on active labor market policies. - Increasing the flexibility of labor regulations. - Fiscal cost and timing: - Reform is expected to cost around 0.4 percent of GDP on an annual basis (mainly from lower social security contributions). - Expected to become effective in the last quarter of 2008. - Expected outcomes: - Facilitate employment generation. - Together with better enforcement of social security contribution compliance, reduce incidence of unregistered employment. ### Energy sector: financial viability, pricing, and investment - Urgency: rising input costs and structural inefficiencies have led to large financial losses in the sector. - TEDAŞ losses estimated at 0.14 percent of GDP in 2007 due to end-user electricity tariffs not being raised between 2002−07 despite substantial international price increases. - Sectoral problems include high rates of electricity theft, loss, and nonpayment, sustained underinvestment in distribution network, discouraged upstream private investment, recent droughts impairing hydro generation, and fast electricity demand growth of 8.5 percent per year over the last five years — creating risk of near-term electricity shortages (IMF Country Report No. 07/362, Box 4). - Authorities’ comprehensive strategy (¶19) aims to: - Restore financial viability via cost-recovery pricing. - Reduce arrears (including from municipalities). - Restart privatization to generate investment and enhance efficiency and bill collection. - Tariff actions and mechanisms: - Tariffs increased on January 1, 2008 by 12.2 percent for industrial users and 19.4 percent for households and retail businesses. - Note: this price adjustment alone will not achieve the programmed contribution to the public sector primary surplus given current projections for international energy prices and the exchange rate. - Under current projections, a mid-year price increase of nearly 15 percent is needed to restore prices to a cost-recovery level going forward. - Authorities plan to implement, by July 1, 2008, an automatic cost-based pricing mechanism to adjust tariffs based on realized costs and revised end-year macroeconomic assumptions; if implemented as planned, this should improve sector finances and help attract private investment. ### Financial sector reform and risks - Financial System Stability Assessment published; some recommendations adopted (¶21). - Actions taken: - New law modernizing institutional framework for insurance sector. - Strengthened loan provisioning by distinguishing “standard” from “special mention” loans. - BRSA raised liquidity requirements for banks. - Corporate sector FX exposure risks: - Large FX indebtedness in corporate sector is a potential risk for banks and the economy. - Scarcity of hedging data hampers assessment; indications that open FX position may have widened and borrowing is predominantly at variable rates. - Potential significant component of unhedged foreign-currency liabilities in the corporate sector. - Staff recommendations and welcome steps: - Monitor FX risks closely and ensure banks’ loan policies account for FX and other market risks. - Central bank’s new survey of corporate FX exposure, plans to encourage banks to enhance oversight of corporates’ FX borrowing, and plan to enhance corporate governance and transparency through a new Commercial Code are welcome. - State bank privatization: - Authorities intend to advance state bank privatization as a key element of strategy under the Fund-supported program. - After the successful IPO of Halkbank last year, authorities intend to sell another 24 percent of Halkbank shares through a secondary equity offering later this year (¶24). - Authorities remain committed to privatizing other state-owned banks (notably Ziraat) in the years ahead. ### Program modalities, external position, and staff appraisal - This is the final review under the current Stand-By Arrangement, which ends on May 10, 2008. Completion of this review will enable Turkey to draw all remaining purchases under the current arrangement (SDR 2.25 billion, or about US$3.7 billion, ¶2–3). - External vulnerabilities have risen since the last review due to the global credit crunch, surging import prices, higher projected current account deficits and external debt, and heightened domestic political tensions. - Despite increased vulnerabilities, indicators of Fund credit suggest a strong capacity to repay the Fund (Table 10). - Staff appraisal summary: - Economic performance and policy implementation mixed since last review; supply shocks have weighed on growth and fueled inflationary pressure; 2007 elections distracted from implementation. - Global credit crunch dampens outlook and heightens vulnerabilities; high and rising current account deficits worsen external debt outlook and increase dependence on external financing. - Strategy for resilience centers on: - Adapting monetary policy to achieve low, stable inflation. - Strengthening public sector balance sheets by lengthening debt maturities, adhering to a medium-term fiscal framework geared toward continued debt reduction, and implementing broad fiscal reforms. - Increasing banking system resilience by building cushions and stepping up oversight. - Fostering private-sector led growth through structural reforms including privatization, tax and energy reforms, and labor market liberalization. - Maintaining a floating exchange rate to act as a flexible shock absorber and encourage hedging against exchange rate risk. - Recent progress includes: - Adoption of social security law. - Significant hikes in end-user electricity prices. - Resumption of privatization process for electricity distribution companies. - Adoption of key tax administration reforms (requiring large firms to pay salaries through bank accounts, unified tax declaration form, risk-based system for VAT refund fraud). - Tightening of bank provisioning and liquidity requirements. *Source: _cr08272.* ### 35. To preserve the credibility of the inflation targeting regime, monetary policy ### To preserve the credibility of the inflation targeting regime, monetary policy ### Monetary policy and inflation - Monetary policy should respond promptly to broadening price pressures. - In response to the recent supply shocks to inflation, the central bank has halted its easing cycle and adopted a clear tightening bias. - With mounting signs that these shocks are starting to exert second-round effects on broader price-setting behavior, monetary policy will need to be tightened in the coming months to restart disinflation and avoid lasting damage to credibility. ### Fiscal stance and targets - Achieving the fiscal targets would underpin investor confidence and further strengthen public sector balance sheets. - A somewhat tighter fiscal stance in 2008 would have been preferable in light of macroeconomic imbalances and to provide a larger cushion against heightened risks. - The current targets provide more space for initiatives (labor tax cuts and infrastructure investment), but leave little room for slippage. - Imperatives: - Secure the fiscal targets by keeping spending to budgeted levels. - Avoid erosion of the tax base through measures such as the VAT rate cut for tourism, which would complicate administration and distort economic activity. ### Medium-term fiscal framework and debt goal - Staff welcomes the adoption of a medium-term fiscal framework and encourages strengthening its institutional underpinnings. - Authorities’ goals and commitments: - Lower gross debt to 30 percent of GDP by 2012. - Stick to the announced primary surplus target for 2009 (3 percent of GDP) and beyond. - Required actions: - Restrain nonessential current spending to make room for priority infrastructure spending and tax cuts. - Adjust policies when needed to preserve the attainability of the debt target. - Consider a stronger institutional framework (e.g., a fiscal responsibility law) to realize restraint of current spending and reduce risk premia by bolstering fiscal policy credibility. ### Fiscal structural reforms (implementation priorities) - Rapid progress on fiscal structural reforms is needed to achieve the authorities’ medium-term fiscal policy goals. - Priority areas for efficiency improvements: - Revenue administration. - Social security contribution collection. - Health spending. - Civil service. - These reforms are essential to create fiscal space to ease Turkey’s heavy tax burden and increase high-priority spending, while sustaining debt reduction. - As outlined in their LOI, the authorities have a significant program of structural reforms in these areas, which should be implemented expeditiously. - Specific recommendation: - Amalgamate tax auditing capability under the Revenue Administration as a key priority to reduce tax evasion and widespread informality. - Concern and guidance on subnational transfers: - Staff is concerned about the large costs of the authorities’ plans to increase transfers to subnational governments, which would likely further aggravate budget rigidity. - Authorities are urged to consider ways to make this reform fiscally neutral or to implement it gradually to give subnational governments time to strengthen their financial management and control capacity. ### Energy sector reform - Energy sector reform is especially critical in light of looming electricity shortages and mounting quasi-fiscal losses at state-owned energy enterprises. - Recent actions: - The recent end-user price increase was a critical first step to reduce losses, expand resources for investment, and provide stronger incentives for conservation. - The resumption of the privatization of electricity distribution companies will facilitate investment and efficiency improvements. - Follow-up measures recommended: - Timely implementation of an automatic pricing mechanism that ensures full pass-through of input costs. - Measures to improve collections (including from municipalities). - Further privatization of electricity distribution and generation. ### Financial sector reform - Financial sector reforms are essential to mitigate vulnerabilities and create an environment conducive to sustained growth. - Staff welcomes recent actions: - Strengthening of provisioning and liquidity requirements. - Initiatives to enhance monitoring of corporate FX borrowing—a key indirect risk to the banking system. - Recommendation: - Advance state bank privatization as market conditions permit to improve efficiency in the sector. ### IMF staff recommendations and approvals - Staff recommends completing the seventh review and inflation consultation and approving the authorities’ request for waivers (¶2-3). - Rationale: - Despite slippages in 2007, the authorities’ renewed reform momentum of recent months and forward-looking policy commitments deserve the support of the international community. - Staff supports requests for waivers of nonobservance of fiscal performance criteria for end-December 2007 in light of the authorities’ restraint of current spending in the 2008 budget and the adoption of key fiscal reforms, which together are envisaged to strengthen the fiscal outlook. *IMF staff report excerpt.* ### 42. The current SBA has overachieved on many key objectives—sustaining this ### _cr08272 - 42. The current SBA has overachieved on many key objectives—sustaining this ### Overview and staff assessment - "The current SBA has overachieved on many key objectives—sustaining this success will require unwavering commitment to reform." - Under the current SBA, strong policies (especially in the first half of the arrangement) and a favorable external environment helped Turkey dramatically reduce public debt and bolster international reserves. - "Turkey remains, however, exposed to external and domestic-political shocks, which leave limited scope for policy error." - "Important structural challenges also remain which constrain Turkey’s growth potential." - Staff recommendation: "Staff encourages the authorities to capitalize on recent economic successes and secure durable improvements in living standards by staying the course of disciplined macroeconomic policies and pursuing structural reforms with vigor." ### Real sector — performance and projections - Real GDP growth rate: 2003: 5.3; 2004: 9.4; 2005: 8.4; 2006: 6.9; 2007: 4.0; 2008: 4.5; 2009: 4.0 (Table 2 and Table 13). - Private consumption growth rate: 2003: 10.2; 2004: 11.0; 2005: 7.9; 2006: 4.6; 2007: 2.8; 2008: 4.6; 2009: 2.7. - Private gross fixed investment growth rate: 2003: 23.7; 2004: 36.1; 2005: 16.2; 2006: 15.0; 2007: 5.5; 2008: 2.7; 2009: 7.5. - Contributions to GDP growth (selected): Private domestic demand 2003: 9.5; 2004: 11.4; 2005: 8.8; 2006: 6.3; 2007: 3.9; 2008: 5.4; 2009: 3.6. Net exports 2003: -3.3; 2004: -2.4; 2005: -1.4; 2006: -0.3; 2007: -1.1; 2008: -1.5; 2009: -0.2. - Inflation: GDP deflator growth rate 2003: 23.3; 2004: 12.4; 2005: 7.1; 2006: 9.3; 2007: 8.1; 2008: 8.1; 2009: 9.9. CPI inflation (12-month; end-of period) 2003: 18.4; 2004: 9.4; 2005: 7.7; 2006: 9.7; 2007: 8.4; 2008: 8.4; 2009: 9.3. ### Fiscal outcomes and public finances - Central government primary balance (percent of GDP): 2003: 3.8; 2004: 4.1; 2005: 4.1; 2006: 4.3; 2007: 3.3; 2008: 2.5; 2009: 2.7. - Central government overall balance (percent of GDP): 2003: -8.7; 2004: -5.3; 2005: -1.6; 2006: -1.2; 2007: -3.6; 2008: -2.7; 2009: -2.8. - Nonfinancial public sector primary balance (percent of GDP): 2003: 4.8; 2004: 5.5; 2005: 5.0; 2006: 4.6; 2007: 4.6; 2008: 3.5; 2009: 3.5. - Nonfinancial public sector overall balance (percent of GDP): 2003: -7.2; 2004: -3.6; 2005: -0.3; 2006: -0.5; 2007: -1.8; 2008: -1.4; 2009: -1.8. - General government gross debt (EU definition): 2003: 67.4; 2004: 59.2; 2005: 52.3; 2006: 46.1; 2007: 38.8; 2008: 37.3; 2009: 34.8. - Net debt (authorities' definition): 2003: 55.2; 2004: 49.1; 2005: 41.7; 2006: 34.2; 2007: 38.5; 2008: 29.0; 2009: 29.1. - Public sector fiscal structure (Table 5 and 6, selected 2007 shares of GDP): Primary revenue 21.9; Tax revenue 18.1; Primary expenditure 18.1; Transfers 7.4; Social security institutions 3.5; Capital expenditure 1.7. ### External sector — balances, financing, and reserves - Current account balance (billions of U.S. dollars, Table 3): 2003: -7.5; 2004: -14.4; 2005: -22.1; 2006: -31.9; 2007: -37.4; 2008: -47.9; 2009: -46.8. - Current account balance (percent of GDP): 2003: -2.5; 2004: -3.7; 2005: -4.6; 2006: -6.0; 2007: -5.7; 2008: -6.4; 2009: -6.1 (Table 3 memorandum). - Trade balance (billions of U.S. dollars): 2003: -13.5; 2004: -22.7; 2005: -33.0; 2006: -40.9; 2007: -46.8; 2008: -57.1; 2009: -55.3. - Exports (f.o.b., billions): 2003: 52.4; 2004: 68.5; 2005: 78.4; 2006: 93.6; 2007: 115.3; 2008: 139.7; 2009: 156.1. - Imports (f.o.b., billions): 2003: -65.9; 2004: -91.3; 2005: -111.4; 2006: -134.6; 2007: -162.1; 2008: -196.8; 2009: -211.4. - Gross foreign reserves (Central Bank of Turkey, billions of U.S. dollars): 2003: 35.2; 2004: 37.6; 2005: 52.2; 2006: 63.3; 2007: 76.5; 2008: 86.4; 2009: 88.9. - Gross external debt (end-of-period, billions of U.S. dollars): 2003: 144.3; 2004: 160.8; 2005: 168.7; 2006: 205.5; 2007: 247.2; 2008: 287.5; 2009: 319.8. - Gross external debt (percent of GDP): 2003: 44.2; 2004: 38.4; 2005: 35.0; 2006: 38.4; 2007: 33.7; 2008: 41.1; 2009: 42.9. - Net external debt (end-of-period, billions of U.S. dollars): 2003: 96.4; 2004: 102.8; 2005: 98.5; 2006: 108.1; 2007: 133.3; 2008: 166.5; 2009: 195.5. ### External financing needs and composition - Gross financing requirement (billions of U.S. dollars): 2003: 45.3; 2004: 64.4; 2005: 76.1; 2006: 109.9; 2007: 118.0; 2008: 129.5; 2009: 135.0. - Net foreign direct investment (billions of U.S. dollars): 2003: 0.4; 2004: 0.5; 2005: 1.9; 2006: 3.6; 2007: 4.0; 2008: 3.0; 2009: 1.7. - Portfolio flows (selected): 2003: 7.8; 2004: 13.2; 2005: 18.1; 2006: 13.9; 2007: 6.5; 2008: 9.5; 2009: 11.0 (Table 4). ### Monetary aggregates and central bank - Broad money (M2Y) nominal growth and levels (selected): M2Y (billions of new Turkish lira) 2003: 229.5; 2004: 237.4; 2005: 267.0; 2006: 270.2; 2007: 284.9; 2008: 279.0; 2009: 293.7 (Table 7). - Net international reserves (Central Bank of Turkey, billions of U.S. dollars): 2003: -0.5; 2004: 1.3; 2005: 22.4; 2006: 32.6; 2007: 43.8; 2008: 52.7; 2009: 58.5 (Table 3 memorandum and Table 8). - Average nominal treasury bill interest rate (selected): 2003: 45.1; 2004: 24.7; 2005: 16.2; 2006: 18.1; 2007: 18.1; 2008: 18.1. - Average ex-ante real interest rate (selected): 2003: 33.9; 2004: 15.3; 2005: 6.0; 2006: 8.6; 2007: 7.5; 2008: 7.5. ### Banking system indicators - Banking system total assets (selected, millions of new Turkish lira): 2001: 97,930; 2002: 119,471; 2003: 142,270; 2004: 175,924; 2005: 237,043; 2006: 265,783; 2007: 274,651. - Nonperforming loans (percent of total loans, banking system): 2001: 29.3; 2002: 17.6; 2003: 11.5; 2004: 6.0; 2005: 4.8; 2006: 3.8; 2007: 3.5. - Capital adequacy ratio (banking system, percent): 2001: 15.3; 2002: 25.3; 2003: 30.9; 2004: 28.8; 2005: 24.2; 2006: 22.1; 2007: 19.0. - Net profit (loss) after tax, banking system (selected): 2001: -9,910; 2002: 2,336; 2003: 5,678; 2004: 6,451; 2005: 5,714; 2006: 10,973; 2007: 3,325. ### Medium-term scenario and vulnerability indicators - Medium-term real GDP projections (Table 13): 2008: 4.0; 2009: 4.3; 2010–2013: 5.0 each year in baseline projection table. - Medium-term fiscal baseline: Nonfinancial public sector primary surplus (percent of GDP) 2003–07 average 4.7; projected 2008–13 average 2.7. - Current account (percent of GDP) trend and projections: 2003: -2.5; 2004: -3.7; 2005: -4.6; 2006: -6.0; 2007: -5.7; 2008: -6.4; baseline projected to remain large in medium term (Table 13). - External debt dynamics (Table on external debt decomposition): Baseline external debt (percent of GDP) 2002: 60.7; 2003: 44.2; 2004: 38.4; 2005: 35.0; 2006: 38.4; 2007: 33.7; 2008: 41.1; projected to rise to 48.7 by 2013 under baseline. - Gross external financing need (billions of U.S. dollars): 2003: 38.9; 2004: 44.2; 2005: 60.4; 2006: 81.9; 2007: 99.3; 2008: 115.6; 2009: 130.6; projected to increase to 192.5 by 2013; percent of GDP: 2003: 18.2; 2004: 13.5; 2005: 14.4; 2006: 17.0; 2007: 18.6; 2008: 15.8; 2009: 18.7; projected rising to 20.5 by 2013. ### Policy implications and recommendations - Maintain disciplined macroeconomic policies to preserve fiscal gains and reserve buffers. - Pursue structural reforms with vigor to raise growth potential and reduce vulnerability to external shocks. - Monitor external financing needs closely given large and rising gross external financing requirements and sizeable current account deficits. - Continue efforts to reduce gross public debt and net public sector debt as achieved under the SBA, while guarding against slipping primary balances. *Sources: Turkish authorities; and IMF staff estimates and projections.* ### Appendix Table I.1. Turkey: External Debt Sustainability Framework, 2002–13 ### Appendix Table I.1. Turkey: External Debt Sustainability Framework, 2002–13 ### External debt dynamics and baseline projections - External debt and related indicators are presented as percent of GDP for 2002–13 (projections). - Figures and charts include baseline and scenario projections, with shaded areas representing actual data (estimated for 2007). - Individual shocks in bound tests are permanent one-half standard deviation shocks; combined shocks use permanent 1/4 standard deviation shocks. - A one-time real depreciation scenario uses a 30 percent real depreciation in 2008. ### Key scenario descriptions and average projection boxes shown in figures - Individual scenarios shown include: - Interest rate shock (i-rate shock) comparisons with baseline. - Non-interest current account shock. - Growth shock. - Real depreciation shock (one-time real depreciation of 30 percent occurs in 2008). - Combined shock (permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance). - Figures present average projections for the respective variables in the baseline and scenario, and show ten-year historical averages. *Source: IMF staff estimates.* --- ### Appendix II: Public Debt Sustainability Analysis ### Major findings (2007 and historical context) - Ratios of net debt to GDP continued to fall in 2007 at a rapid pace. - Net debt of the public sector fell 5 percentage points of GDP to 29 percent. - Net debt declines were also recorded in: - Nonfinancial public sector (NFPS) net debt and gross measures of debt. - Reduction in debt levels since 2001: net debt more than halved during this period. - A strong appreciation of the lira in 2007 accounted for 2½ percentage points of NFPS debt reduction. - Contributions of fiscal policy and growth in 2007 were positive but smaller than their average contributions during the previous three years. ### Public sector debt levels, selected series (percent of GDP) - Net debt (public sector, NFPS, general government, central government) and gross debt series are shown for 2001–2007 in the source table. - Memorandum item: General government gross debt (EU definition) at end-2007: 38.8 percent of GDP. - Public sector net debt (public sector, NFPS, general government, central government) numbers for 2001–2007 are presented in the source tables (exact yearly values preserved in the original tables). ### Medium-term fiscal framework (MTFF) objective and staff projection - Authorities’ MTFF objective: reduce general government gross debt (GGGD) under the European Union definition to 30 percent of GDP by 2012 (from 39 percent of GDP at end-2007). - MTFF underpinned by: - Gradually declining primary surpluses (from 3½ percent of GDP in 2008 to 2½ percent of GDP in 2012). - Privatization receipts projected to yield cumulative receipts of 3½ percent of GDP during 2008–12. - Staff projection under conservative macroeconomic assumptions (growth averaging 4.7 percent during 2008–12): gross debt would decline gradually to 30 percent of GDP by 2012. ### Stress tests and tailored scenarios: key assumptions and outcomes - Stress tests are carried out in terms of NFPS net debt. - Tailored stress tests considered: - C1. Persistent deterioration in the global environment (large global liquidity shock) - Assumes: sharp lira depreciation by 30 percent, increase in real interest rates by 500 basis points during 2008–09, growth slowing to 2½ percent during 2008–09; economy returns to baseline thereafter. - Outcome: debt rises in the near term by 8 percentage points and then declines very slowly. - C2. Transient deterioration in the global environment - Assumes: exchange rate depreciates by 10 percentage points over the baseline, interest rates increase by 200 basis points over the baseline, growth slows temporarily to 2½ percent. - Outcome: debt increases by some 2 percentage points of GDP in the near term but resumes decline afterwards. - C3. Domestic policy complacency - Assumes: loss of fiscal discipline via revenue-reducing tax changes, large net increases in transfers to subnational governments, ambitious capital expenditure from 2009 without offsets; primary surplus falls to ½ percent of GDP in 2012; structural reforms stall; real interest rates increase by 250 basis points by end of projection period; potential growth slows to 4 percent. - Outcome: debt ratios plateau at 4 percentage points above the 2012 baseline level. ### Interpretation and policy implication - The scenarios underscore the importance of preserving fiscal discipline to safeguard debt sustainability. - Reported debt-stabilizing primary surplus: currently around 2 percent of GDP. - The debt-stabilizing primary surplus is not far below the central government primary surplus for 2009 envisaged in the authorities’ MTFF: 2.3 percent of GDP. - Policy recommendation: continue to build cushions against future shocks. --- ### Appendix Table II.1. Turkey: Public Sector Debt Sustainability Framework, 2002–13 (selected data and projections) ### Selected historical and projection values (percent of GDP) - General government gross debt (/1 Maastricht-consistent): - 2002: 73.7 - 2003: 67.4 - 2004: 59.2 - 2005: 52.3 - 2006: 46.1 - 2007: 38.8 - 2008: 37.3 - 2009: 34.8 - 2010: 33.1 - 2011: 31.5 - 2012: 30.2 - 2013: 29.2 - Nonfinancial (NFPS) public sector net debt: - 2002: 68.8 - 2003: 60.6 - 2004: 54.1 - 2005: 46.3 - 2006: 40.2 - 2007: 34.0 - 2008: 32.2 - 2009: 29.8 - 2010: 27.7 - 2011: 25.6 - 2012: 23.8 - 2013: 22.3 - Foreign-currency denominated share of NFPS net debt: - 2002: 38.5 - 2003: 27.3 - 2004: 22.0 - 2005: 16.5 - 2006: 13.9 - 2007: 12.0 - 2008: 12.0 - 2009: 10.8 - 2010: 9.5 - 2011: 8.6 - 2012: 8.1 - 2013: 7.9 ### Debt dynamics components and projections (percent of GDP) - Change in NFPS net debt: - 2002: -7.2 - 2003: -8.2 - 2004: -6.5 - 2005: -7.8 - 2006: -6.1 - 2007: -6.3 - 2008: -1.8 - 2009: -2.3 - 2010: -2.2 - 2011: -2.1 - 2012: -1.8 - 2013: -1.5 - Identified debt-creating flows: - 2002: -11.7 - 2003: -7.5 - 2004: -8.2 - 2005: -8.1 - 2006: -7.9 - 2007: -4.7 - 2008: -3.5 - 2009: -2.8 - 2010: -2.5 - 2011: -2.4 - 2012: -2.0 - 2013: -1.7 - Primary deficit (percent of GDP): - 2002: -3.2 - 2003: -4.9 - 2004: -5.5 - 2005: -5.1 - 2006: -4.6 - 2007: -3.5 - 2008: -3.5 - 2009: -3.0 - 2010: -2.7 - 2011: -2.5 - 2012: -2.4 - 2013: -2.4 - Automatic debt dynamics (contribution from interest rate/growth differential): - 2002: -8.1 - 2003: -2.3 - 2004: -2.2 - 2005: -2.2 - 2006: -1.6 - 2007: 0.3 - 2008: 1.0 - 2009: 1.2 - 2010: 0.9 - 2011: 0.7 - 2012: 0.7 - 2013: 0.7 - Contribution from real interest rate (component of automatic dynamics): - 2002: -4.9 - 2003: 0.5 - 2004: 2.4 - 2005: 1.7 - 2006: 1.2 - 2007: 1.9 - 2008: 2.2 - 2009: 2.5 - 2010: 2.3 - 2011: 2.0 - 2012: 1.9 - 2013: 1.8 - Contribution from real GDP growth (component of automatic dynamics): - 2002: -3.2 - 2003: -2.8 - 2004: -4.6 - 2005: -3.9 - 2006: -2.7 - 2007: -1.6 - 2008: -1.2 - 2009: -1.3 - 2010: -1.4 - 2011: -1.3 - 2012: -1.2 - 2013: -1.1 - Contribution from exchange rate depreciation (selected): - 2002: 4.9 - 2003: -4.9 - 2004: -1.0 - 2005: 0.0 - 2006: 0.8 - 2007: -2.5 - (further entries indicated with ellipses in source) ### Other identified flows and residuals (percent of GDP) - Other identified debt-creating flows: - 2002: -0.4 - 2003: -0.4 - 2004: -0.4 - 2005: -0.8 - 2006: -1.7 - 2007: -1.5 - 2008: -1.0 - 2009: -0.9 - 2010: -0.6 - 2011: -0.5 - 2012: -0.2 - 2013: 0.0 - Privatization receipts (negative): - 2002: -0.2 - 2003: -0.1 - 2004: -0.3 - 2005: -0.6 - 2006: -1.6 - 2007: -1.4 - 2008: -1.2 - 2009: -1.0 - 2010: -0.7 - 2011: -0.5 - 2012: -0.2 - 2013: 0.0 - Residual, including asset changes 2/: - 2002: -0.4 - 2003: 4.2 - 2004: 2.7 - 2005: 0.3 - 2006: 1.0 - 2007: 0.9 - 2008: 1.7 - 2009: 0.4 - 2010: 0.3 - 2011: 0.3 - 2012: 0.1 - 2013: 0.2 ### Key macroeconomic and fiscal assumptions (historical and projections) - Real GDP growth (in percent): historical 2002–07 series and projections: - Historical (selected years): 2002: 6.2; 2003: 5.3; 2004: 9.4; 2005: 8.4; 2006: 6.9; 2007: 4.5 - Projections: 2008: 4.7; 2009: 5.1; 2010: 4.0; 2011: 4.3; 2012: 5.0; 2013: 5.0 - Average nominal interest rate on public debt (in percent) 3/: - Historical and projections include values such as 2002: 30.4; 2003: 25.4; 2004: 18.5; 2005: 11.4; 2006: 12.9; 2007: 13.7; 2008: 42.1; 2009: 32.3; 2010: 17.6; 2011: 14.1; 2012: 12.6; 2013: 11.9; subsequent standard projections: 12.1; 12.3 (as shown). - Average real interest rate (nominal rate minus change in GDP deflator, in percent): - Historical and projections include: 2002: 7.1; 2003: 13.0; 2004: 6.1; 2005: 4.3; 2006: 3.6; 2007: 5.6; 2008: 15.5; 2009: 13.7; 2010: 7.7; 2011: 8.7; 2012: 8.6; 2013: 7.9; projections: 8.1; 8.3. - Nominal appreciation (increase in U.S. dollar value of local currency, in percent): - Historical: 2002: -11.9; 2003: 17.1; 2004: 4.0; 2005: -0.1; 2006: -5.0; 2007: 21.3; 2008: -12.4; 2009: 24.9; further entries include ellipses in the source. - Inflation rate (GDP deflator, in percent): - Historical and projections include: 2002: 37.4; 2003: 23.3; 2004: 12.4; 2005: 7.1; 2006: 9.3; 2007: 8.1; 2008: 33.0; 2009: 24.3; 2010: 9.9; 2011: 5.4; 2012: 4.0; 2013: 4.0; projections thereafter: 4.0; 4.0. - Primary deficit (percent of GDP) (repeated here for emphasis): - 2002: -3.2; 2003: -4.9; 2004: -5.5; 2005: -5.1; 2006: -4.6; 2007: -3.5; 2008: -3.5; 2009: -3.0; 2010: -2.7; 2011: -2.5; 2012: -2.4; 2013: -2.4 ### Alternative and bound test outcomes (selected entries from Table II.1) - A. Alternative Scenarios (based on NFPS net debt) - A1. Key variables at historical averages in 2008–13: 2007 NFPS net debt 34.0 → 2008: 33.3 → 2013: 29.8 (selected series shown). - A2. No policy change (constant primary balance) in 2008–13: 2007: 34.0 → 2008: 31.1 → 2013: 15.3 (selected series shown). - A3. 2008 GDP growth reduced by one standard deviation relative to baseline: 2007: 34.0 → 2008: 32.8 → 2013: 20.1 (selected series shown). - B. Bound Tests (based on NFPS net debt) - B1. Real interest rate at historical average plus one-half standard deviation: 2007: 34.0 → 2008: 36.8 → 2013: 56.9 (selected series shown). - B2. Real GDP growth at historical average minus one-half standard deviation: 2007: 34.0 → 2008: 31.7 → 2013: 24.8. - B3. Primary balance at historical average minus one-half standard deviation: 2007: 34.0 → 2008: 33.2 → 2013: 24.2. - B4. Combination of B1–B3 using one-quarter standard deviation shocks: 2007: 34.0 → 2008: 36.5 → 2013: 50.9. - B5. One-time 30 percent real depreciation in 2008 4/: 2007: 34.0 → 2008: 37.9 → 2013: 29.4. - B6. 10 percent of GDP increase in other debt-creating flows in 2006: 2007: 34.0 → 2008: 41.3 → 2013: 33.5. - C. Tailored Tests (selected outcomes) - C1. Deterioration in global environment (liquidity tightening and low world growth): 2007: 34.0 → 2008: 40.4 → 2013: 38.9. - C1 (Temporary deterioration): 2007: 34.0 → 2008: 33.8 → 2013: 24.2. - C3. Domestic policy complacency: 2007: 34.0 → 2008: 32.2 → 2013: 29.2. Notes from table footnotes: - 1/ General government debt consistent with the Maastricht definition. - 2/ For projections, this line includes exchange rate changes. - 3/ Derived as nominal interest expenditure divided by previous period debt stock. - 4/ Real depreciation defined as nominal depreciation minus domestic inflation (GDP deflator). - 5/ C1 assumes a 30 percent depreciation in 2008 over the baseline, and a 500 bps increase in real interest rates in 2008–09, which reduces growth to 2.5 percent in these years. From 2010–13 interest rates will gradually ease 100 bps each year, while growth gradually accelerates to its 5 percent trend. - 6/ Assumes a 10 percent depreciation, interest rates above baseline by 200 bps, and growth at 2.5 percent in 2008. - 7/ Domestic policy complacency description: revenue-reducing reforms, local government reform, and ambitious capital expenditure plans implemented without offsetting spending compression; no new structural reforms; real interest rate creeps up and growth remains at 4 percent. --- *Italic: Source: IMF staff estimates and Appendix tables and figures in the original document.* ### 3. In light of this recent progress, we request completion of the Seventh Review under ### _cr08272 - 3. In light of this recent progress, we request completion of the Seventh Review under ### Request for Seventh Review and Waivers - Request completion of the Seventh Review under the Stand-By Arrangement. - Request waivers for the end-December performance criteria on: - the primary surplus of the consolidated government sector, - the primary surplus of the consolidated government sector excluding SEEs, - the primary spending of the central government and social security institutions, - the balance of the social security institutions. - This will be the final review under the current Stand-By Arrangement, which ends on May 10, 2008, and will enable Turkey to draw all remaining purchases under the current arrangement (SDR 2.25 billion, or about US$3.7 billion). ### Macroeconomic framework for 2008 - 2007 GDP growth: 4½ percent (one-half percentage point below original target). - 2007 factors for slower activity: drought-related shortfall of agricultural production and a weakening of net exports. - Revised growth target for 2008: around 4½ percent. - Export volumes in 2007: grew by 10.9 percent. - Import growth in 2007: 11.1 percent for the year as a whole. - Current account deficit: - 2007: declined to 5.7 percent of GDP, from 6.0 percent of GDP in 2006. - 2008 projection: expected to increase slightly back to around 6½ percent of GDP, mainly on account of surging oil prices. - External financing in 2007: foreign direct investment covered more than half of the current account deficit (driven mainly by strong private merger and acquisition activity). - Foreign direct investment in 2008: expected to exceed one-fourth of the current account deficit, supported by ongoing mergers and acquisitions and the resumption of privatization activity. - Authorities’ stance: monitoring current and capital account developments closely and prepared to adjust policies as needed in light of the recent credit crunch and repricing of risk in global markets. ### Monetary policy - Central bank stance since mid-2006: tight monetary policy leading to a marked decline in core inflation from early 2007. - Recent headline inflation pick-up: largely reflects surging global commodity prices and domestic price and tax adjustments. - Specific price adjustments affecting headline inflation: - November adjustment of specific excises on petroleum products and tobacco. - January increase in end-user energy prices to reflect higher input costs (paragraph 19). - These adjustments: exerted some temporary upward pressure on headline inflation but are expected to support lower inflation in the medium term by contributing to a prudent fiscal stance and expanding domestic energy supply. - Interest rate policy: continued easing of core inflation allowed a gradual reduction in interest rates during September 2007 to February 2008. - Outlook and risks: macroeconomic policies expected to remain supportive of further disinflation; volatile energy and food prices and international financial market uncertainties pose upward risks to the inflation outlook. - Central bank operational principle: policy geared toward containing second-round effects and bringing inflation down to the official target by being more responsive to adverse developments than favorable developments to the inflation outlook. - Exchange rate and reserves policy: - Commitment to the floating exchange rate system. - Accumulating international reserves remains a key objective. - Daily minimum purchase amount recently reduced to US$15 million (from the US$30 million announced in the central bank’s yearly program for 2008), with the option for banks to sell up to US$30 million in additional foreign exchange to the central bank. - Retain the option to change daily auction/optional selling amounts, temporarily suspend auctions in extreme circumstances, and use discretionary intervention to prevent excessive exchange rate volatility. ### Fiscal policy - Historical role: high primary surpluses of the past several years have driven declines in the debt-to-GDP ratio, inflation, and real interest rates. - Shift in framework: replace the primary surplus target of 6.5 percent of (pre-revision) GNP with an explicit medium-term fiscal framework anchored to a debt reduction objective and strengthened institutional arrangements for expenditure restraint (paragraph 12). - Short-term fiscal aim: support central bank disinflation efforts and reduce pressures on the external current account. - 2007 outcome: higher-than-planned spending and weaker-than-expected revenue resulted in a lower-than-targeted primary surplus. - Tax administration: stepped-up collection efforts have begun to yield a recovery in revenue in late 2007 and early 2008. - Revised 2008 budget target: a primary surplus of no less than 3½ percent of GDP, in line with the 2007 outturn. - Revisions for 2008 accommodate: acceleration of labor market reforms (previously planned for 2009) and some priority investment projects, cumulatively amounting to no more than ½ percent of GDP in 2008. - Measures to promote achievement of the 2008 target: - Boost revenue by adjusting specific excises on petroleum products and tobacco, and strengthen tax administration; readiness to implement additional measures if revenues fall short or other assumptions do not materialize. - Expenditure as a share of GDP expected to be slightly lower than in 2007; hiring caps maintained (limiting replacement of civil servants leaving to attrition to 50 percent) to contain the wage bill. - To contain the Social Security Institution (SSI) deficit: implementing measures to improve health spending efficiency (paragraph 13). - Recent price increases for electricity and natural gas expected to improve SEEs’ 2008 income by 0.4 percent of GDP (relative to what it would have been otherwise). ### Short-term labor and health measures - Labor market reform package (cost to 2008 budget contained to less than ¼ percent of GDP) includes: - Reduce nonfinancial burdens, including easing special hiring and licensing requirements for private companies. - Expand active labor market programs. - Ease restrictions on temporary employment. - Reduce employers’ social security contributions by 5 percentage points, with additional targeted incentives for youth employment. - Health system measures for 2008: - Adopted tight global caps for state hospitals’ 2008 budgets on a quarterly basis. - Used the “discount” system to legally settle all 2007 invoices and renewed this authority in March to apply the same system in 2008. - Soon to announce differentiated copayments for outpatient services with payments increasing with level of service: - Between 0 and 2 YTL for primary care, - Between 5 and 10 YTL for secondary care, - Between 8 and 10 YTL for tertiary care services, - 100 percent discount for secondary and tertiary care with a physician referral. - Technical preparations under way for a referral system and early adoption of differentiated copayments. - Plan to publish an actuarial report on health finances by end-June 2008. - Expansion of the family medicine system extended to 20 regions by April 2008. ### Medium-term fiscal framework and transparency - Prior action: soon announce a revised medium-term fiscal plan, including: - a debt reduction target to 30 percent of GDP in gross terms as per the Maastricht definition by 2012, - a path for the primary surplus and primary spending consistent with meeting this target (details to be posted on www.hazine.gov.tr). - Commitment to preserve the primary surplus target in the near term (2009) even if debt falls below projections. - Study alternative options to institutionalize the framework with a decision before the 2009 budget. - Fiscal transparency steps: - Started releasing fiscal statistics in line with a preannounced release calendar. - Publishing more data on sectors outside the central government, including the social security institution, SEEs, and revolving funds. - Will publish accounts that consolidate the central government and social security institution. ### Measures regarding SEEs and energy sector - SEE employment policy: continue to replace no more than 10 percent of employees leaving SEEs. - Maintain excise taxes and SEE prices (including energy prices) in line with program assumptions, or promptly take corrective measures. - Prohibitions: refrain from (i) introducing sectoral tax cuts that would undermine the structure of the VAT or income tax, or (ii) creating any extrabudgetary fund that would prejudice fiscal transparency and financial discipline. - Energy sector financial viability plan combines four elements: - An upfront adjustment of end-user electricity tariffs. - Implementation of a reliable, automatic pass-through mechanism. - Resolution of nonpayment by municipalities. - Swift resumption of the sectoral privatization strategy. - Implemented a 16½ percent increase in average end-user tariffs for electricity on January 1, 2008. - Adopted, effective July 1, 2008, an automatic price adjustment mechanism that will ensure full pass-through and create a reliable basis for future private investment in the sector. - Preparing an action paper to resolve nonpayment by municipalities (including street lighting) and reduce technical losses and theft. - Tender process soon to be launched for privatization of four regional electricity distribution companies (prior action); may review possible need to adjust performance targets and investment obligations for distribution companies under the original timetable. - Commitment to privatize generation companies in due course. ### Structural fiscal reforms and tax administration - Social security reform: - Parliament adopted a revised social security reform law addressing Constitutional Court objections to Law 5510 while retaining most of Law 5510’s savings. - The reform establishes a new universal health insurance framework and authorizes the Social Security Institution to set differentiated copayment rates for outpatient services between primary, secondary, and tertiary levels. - Expect to implement the law in its entirety starting from October 2008. - Interim measure: ensure pension increases do not exceed growth rates implied by indexation parameters in the new law before it comes into force. - Measures to improve social security contribution collection: - Adopted a legal framework requiring large employers to pay salaries through bank accounts (prior action). - Established special departments focused on debt collection issues within the Social Security Institution. - Working to establish a separate subdivision within the Department of Premium Collection in the Social Security Institution to deal with large employers. - Operationalizing Large Employer Offices in Istanbul, Ankara, and Izmir, expected to start operations by end-September 2008. - Passed legislation enabling a unified tax declaration form, intended for implementation by end-2008. - Tax administration improvements: - Expanded auditors assigned to the Large Taxpayer Unit to 50, with plans to add more as suitable candidates are identified. - Measures to guard against VAT refund fraud: - Eliminated ability to offset third-party tax liabilities (limiting offsets to the claimant’s own liabilities). - Introduced a risk-based audit system for VAT cash refunds with a pilot system (prior action) to be expanded by end-2008 if results are positive; in the interim, post-refund audits of offsets will be introduced. - Will soon introduce monthly cross-matching of purchase and sales invoices for larger taxpayers. - Will raise audit staff levels from 5 to 10 percent of total resources over the medium term. - To improve compliance: - Will review penalties for serious fraud and evasion with the goal of strengthening sanctions by end-2008. - Will remove the option to pay a fine to avoid custodial sentences by end-2008. - Will enhance cash teams by introducing test purchasing backed up by verification. - Civil service reform commitment: improve efficiency, eliminate discrepancies between pay for equal work (by consolidating the legal framework governing salary setting), and contain personnel costs through strengthened monitoring of employment and pay policy changes. ### Financial sector reforms - Supervisory and regulatory alignment with international best practices continues; acknowledged in the Financial System Stability Assessment. - BRSA actions: - Recently tightened liquidity requirements. - Issued a new regulation setting specific provisioning rules for special mention loans in accordance with good prudential practices. - Will further emphasize banks’ responsibilities to comprehensively monitor foreign exchange risks. - Postponed full implementation of Basel II until early 2009; will soon announce risk weightings for banks’ various assets. - Central bank action: launched a new survey of corporate sector foreign exchange exposure to improve oversight of these risks; results will be published by end-2008. - Corporate transparency: committed to ensure parliamentary adoption of the new Commercial Code during 2008; the Commercial Code will require corporate financial statements be prepared in line with International Financial Reporting Standards. - Mortgage market reforms: - CMB has issued important implementing regulations for the February 2007 Mortgage Law. - A draft regulation on asset-backed securities was disclosed for public comments and a draft regulation on mortgage finance corporations will be disclosed shortly; both regulations will be issued in final form by end-June 2008. - BRSA plans supervisory measures to monitor implementation by banks and affiliates, including requiring proper systems to identify all risks related to mortgage lending. - Capital market and privatization: - Initial public offering of 25 percent of Halkbank shares in May 2007 was highly successful. - Preparations for a secondary equity offering (SEO) of another 24 percent of shares in the period ahead, depending on market conditions; could be followed by further block sale of the majority shares. - Committed to preparing a privatization strategy for Ziraat once Halkbank is fully privatized. - SDIF actions: - SDIF is better positioned to focus on deposit insurance agency role. - Decided on the design of risk-based premiums to improve the deposit insurance scheme. - Authorities will continue to ensure high-quality cooperation and sharing of information among all relevant regulatory and supervisory agencies. ### Investment climate - Authorities emphasize restoring financial viability in energy SEEs, resuming privatization, and strengthening regulatory and supervisory frameworks to support private investment and a stable financial environment. *Document: IMF staff report content as provided in the supplied PDF excerpt.* ### 26. Foreign direct investment reached a new record in 2007, with net inflows of US$20 ### _cr08272 - 26. Foreign direct investment reached a new record in 2007, with net inflows of US$20 ### Foreign direct investment and privatization - Net FDI inflows in 2007: US$20 billion, surpassing 2006’s record level of US$19 billion. - Ongoing merger and acquisition activity and a renewed privatization drive expected to support FDI inflows in 2008 and over the medium term. - Main elements of the 2008 privatization agenda: - Tekel tobacco (tender completed in February) - Türk Telecom (IPO for 15 percent) - electricity distribution and generation - sugar refineries - toll roads and bridges - the national lottery - Halkbank share offering - Commitment to pass revised legislation as necessary to preserve the rights of foreign investors to own real estate in Turkey, to ensure continued robust FDI. ### Investment climate reforms and governance - Commitment to redoubling efforts to improve Turkey’s investment climate and continued close work with the private sector to implement investment-friendly reforms. - Notable recent progress: - streamlining of business license requirements - simplification of customs procedures - expected parliamentary passage of the Commercial Code (strengthening corporate governance and transparency) ### Program stock-taking and macroeconomic outcomes - As the Stand-By Arrangement ends, most key objectives set at the program outset are considered achieved. - Achievements highlighted: - continued discipline in fiscal and monetary policies within the inflation targeting framework - consolidation of macroeconomic stability - "three more years of strong and steady growth with comparatively low inflation" - sharply rising FDI - strengthened public balance sheets - resilience to external shocks, including financial market turbulence - structural progress in social security, tax administration, banking supervision, state bank restructuring, and privatization - Turkey has: - expanded trade and investment links with the rest of the world - converged further to EU economies - strengthened international reserve position - reduced reliance on Fund financial support - Policy intent: persevere with disciplined macroeconomic policies and structural reforms to secure greater economic prosperity. ### Inflation outcomes, drivers, and monetary policy response - End-year inflation target for 2007: 4 percent, with an uncertainty band of 2 percentage points on either side. - Annual CPI inflation outturn by end-December 2007: 8.39 (breaching the upper limit of the uncertainty band). - Main factors for exceeding the target: - Food: - End-year food inflation: 12 percent. - Contribution of food prices to headline inflation in 2007: about 3.4 percent (food contribution became the main factor impeding disinflation in 2007). - Food share in CPI contribution comparison: - 2004–2006 Average: Food* 23.9% - 2007: Food* 40.8% - Note: Food defined as "Food and non-alcoholic beverages". - Energy and administered prices: - Crude oil price in December 2007 was nearly 50 percent above end-2006 levels. - Contribution of energy price hikes to headline inflation: 1.6 points. - Contribution of energy and tobacco products to headline annual inflation at end-2007: 2.4 percentage points (administered component outweighed oil price impact). - Tobacco: - Prices of tobacco products increased by about 18 percent in 2007 due to adjustments in special consumption tax. - Tobacco share in CPI contribution: - 2004–2006 Average: Tobacco** 9.7% - 2007: Tobacco** 10.4% - Note: Tobacco defined as "Tobacco products and alcoholic beverages". - Tabled contributions (exact figures reported): - Table 1: Contribution to Annual CPI Inflation (percentage points) - 2007: Energy 1.57, Food* 3.42, Tobacco** 0.87, Goods exc. Food, Energy and Tobacco 0.24, Food, Energy and Tobacco 2.28, Services (implicitly the residual) - 2006: Energy 1.51, Food* 3.09, Tobacco** 0.28, Goods exc. Food, Energy and Tobacco 1.43, Services 3.33 - Core inflation and services: - Rapid disinflation in services and core goods in 2007, confirming supply-side shocks were mainly responsible for the breach of the uncertainty band. - Services inflation eased, declining by 3.6 percentage points throughout 2007; notable fall in rent inflation. - International context: - Inflation rose broadly worldwide in 2007; Turkey’s inflation followed a more favorable trend compared to other emerging inflation-targeting economies despite administrative price hikes in November 2007 (which added about 1-percentage point to Turkish CPI). - During the past year the report notes: Turkish inflation declined from 9.7 percent to 8.4 percent, while average inflation in emerging market economies under inflation targeting rose from 3.4 percent to 5.1 percent. ### Monetary policy actions and expectations - Monetary tightening since mid-2006 led to significant reduction in underlying inflation but headline inflation fell less due to supply-side factors outside monetary control. - Monetary policy actions: - Policy rates were hiked by a total of 425 basis points in mid-2006 in response to market volatility and deteriorating inflation expectations. - Policy rates were held on hold for the following 13 months. - Measured rate cuts were signaled for late 2007; the MPC began a measured rate cut cycle in September 2007. - Policy rates lowered by 200 basis points since September 2007. - MPC decisions and interest rates (selected exact entries from the MPC table): - January 16, 2007 — No Change — 17.50 - February 15, 2007 — No Change — 17.50 - March 15, 2007 — No Change — 17.50 - April 18, 2007 — No Change — 17.50 - May 14, 2007 — No Change — 17.50 - June 14, 2007 — No Change — 17.50 - July 12, 2007 — No Change — 17.50 - August 14, 2007 — No Change — 17.50 - September 13, 2007 — -.25 — 17.25 - October 16, 2007 — -.50 — 16.75 - November 14, 2007 — -.50 — 16.25 - December 13, 2007 — -.50 — 15.75 - January 17, 2008 — -.25 — 15.50 - Inflation expectations: - Both 12-month and 24-month ahead inflation expectations declined throughout 2007, though improvement in the last quarter was limited. - As of January (year implied in source), one-year and two-year ahead inflation expectations are at 6.01 and 5.17 percent, respectively. - Outlook and factors supporting further disinflation: - CPI excluding food, energy and tobacco implies an inflation trend of 4.8 percent. - Under the assumption that oil and food inflation follow a more benign path in 2008 than in 2007, base effects are expected to contribute to disinflation. - A continuing output gap is cited as another factor likely to contribute to disinflation. *Source: _cr08272 - 26. Foreign direct investment reached a new record in 2007, with net inflows of US$20 (IMF PDF content provided).* ### 2006. The sharp slowdown in the second half of 2006 created an ample slack in the ### _cr08272 - 2006. The sharp slowdown in the second half of 2006 created an ample slack in the ### Economic activity, output gap, and labor market - The sharp slowdown in the second half of 2006 created an ample slack in the economy. - Domestic demand showed some signs of recovery in the second half of 2007, and latest readings suggest activity was more vigorous at the turn of the year than implied by Q3 figures; nevertheless, the pace of domestic demand was not enough to completely eliminate the output gap. - The output gap remains negative and continues to contribute to the disinflation process (Figure 9). - Labor market: unemployment in September-November period rose from 9.3 percent in 2006 to 9.7 percent in 2007. Annual rate of growth in non-farm employment in this period was only 1 percent, the lowest value registered in the past two years. ### Monetary stance and inflation dynamics - Tight monetary conditions continue to support disinflation. Despite recent rate cuts, monetary policy can still be considered restrictive. - Underlying rate of monetary expansion remains modest, consistent with a relatively restrictive monetary stance. - Medium-term interest rates trended downward in the past quarter, but 2-year real rates at this point fluctuate between 9 and 10 percent, implying a non-accommodative monetary stance. - The currency remains strong, curbing inflationary pressures and easing the impact of rising commodity prices on domestic production costs (Figure 10). - Core inflation measure H: CPI excluding unprocessed food, energy, alcoholic beverages, tobacco, and gold; official “Special CPI Aggregates” do not exclude processed food prices, but excluding processed food provides a better proxy for recent inflation trends. ### Credit conditions and household lending - Credit data suggest monetary conditions are still non-accommodative. Annual growth rates in automobile and housing loans are much lower compared to periods of vigorous domestic demand (Figure 11). - Consumer credits showed signs of recovery after Q1 2007 following the significant slowdown in H2 2006. Cautious monetary policy stance and tightening global credit conditions are likely to restrain credit expansion going forward. - Table 3: Consumer Loans and Claims From Credit Cards (Quarterly Real Percentage Change) - Consumer Loans: 2006Q2 20.0; 2006Q3 1.5; 2006Q4 3.6; 2007Q1 2.6; 2007Q2 9.0; 2007Q3 10.0; 2007Q4 6.6 - Housing: 2006Q2 22.8; 2006Q3 0.9; 2006Q4 2.2; 2007Q1 2.7; 2007Q2 7.5; 2007Q3 10.2; 2007Q4 5.4 - Automobile: 2006Q2 5.1; 2006Q3 -6.4; 2006Q4 -5.0; 2007Q1 -8.9; 2007Q2 -3.4; 2007Q3 -2.0; 2007Q4 -1.4 - Other: 2006Q2 24.3; 2006Q3 6.0; 2006Q4 8.9; 2007Q1 6.6; 2007Q2 14.5; 2007Q3 12.8; 2007Q4 9.9 - Claims From Credit Cards: 2006Q2 6.8; 2006Q3 2.1; 2006Q4 2.1; 2007Q1 -1.6; 2007Q2 7.7; 2007Q3 2.4; 2007Q4 3.2 ### External demand, global risks, and fiscal policy - External demand conditions are expected to contribute to disinflation in 2008. Recent global data suggest world economic growth is likely to moderate going forward. - Difficulties in credit markets and concerns on financial stability have increased downside risks to global demand and export growth. Central bank liquidity injections and easier policy have alleviated concerns somewhat but are not expected to engineer a near-term rebound in activity. - Fiscal policy should support disinflation in 2008. Rising fiscal expenditures in 2007 partly offset monetary tightening, but fiscal targets for 2008 imply a relatively more restrictive policy: taking government targets/projections as given, the contribution of fiscal expenditures to aggregate demand is expected to decline in 2008. - The report emphasizes that maintaining prudent fiscal policy, especially given worsening risk appetite, is critical for preserving economic resilience. Medium-term projections assume government expenditure targets will be met in 2008 and any extra need to readjust the primary budget balance will be implemented primarily through expenditure cuts rather than hikes in indirect taxes. Aside from January 2008 hikes in electricity and natural gas, no major administered price shocks are envisaged. ### Forecasts, assumptions, and projection revisions - The October 2007 Inflation Report assumptions and subsequent revisions: - Earlier oil price assumption: 70 USD per barrel (used in the 2007 October Inflation Report). - Revised oil price assumption for 2008: 85 USD per barrel. - Higher oil price assumption added about 0.5 percentage points to the end-2008 inflation forecasts. - The first-round impact of recent hikes in end-user electricity and natural gas prices is computed to be around 0.6 percentage points, higher than assumed previously. - Processed food inflation expected to remain at relatively high levels throughout 2008 due to lagged impacts of drought and elevated global agricultural commodity prices. - These factors, together with higher food inflation assumptions, explain the upward revision of the end-2008 inflation forecast and imply it will take longer to bring headline inflation to 4 percent than envisaged in the previous Inflation Report. In the absence of a significant correction in food inflation, headline inflation will most probably exceed the target level of 4 percent at end-2008. ### Quantitative inflation forecast and policy path - Forecast (70 percent probability): - End-2008 inflation: between 4.1 percent and 6.9 percent (midpoint 5.5). - End-2009 inflation: between 1.8 percent and 5.5 percent (midpoint 3.7). - Forecast is based on a scenario in which policy rates display a limited decline in 2008. The main message: continuation of the gradual easing cycle that started in September 2007 will remain conditional on favorable data and developments. The current policy stance envisages a more moderate decline in policy interest rates than indicated in the previous Inflation Report. - The report stresses that any new data or information on the inflation outlook may lead to revisions in policy stance and the indicated policy path is not a commitment by the CBT. ### Risks and policy strategy - Upside and downside risks to inflation and monetary policy outlook: - Main upside risk: potential second-round effects of accumulated supply shocks (food and energy), which may create higher-than-expected inflation inertia and affect medium-term inflation expectations. So far, second-round impacts of food prices have been limited and confined to selected sub-components (e.g., restaurants and catering services), but the potential second-round impact should not be overlooked. CBT will monitor price setting behavior and various core inflation measures. Policy strategy: tolerate first-round impacts from food, energy and one-off administered price adjustments while remaining responsive to second-round effects. - External risk: ongoing reappraisal of risk in financial markets creates uncertainty about the global economy. Baseline assumes a soft landing in developed economies with no major portfolio shock on Turkish financial markets. A sharper slowdown could dampen global risk appetite, weaken YTL, and pose an upside risk for short-term inflation while creating a medium-term downside risk via weaker external demand. - Food price risk: food items constitute more than one fourth of the CPI basket. Course of food inflation depends on domestic weather and global developments. Baseline envisages higher food inflation than in the previous report, but there is significant chance of a downward correction in unprocessed food inflation due to base effects from elevated prices in the past two years; conversely, global developments and rising demand for certain food items could further push prices up. Potential volatility in food prices poses risks to the inflation outlook on both sides. - Energy price adjustments: recent increases in end-user energy prices may exert temporary upward pressure on headline inflation in coming months, but these adjustments support lower inflation in the medium term by contributing to prudent fiscal stance and expanded domestic energy production. Central bank policy is not to react to these price adjustments except to contain second-round effects. *Central Bank of Turkey; content as presented in the provided document.* ### Conclusion ### _cr08272 - Conclusion ### Monetary policy, inflation outlook, and central bank strategy - Despite persistently high food and energy inflation, monetary policy managed to control underlying inflation and inflation expectations in 2007. - Inflation excluding energy, food and tobacco items is expected to stay close to medium term inflation target of 4 percent in the forthcoming period. - Barring new supply shocks, the restrictive monetary conditions over the coming months are expected to drive headline inflation towards the target. The speed of convergence will largely depend on the course of food and energy prices. - The CBT will not react aggressively to shocks beyond the control of monetary policy in the short run, to avoid undesirable fluctuations in economic activity and distortions in relative prices; in the case of persisting supply shocks, the CBT will tolerate inflation to exceed the target temporarily while closely monitoring core indicators. - With the official inflation target missed by a noticeable margin in the past two years, managing expectations is of utmost importance. The CBT remains prepared to act preemptively to prevent second-round effects of rising energy and food prices. Ongoing global uncertainties, hikes in electricity prices, and risks to price-setting behavior require attentiveness to incoming information; further monetary accommodation will depend on factors affecting the medium term inflation outlook. ### Recent data, forecasts, and market reaction - April data: monthly inflation was 1.7 percent (above market expectations), raising the annual rate to 9.7 percent from 9.2 percent a month earlier. Food and energy prices accounted for the bulk of the increase in headline inflation, while a pick-up of core inflation points to a broadening of price pressures. - The central bank revised its inflation forecasts upward and signaled a tightening of monetary policy: - New midpoint inflation forecasts: end-2008 = 9.3 percent; 2009 = 6.7 percent (compared to 5.5 and 3.7 percent in the January Inflation Report). - Inflation is projected to fall to 4.9 percent at end-2010 and reach the 4 percent target in 2011. - The upward revision is based on the conservative assumption that supply shocks (especially to food prices) will continue to exert significant upward pressure on inflation during the next two years. - Central bank analysis indicates that, even under benign supply-shock developments, near-term interest rate hikes will be necessary to contain inflationary pressure. - In response to the announcement, the yield curve on government bonds shifted upward, reflecting expected near-term rate hikes and possibly upward revisions to market expectations for inflation. ### Fiscal policy, structural reforms, and resilience - Turkish economy has been resilient to reappraisal of risks in global financial markets. The support of fiscal policy and structural reforms are critical in shielding the economy against possible further deterioration in global sentiment. - The European Union accession process and the implementation of structural reforms envisaged in the economic program remain important. Advances in structural reforms that enhance fiscal discipline and raise productivity are monitored closely for implications on macroeconomic and price stability. - Two pending prior actions implemented: - On May 3, authorities announced a revised medium-term fiscal plan targeting a gross debt ratio of 30 percent of GDP by 2012, underpinned by a primary surplus path declining gradually from 3½ percent of GDP in 2008 to 2½ percent of GDP in 2012. - Tender processes for privatization of four regional electricity distribution companies (Baskent, Sakarya, Meram, and Aras) were announced during April 25–30. ### IMF program, Fund relations, and statistics - Fund arrangements and balances: - A three-year SDR 6.7 billion (559 percent of quota) Stand-By Arrangement was approved in May 2005. Cumulative purchases amount to SDR 4.4 billion. A further SDR 2,248 million will become available upon completion of the seventh review. Outstanding Fund credit amounted to SDR 4.2 billion at end-March 2008. - Projected payments to Fund (Expectations Basis) (In millions of SDRs): - Principal: 2008 = 936.63; 2009 = 1,880.64; 2010 = 1,217.90; 2011 = 187.37. - Charges/Interest: 2008 = 137.32; 2009 = 113.39; 2010 = 40.40; 2011 = 5.65; 2012 = 1.78. - Total: 2008 = 1,073.95; 2009 = 1,994.03; 2010 = 1,258.30; 2011 = 193.02; 2012 = 1.78. - Projected payments to Fund (Obligations Basis) (In millions of SDRs): - Principal forthcoming: 2008 = 936.63; 2009 = 1,880.64; 2010 = 1,217.90; 2011 = 187.37. - Charges/Interest: 2008 = 148.46; 2009 = 183.96; 2010 = 113.66; 2011 = 40.53; 2012 = 5.67. - Total: 2008 = 148.46; 2009 = 1,120.60; 2010 = 1,994.29; 2011 = 1,258.44; 2012 = 193.04. - Safeguard assessments: A new assessment of the central bank’s safeguards framework was completed on June 29, 2005; it uncovered no material weaknesses and recommended measures in internal audit and controls that have been implemented. - Exchange rate arrangement: Since February 22, 2001, the lira has been under an independent floating exchange rate regime. - Data provision: Data provision to the Fund is broadly adequate for surveillance and program monitoring purposes. Turkey subscribes to the Special Data Dissemination Standard. *Source: Central Bank of the Republic of Turkey; International Monetary Fund — Turkey: Seventh Review and Inflation Consultation Under the Stand-By Arrangement and Request for Waiver of Nonobservance of Performance Criteria—Informational Annex (April 28, 2008) and Supplementary Information (May 6, 2008).* ### 4. Launch of the tender process for the privatization of four regional ### 4. Launch of the tender process for the privatization of four regional electricit y distribution companies (¶20) ### Inflation-targeting framework and accountability - The Central Bank of Turkey (CBT) has been implementing a formal inflation-targeting regime since the beginning of 2006. - Central Bank Law, Article 42, requires the CBT to be accountable for the non-fulfillment of inflation targets. - Inflation target for end-year 2008 was jointly set with the Government as 4 percent. - The policy statement “Monetary and Exchange Rate Policy in 2008” disclosed a quarterly path consistent with the end-year 2008 targets along with an uncertainty band; any breach of upper or lower limits requires the CBT to write an open letter to the Government explaining reasons and measures. - Inflation outturn as of March 2008 was 9.15 percent, breaching the upper limit of the uncertainty band, which was set at 9.1 percent for the end of the first quarter. ### Reasons for breaching the target - Headline inflation rise was driven mainly by factors largely beyond monetary policy control: food, energy, and administered prices. - October 2006 Inflation Report forecast assumed food inflation would moderate and oil prices remain stable at 60 USD per barrel; instead: - Oil prices averaged around 100 USD per barrel in the first quarter of 2008. - Annual food price inflation reached 13.4 percent in March. - Contribution breakdown (March 2008): - 6.13 percentage points of the 9.15 percent annual CPI inflation resulted from the food and energy items. - Domestic factors: - Prolonged shortage of rainfall in Turkey led to low crop yields in 2007, creating an adverse supply shock. - Processed food prices showed pronounced increases due to global demand and elevated agricultural commodity prices. - Annual food inflation contributed about 2.3 points to the 3.1 percent year-to-date headline inflation. - Energy price developments: - Rising oil prices led to significant hikes in fuel-oil products and affected housing utilities including electricity tariff rates. - Contribution of energy items to year-to-date CPI inflation reached about 0.9 percentage points. - Exchange rate movements affected March inflation through fuel and high-tech consumer durables; first-round exchange rate pass-through expected to continue in short term. - CPI excluding food, energy and tobacco remained flat over the previous quarter at 4.8 percent. ### Disaggregated inflation contributions and subcomponents (first quarter) - Table 1: Contribution to First Quarter CPI Inflation (Percentage Points) - CPI 2008: 3,09 - Food* 2008: 2,31 - Energy 2008: 0,86 - Goods exc. Food and Energy 2008: -0,74 - Services 2008: 0,65 - CPI 2007: 2,36; Food 2007: 1,93; Energy 2007: 0,22; Goods exc. Food and Energy 2007: -0,39; Services 2007: 0,60 - CPI 2006: 1,25; Food 2006: 1,41; Energy 2006: 0,38; Goods exc. Food and Energy 2006: -1,20; Services 2006: 0,66 - *Food: Food and non-alcoholic beverages. - Services subcomponents (first quarter cumulative percentage change) showed: - Elevated food and energy prices exerted upward pressures on catering and transport services. - Rents and other services continued to decelerate. ### Monetary policy reaction and MPC decisions - CBT approach: tolerate first-round effects of shocks beyond control, but promptly respond to deterioration in overall pricing behavior. - September 2007–February 2008: policy rates lowered by 225 basis points between September 2007 and February 2008. - Monetary Policy Committee (MPC) decisions in 2007 and 2008 (interest rates preserved exactly as in source): - January 16th, 2007: No Change — 17.50 - February 15th, 2007: No Change — 17.50 - March 15th, 2007: No Change — 17.50 - April 18th, 2007: No Change — 17.50 - May 14th, 2007: No Change — 17.50 - June 14th, 2007: No Change — 17.50 - July 12th, 2007: No Change — 17.50 - August 14th, 2007: No Change — 17.50 - September 13th, 2007: -0,25 — 17.25 - October 16th, 2007: -0,50 — 16.75 - November 14th, 2007: -0,50 — 16.25 - December 13th, 2007: -0,50 — 15.75 - January 17th, 2008: -0,25 — 15.50 - February 14th, 2008: -0,25 — 15.25 - March 19th, 2008: No Change — 15.25 - April 17th, 2008: No Change — 15.25 - January 2008 Open Letter highlighted global uncertainties, hikes in electricity prices, and risks to price-setting behavior; MPC suspended rate cuts in March meeting and announced a tightening bias in April meeting. ### Inflation outlook, forecasts, and key assumptions - Current supply and demand conditions support a downward trend in inflation; consumer credit data suggest monetary conditions continue to be non-accommodative. - Automotive and housing loan annual growth rates are at lower levels compared to periods of vigorous domestic demand; tightening in global credit conditions is likely to restrain credit expansion. - Output and labor: - Sharp slowdown in second half of 2006 created slack in economy. - Methodological change in national accounts led to a limited upward revision in output gap measure but did not change inflation outlook. - Expectation of continued moderation in economic activity and non-farm employment due to rising precautionary saving. - Exchange rate and risk premium: - Domestic currency depreciated by more than 15 percent in nominal terms since the beginning of the year. - First-round impact of exchange rate pass-through estimated to be close to 2-percentage points at the end of 2008. - Longer-term interest rates increased due to rising risk premium; impact on pricing behavior should be closely monitored. - Inflation expectations: - One year forward expectations are at 7 percent. - 2-year ahead inflation expectations stand at around 6 percent. - Recent upward movement in expectations increased risks to price-setting behavior. - Revisions to assumptions and forecasts: - Food inflation assumptions raised to 13 percent for 2008 and 8 percent for 2009. - These changes led to upward revisions in inflation forecasts by about 1.2 points for 2008 and 1.1 points for 2009. - Oil price assumption revised from 85 USD per barrel (January Inflation Report) to 105 USD per barrel given first quarter average about 100 USD. - These changes imply upward revisions in forecasts by 0.9 points for end-2008 and 0.4 points for end-2009. - Assuming measured and gradual tightening towards mid-2008 and constant policy rates thereafter for the rest of 2008, medium-term forecast (with 70 percent probability) implies inflation will be between 4.9 and [text truncated in source]. - Point forecast: - Forecast inflation to be around 9.3 percent at the end of 2008. *Attachment: Central Bank of Turkey, Ankara, April 30, 2008 — Mehmet MÜEKK (Minister of State).* ### 8.5 percent (mid point 6.7) at the end of 2009 (Figure7). Assuming a gradual ### _cr08272 - 8.5 percent (mid point 6.7) at the end of 2009 (Figure7). Assuming a gradual ### Inflation outlook and forecasts - CBT now forecasts annual inflation to be around 9.3 per cent at the end of 2008. - CBT medium-term forecast (assuming a measured and gradual tightening towards mid-2008 and constant policy rates thereafter): - Inflation will be between 4.9 per cent and 8.5 per cent (mid-point 6.7 per cent) at the end of 2009. - Headline inflation is expected to decelerate to 4.9 percent at the end of 2010. - Inflation is expected to come down to 4 percent by mid-2011. - Revised projections suggest the contribution of energy, food and services will be close to 5 percent at the end of 2009. - Meeting the 4 percent target at the end of 2009 would be possible only if the prices of goods excluding food, energy and tobacco deflate by 3 percent, assuming no further hikes in administered prices (except automatic pricing mechanisms). - The earliest time for reaching the 4 percent medium term target is likely to extend beyond two years, even if tight monetary policy is maintained for an extended period. - Forecasts are intended to serve as anchors for the intermediate term, representing the inflation path likely to be followed en route to the 4 percent medium term target. ### Risks and scenario projections - Supply shocks have been more persistent than expected, increasing risks of second round effects and prompting a significant upward revision in inflation forecasts. - April Inflation Report alternative scenarios: - Pessimistic scenario: - Food inflation materializes at 17, 11 and 10 percent in the next three years. - Oil prices soar to 150 USD per barrel at the end of 2009. - Under this scenario, assuming policy rates increase gradually throughout 2008 and then stay constant for a while, it takes four years for inflation to go back to 4 percent. - Optimistic scenario: - Food inflation materializes at 9, 5 and 4 percent in the next three years. - Oil prices ease to 85 USD per barrel at the end of 2009. - Under this scenario, assuming a limited rate hike in the short term and gradual cuts starting from the last quarter, inflation reaches 4 percent at the end of 2010. - Downside risks are as significant as upside risks due to conservative assumptions on food and energy prices in the baseline projections. - Other identified risks: - Rising import prices and potential second round impacts of supply shocks could impose downward stickiness in goods prices. - A sharper than expected slowdown in global economic activity could lead to further volatility in financial markets and slow capital flows to emerging economies. - Any deviation from assumed government expenditures or additional indirect tax or administered price increases (beyond automatic pricing mechanisms) may affect the inflation outlook and monetary policy. ### Monetary policy stance and implications - Monetary policy has already assumed a more cautious/tighter stance to prevent materialization of potential second round effects. - Ensuring a steady decline in inflation will likely require tight monetary policy to be maintained for an extended period. - The CBT suspended the easing cycle in March 2008 because of the medium term outlook for inflation. - The CBT has emphasized that updated inflation forecasts will serve as an anchor in the short run while the 4 percent inflation target remains the medium-term anchor. - The CBT stated that extending the horizon for convergence to the target does not imply loose monetary policy; monetary policy will be more responsive to bad news than good news in the period ahead. - The CBT will not react to temporary fluctuations in financial markets but will tighten policy in case of a significant worsening in overall pricing behavior. - If price setting behavior further deteriorates, it may be necessary to pursue a tighter monetary policy. ### Fiscal policy, structural reforms, and supporting measures - Sound fiscal policy and structural reforms are critical complements to monetary policy for attaining price stability. - Turkey sustained large primary surpluses during 2003-06, with the average primary surplus at 5 percent of GDP. - Public sector net debt fell from 61.5 percent of GDP in 2001 to 29.1 percent in 2007; gross public sector debt was 38.8 percent of GDP in 2007. - Public sector net debt in foreign currency or linked to foreign currency was 3.2 percent of GDP in 2007, down from 35.4 percent in 2002. - Authorities announced a new medium-term fiscal framework centered on a gross debt target of no more than 30 percent of GDP by 2012, to be reached by observing primary surpluses of at least: - 3.5 percent of GDP in 2008, - 3 percent of GDP in 2009, - (and gradually declining thereafter per the framework). - The role of fiscal policy will continue to be critical; preserving economic resilience requires continuation of fiscal discipline and structural reforms. - The European Union accession process and implementation of structural reforms envisaged in the economic program are of utmost importance and are monitored by the CBT for their macroeconomic and price stability implications. ### Conclusion and policy guidance - Inflation targets have been breached by a significant margin due to persistent supply shocks; shocks are likely to persist for some time. - Revised projections suggest inflation in 2008 and 2009 is likely to materialize above 4 percent. - The envisaged framework: inflation forecasts serve as short-term anchors while the 4 percent target remains the medium-term anchor. - Extending the horizon for convergence does not imply looser monetary policy; forecasts are based on a tighter monetary policy stance compared to the previous period. - Monetary policy will be more responsive to adverse developments than to favorable ones, reflecting a firm commitment to attaining price stability. - Prudent monetary policy is necessary but not sufficient; fiscal support and structural reforms remain essential to achieve and sustain price stability. *Central Bank of Turkey (text as provided in the content unit)* ### 2.4 percent in 2012. ### 2.4 percent in 2012. ### Fiscal framework and public investment - The new primary surplus path will allow the authorities to address acute investment needs and finance the cost of the long overdue labor market reform. - Turkey has the highest taxation on labor income in the OECD, which is a significant deterrent for creating formal employment; tax rates on labor income will need to be reduced. - The new fiscal framework will allow higher infrastructure investments in the Southeastern Anatolian Project, which is expected to increase agricultural production, create employment and address income inequalities in the area. - Authorities are considering using a limited part of the fiscal space for reforming local administrations to increase the efficiency of public services. - The Turkish authorities are committed to continue with prudent fiscal management and will comply in the near term with the announced primary surplus targets, even if the debt ratio falls below the projected level. - Authorities are examining various options to institutionalize this framework before the 2009 budget. - As underscored by staff, the 2008 primary surplus target of 3.5 percent of GDP represents a slight tightening of the structural balance. - To secure the 2008 budget target, the authorities have taken measures including: - upfront increase of electricity tariffs; - automatic price adjustment mechanism in electricity; - adjustment of certain excise taxes; - hiring caps in public sector; and - enhancing the efficiency of healthcare spending. ### Structural fiscal reforms - A landmark social security reform was adopted in the Parliament last month, after the previous reform of 2006 was struck down by a Constitutional Court. - The new law addresses the concerns raised by the Constitutional Court while preserving the overall budget savings targeted in the original 2006 law. - The law establishes a universal health insurance, and creates incentives and authority to manage health expenditures better. - Strengthening of the tax administration is a top reform agenda item; authorities are determined to increase tax compliance and collection. - Important steps taken include: - introduction of a risk based audit system for VAT refunds; - requiring employers to pay salaries through bank accounts; and - unified forms for social security and tax declarations. - Authorities are considering IMF staff advice regarding the merger of all audit functions and will soon make a decision. - Authorities express gratitude for the Fund’s technical support to enhance tax administration capacity. ### Financial sector - The impact of global developments on the banking sector has so far been limited. - Authorities remain vigilant and continue to upgrade regulatory and supervisory practices as advised by the 2006 FSAP study. - Turkish banks enjoy high capital adequacy, strong profitability and sound liquidity. - The Banking Regulatory and Supervisory Agency (BRSA) recently tightened provisioning and liquidity requirements as part of preemptive policy action. - Authorities are taking further steps to better monitor foreign exchange risk in banking and corporate sectors. - The adoption of a new commercial code will reinforce supervisory efforts in the period ahead. ### Privatization and investment environment - Turkey undertook unprecedented privatization, reaching USD 30 billion in the period 2003-07. - Authorities are committed to pushing ahead with the privatization agenda in 2008, including: - electricity distribution and generation; - the national lottery; - Turk Telekom (an IPO of 17.5 per cent of the remaining 45 percent state share); - the sugar factories; - the tobacco company; and - an additional share offering of Halkbank. - The tender process has begun for four electricity distribution companies and the IPO of Turk Telekom has been launched. - Preparations for 24 percent of Halkbank’s second offering are underway. - Authorities’ efforts to improve the investment climate elevated Turkey’s ranking in the World Bank’s Doing Business Report from 93 in 2006 to 57 in 2008. ### Stocktaking and program assessment - This is the last Review under the current Stand-by Arrangement. - Increased resilience of the Turkish economy, continuously tested by many external and internal shocks, is highlighted as the best testimony to the success of the program. - Main achievements under the program include: - rapid convergence with the EU; - consolidation of macroeconomic stability; - high and uninterrupted growth with relatively low inflation; and - deep-rooted structural reforms in many areas ranging from social security to privatization. - The Turkish authorities appreciate the strong support provided by the Fund during the program period and thank the Executive Board, Management and staff for their policy advice. - Constructive and open dialogue and cooperation between Turkey and the Fund remains important to overcome many challenges facing the economy. *Source: IMF staff report excerpt.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08272.pdf_