Public Information Notice No. 11/150

Public Information Notice: IMF Executive Board Concludes 2011 Article IV Consultation with Turkey

December 7, 2011

On November 30, 2011, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Turkey.¹

Background

The Turkish economy continued to grow strongly through the first half of 2011, reaping the benefits of institutional reforms and revamped policy frameworks implemented in the previous decade. However, growth became increasingly fueled by domestic demand and imports. This was supported by strong credit growth, reflecting an appreciated currency combined with low interest rates and a surge in short-term capital inflows. The current account deficit widened sharply to near 10 percent of GDP. Inflation is rising quickly, reflecting pass-through from a large nominal depreciation since late 2010, numerous tax and regulated-price increases, and underpinned by tight domestic supply conditions, and is forecast to reach 9½ percent at end 2011, well above the point target of 5½ percent.

The externally-financed demand boom has weakened Turkey’s resilience in some areas. Capital inflows are dominated by potentially-volatile financing, and short-term external debt has climbed sharply. With banks absorbing much of these inflows, an external funding shortfall will slow down credit. Nonfinancial corporates’ net FX liabilities increased substantially, exposing them to currency depreciation. While the headline fiscal balance continues to improve and the public debt-to-GDP ratio is declining, fiscal performance has been supported by benign economic conditions at home and abroad.

Policy responses were insufficient to prevent the development of a large current account deficit and high inflation. Monetary policy shifted to an unconventional mix of reserve requirements, the interest rate corridor, and the policy rate, which has not demonstrated it can deliver price- or financial–stability. Numerous prudential measures aimed at slowing credit growth and building buffers were introduced but, from a macroprudential perspective, were sometimes delayed. The primary balance of the nonfinancial public sector continued to improve, largely reflecting buoyant—but transient—tax revenue from the boom in output and imports and proceeds from a tax restructuring scheme, which masked a relaxed fiscal stance.

Growth is expected to slow sharply to 2 percent in 2012 due to weaker capital inflows, reflecting in part concerns about Turkey’s large current account deficit. More limited foreign financing would constrain the current account deficit to about 8 percent of GDP and compresses imports. In line with Turkey’s previous capital flow-driven corrections, with fewer imports of key raw materials and intermediates, GDP growth is forecast to be sharply scaled down. Inflation is projected to decline to a still-elevated 6½ percent, eroding external competitiveness.

Executive Board Assessment

Executive Directors commended the Turkish authorities for their agile economic management during the global crisis, which, together with structural reforms undertaken earlier, had contributed to a rapid recovery. Going forward, Directors urged the authorities to rebalance the policy mix to ensure a soft landing, in view of volatile capital flows, a widening current account deficit, and an externally financed credit boom. Tightening the structural fiscal position and gearing macroprudential policies to preventing systemic risk would allow monetary policy to focus on price stability, helping to preserve the credibility of the inflation-targeting framework and strengthen Turkey’s resilience to changes in global liquidity conditions. It will also be important to accelerate structural reforms to reverse eroding competitiveness and improve the business climate, facilitating current account adjustment.

Directors welcomed the decline in public debt and the fiscal deficit. They encouraged the authorities to tighten fiscal policy, with a view to stemming domestic demand, supporting disinflation, while also providing a fiscal buffer in the event capital flows reverse. Directors recommended front loading the adjustment as much as feasible, and establishing fiscal targets in structural terms. They emphasized in particular the need to restrain current spending, expand the tax base to ensure sustainable revenues, and strengthen the oversight of public-private partnerships.

Directors acknowledged the difficult environment under which monetary policy operates. With a tighter fiscal stance and appropriate macroprudential policies in place, they saw scope for cautiously raising the single policy interest rate, taking into consideration the possible impact on economic growth and capital flows. Directors recommended moving toward a more transparent and consistent monetary policy framework to re-anchor inflation expectations and avoid excessively rapid disintermediation. Narrowing the inflation tolerance band and gradually lowering the inflation target will help moderate the impact of future capital flow cycles.

Directors noted the strong performance of the banking sector, but encouraged further efforts to address weaknesses in the financial sector, in particular its vulnerability to an external funding shock and possible deleveraging by banks in the region. They urged caution in implementing near-term measures to bolster banks’ resilience so as to avoid a sharp drop in credit. Timely detection and response to future emerging systemic risk is crucial, along with further strengthening of financial sector oversight and regulation, as recommended in the Financial Sector Stability Assessment. Directors saw an important role for the recently established Financial Stability Committee in this regard. They underscored the importance of Turkey bringing its Anti-Money Laundering/Combating the Financing of Terrorism legislation into line with international standards.

Directors endorsed labor and product market reforms to enhance competitiveness and social equity. They recommended measures to enhance labor market flexibility, tailor training to employers’ skill needs, and better align employment costs—including the minimum wage—with regional peers. Timely adjustment of regulated energy prices to movements in the domestic cost of imports would help lower Turkey’s energy trade deficit.