Speech

Turkey's Economy: A Future Full of Promise, Speech by Anne O. Krueger, First Deputy Managing Director, IMF

May 5, 2005

Good morning. I am very pleased to have the opportunity to participate once more in the Istanbul Forum. This event has, rightly, become an important fixture on the calendar of those who follow the progress of Turkey's economy.

I am especially pleased to be visiting Turkey at a time of such excellent economic performance. The country's progress in recent years has been remarkable. The benefits of the government's commitment to its economic program are clearly visible. This year's Forum has a forward-looking theme, and rightly so. Much has been achieved since the current reform program was started. The challenge now is to build on those achievements and exploit Turkey's potential as a rapidly-growing and increasingly sophisticated economy.

I want this morning to review some of the recent accomplishments and then say something about the opportunities that lie ahead.

One focus of the Forum is the need to prepare for EU membership. This is, of course, important.

But the strongest argument for economic reforms is that they will improve the lives of Turkey's citizens. The fact that the reforms needed will also help Turkey fulfill the conditions for EU membership is an added bonus.

Macroeconomic stability has largely been achieved as a result of the reform program of the past few years. But there is much still to do. What Turkey needs to do now is raise the potential growth rate of the economy. Structural reforms-reforms that make the economy more flexible, that permit individuals and firms to respond to incentives more rapidly and more flexibly-will raise the economy's growth potential. More rapid growth, sustained over a long period, will raise living standards and reduce poverty.

Recent achievements

Turkey's recent experience illustrates this. Most of us here have vivid memories of the economic problems Turkey faced during the watershed years of 1999-2001, when the banking crisis precipitated a radical policy shift. Chronic inflation over 25 years had undermined Turkish economic performance. Economic growth had been weak, and volatile. Worse, Turkey's growth record was well below the average of successful emerging market economies. Persistent resource misallocation—one result of the shortcomings of the financial system—had reduced the economy's growth. Nominal and real interest rates were high, and unstable. The public debt burden was high and rising.

This was clearly unsustainable; change was urgently needed, and macro-reforms were implemented in monetary, fiscal, and exchange rate policies; while structural reforms were implemented in the banking system, public finances and other major areas of economic activity. There had been reforms in earlier periods, and these had laid some of the groundwork. The trade liberalization of the 1980s, for example, meant that the Turkish economy was better placed to benefit from the most recent series of macroeconomic and structural reforms than might otherwise have been the case.

But, as many of us remember, previous reform attempts in Turkey had tended to be short-lived, or abandoned before completion. Even the ambitious reform program of the early 1980s failed, in the end, to mark the decisive break with the past for which we had all hoped. Trade liberalization was important. But the banking reforms did not go far enough, as the crisis of 2000-2001 showed. And macroeconomic stability was not achieved in the 1980s reforms. Chronic fiscal imbalances and inflation prevented the full realization of the potential benefits that might otherwise have flowed from those structural reforms that were undertaken. From the 1980s onwards, inflation averaged over 60% a year.

The crisis of 2000-2001 brought things to a head, and this time there was a real turning point. Turkey's citizens had lost patience with economic instability and recurring crises that were only temporarily resolved. There was a strong desire for economic change that confronted the country's problems in a decisive way.

Even the greatest optimist could not have anticipated the extent to which the reforms implemented in the past few years have succeeded. Economic policymaking has been transformed—and so has Turkey's economy. And the benefits have been swift to materialize. Average real GNP growth over the past three years has been close to 8%—it was just short of 10% last year. The inflation rate which was 70% just three years ago is now down close to 8%: its lowest level in 35 years. The primary surplus-an essential part of the strategy to reduce the public debt burden-was almost 7% last year, ahead of the government's 6.5% target. The ratio of public debt to GNP has fallen by 30 percentage points of GNP since its 2001 peak: but further reductions will be necessary to strengthen the resilience of the economy and reduce vulnerability to shifts in the world economic conditions.

These are striking achievements and underline the enormous potential of the Turkish economy. The credibility of Turkish economic policymaking has been greatly strengthened. Pressing on with the reform program now will ensure that the full benefits of the reforms already implemented will be realized. Reforms have a cumulative beneficial impact. Each reform increases the returns to all other reforms; and the more successful economic reforms are, and are perceived to be, the smaller the chance that they can successfully be opposed by narrow interest groups.

But let me now mention some of the areas where there is scope for further progress, and say something about the contribution further reforms could make to raising Turkey's growth potential—a result that would benefit all Turkey's citizens. I want to focus on inflation, fiscal policy and structural reforms.

Inflation

I start with inflation.

At one point in the not too distant past, it had begun to look as if a low inflation world would always be a distant memory. Inflation seemed to be a chronic problem in many parts of the world. There was a widespread failure to recognize the extent to which inflation resulted in inefficient resource allocation and thus reduced potential growth rates. Inflation imposes high costs on economies and societies: this we are learning as inflation rates fall. It disproportionately hurts the poor. And it creates uncertainty throughout the economy and undermines macroeconomic stability.

But policymakers finally confronted the challenges that inflation poses. Counter-inflation policy has become much more successful, and at lower cost, than was thought possible in almost every part of the world. In my view it is not by chance that this decline in inflation rates coincided with accelerated growth of the world economy in the 1990s. Lower inflation worldwide also contributed to the fact that the global downturn of 2001-2202 was more moderate that many previous slowdowns, with a more rapid recovery. The low inflation environment played an important part in this, along with flexible exchange rates and positive real interest rates and other factors.

Here in Turkey we have witnessed a spectacular decline in inflation: and this has happened in the context of the fiscal consolidation that has been achieved in the past few years, and during a period of healthy growth. For three consecutive years now, the Central Bank has done better than the end-year target it set for itself. And the fall in the inflation rate has, in turn, strengthened the credibility of monetary policy.

There are additional gains to be had, if the Turkish inflation rate is brought down further, say to the 2% - 4% range. Macroeconomic management will be further improved, and resource allocation will become still more efficient, as will decision-making by businesses. These are benefits worth having in themselves. Low inflation will also help Turkey converge with the industrial economies—those in the EU, yes, but also in countries like the United States and Canada.

It is clear that the government and the central bank recognize this. Their commitment to further reductions in the inflation rate can only strengthen the credibility of policymaking. The independence of the central bank has been an important factor in the policy success so far; and the planned introduction of inflation targeting next year should facilitate the further falls in the inflation rate that the Turkish economy needs and that Turkish policymakers and citizens want.

Fiscal policy

Fiscal imbalances, and the failure to correct them, were the root cause of Turkey's inflation problem. Bringing the fiscal situation under control was therefore essential to end the crisis, to reduce inflation and to bring about macroeconomic stability.

The large fiscal adjustment that has been undertaken over a relatively short period has permitted a significant reduction in Turkey's public debt burden, and a reduction in the risk premium applied to Turkish debt. It has also helped restore confidence in macroeconomic policy.

And here, too, the government is firmly committed to pressing on. The primary surplus target—exceeded last year, as I noted—is to be maintained. This will make possible further reductions in the debt burden. External debt is still more than 50% of GNP, and the gross public debt is over 75% of GNP. These are still uncomfortably high levels. Currently a large part of the public debt is indexed to foreign currencies or linked to short-term interest rates. Further reductions in the debt to GDP ratio, and further smoothing of the debt profile, will reduce Turkey's vulnerability to rising worldwide interest rates and exchange rate volatility.

I cannot help but note that the substantial fiscal adjustment we have seen thus far has taken place in the context of truly impressive growth performance. The high primary surplus has not inhibited growth, any more than has the rapid decline in the rate of inflation. Indeed, the opposite is true: it is the macroeconomic program and resulting stability that has enabled such rapid growth.

Structural reforms

Of course, the pace of growth is likely to moderate in the coming years. But there is every reason to think that the Turkish economy can continue to grow at a rapid and sustainable pace. The objective now is to raise the potential rate of growth that can be achieved without fuelling inflationary pressures. That will accelerate the growth of incomes of Turkish citizens and the reduction in the incidence of poverty. Achieving that objective of higher growth will, as I noted earlier, mean implementing further structural reforms, aimed at making the economy more flexible, more oriented towards market forces and enabling firms and individuals to respond appropriately to economic incentives.

Many structural reforms have already been undertaken. I mentioned the trade liberalization and banking reforms of the early 1980s. Since the turn of the century, reforms have been implemented in the financial sector; in the management of the public finances; and in the area of business regulation. But further reforms in these areas are needed if that higher growth potential I mentioned is to be achieved. Wise reforming policymakers pursue reforms on as many fronts as possible simultaneously, and that has been true of Turkish efforts in recent years. Many structural changes take time to work through, and the more rapidly such reforms are introduced and implemented, the sooner the results will become evident.

Let me mention some specific areas where further structural reforms will help improve Turkey's growth potential.

The banking crisis prompted significant financial sector reforms. The regulatory framework has been brought closer to international standards, and state banks have been restructured and recapitalized. Banks have also begun to restructure their portfolios away from government paper, thus enabling commercial and consumer lending to rise rapidly. So far, so good. But further reforms are essential if the financial sector is to fulfill its role in making the economy more productive.

Since the 1990s, we have all become increasingly aware of just how important a sound financial sector—not least in a rapidly—growing economy. The financial system provides the means by which resources for investment are allocated: it is, in a sense, the oil that drives the engine of the economy. As an economy grows and becomes more sophisticated, efficient credit allocation and assessment of risk become increasingly important. The banking system needs to be sound, and financial intermediation needs to be increasingly wide and deep.

The government is cognizant of this. Currently, it has submitted a new Banking Law to Parliament that, in part, attempts to correct weaknesses in the regulatory system that were identified by the Imar Commission Report, published last August. It also aims to tackle problems with bank intervention and bank resolution encountered during the crisis.

The pressure for further reforms in this area is unlikely to ease. The financial system needs continuously to evolve if it is to continue to meet the needs of the economy as it evolves and expands. Otherwise, the financial sector can act as a brake on growth, because it is unable to allocate credit as efficiently as is needed. Inefficient or less than optimal allocation of credit reduces the rate of growth and therefore impedes the growth potential of the economy.

Reforms to improve budgetary transparency have already been set in train, as have improvements to the tax system, and more are envisaged. High rates of taxation, and complexity, encourage participation in the informal sector of the economy. But the lower the rates of tax collection, and the narrower the tax base, the higher the tax rates need to be to maintain government revenues. Streamlining and simplifying the income tax system and lowering tax rates will reduce distortions and will help discourage participation in the informal sector, thus also generating additional revenues. Broadening the corporate tax base and improving compliance will also help raise revenues.

On the expenditure side, the need for reform in several areas is becoming more pressing. Reforms to the pension system were introduced in 1999. But despite these, the pension deficit widened from 2.5% of GNP in 2000 to 3.5% in 2004; on current trends, without further reforms, it could grow to 7% of GNP over the longer term. The overall social security deficit [which also includes health expenditures] would be more than double the current 4.5% of GNP in the long run. Such rapid growth in these deficits would divert government resources away from infrastructure, education and other areas necessary for growth.

Plans for further social security reform are already in train. Legislation already submitted to Parliament should reduce the annual pension deficit by nearly 1% of GNP over a ten-year period and bring the deficit to below 1% of GNP over the longer term. This will be a major step.

But beyond these key areas, there remains a full agenda of expenditure reform. Better targeted and more efficiently administered expenditure in areas such as civil service pay and employment, health and education spending, the judiciary, and government subsidies for farmers all offer scope for significant budgetary savings while removing distortions that hamper economic growth. Resources for vital infrastructure spending-vital both to improve the standard of living of citizens but also to foster the growth of commercial enterprises-can increase as these reforms permit savings elsewhere in the budget.

Privatization of government assets will also contribute to an improvement in the functioning both of the economy as a whole, through its effects on private sector competition, and because it will reduce the burden on the state sector. Competition based on a level playing field for all economic actors—domestic and foreign—is essential for growth.

And considerable progress has been made in creating a much-improved climate for business. The 2003 Foreign Direct Investment Law helped level the playing field for foreign and domestic investors. The Investment Advisory Council was established in 2004—and my colleague, Rodrigo de Rato, the Fund's managing director, attended last week's meeting. The government has now embarked on reforms aimed at cutting red tape—the bane of any would—be entrepreneur; improving the efficiency of the court system; and bringing business standards generally more into line with those of the EU.

It now only takes 3 procedures instead of 13 to open a business; and the average time to register has recently been cut to less than a week. Plans are afoot to create a one-stop-shop system for obtaining business permits.

A more flexible labor market would also provide a stimulus for investment. Labor market rigidities and high minimum wages act as a disincentive to hire new staff. They encourage participation in the informal sector, with consequences for tax revenues and for export growth since informal enterprises cannot export. And labor market inflexibility explains at least some of the current stickiness of the unemployment rate.

The costs of complying with statutory employment legislation remain high: here in Turkey, firms have to pay 112 weeks wages to lay someone off, compared with 40 for the OECD average. And on measures such as the difficulty of hiring workers, the rigidity of working hours, Turkey currently scores poorly in international comparisons. Yet evidence suggests that once employers are free to fire workers, they start hiring them. Changes in labor market regulation would greatly improve the business climate, and could do much to foster growth in new areas of economic activity. And by helping to reduce unemployment, labor market reforms could build greater recognition that economic reforms bring tangible rewards.

Experience elsewhere—both in the European Union and beyond—shows that countries with structural rigidities in the labor market tend to struggle with high unemployment rates and sluggish growth. Yet those countries like the United States, the United Kingdom, Australia and Chile, where reforms have increased flexibility have had most success in reducing unemployment and increasing employment. Significant enhancements in Turkish wage and price flexibility will facilitate more rapid and sustained growth; they will help raise real incomes; and they will help reduce poverty. These are objectives we all seek and they are desirable in themselves, because they will improve the lives of all Turkish citizens. They will help Turkey converge more closely with the EU and other industrial countries, and so promote the objective of Turkish membership of the European Union as an added bonus. But it should not be the main motive for pursuing labor market or any other economic reforms.

Conclusion

Let me briefly sum up.

The need for structural reform is never-ending in the modern global economy. We can see this in the advanced industrial economies just as much as in emerging market and low income countries. Firms in many industries and national policymakers are often reluctant to grapple with the implications of changing trade patterns and greater liberalization. They would rather try to put up barriers than adapt.

Yet a modern economy has constantly to adapt if it is to remain competitive. Rapid advances in transport and communications, technological change affecting manufacturing and services industries—globalization itself means that economies that fail to keep pace with change risk falling behind. Macroeconomic stability is, of course, a prerequisite for the sustained economic growth that brings the poverty reduction and rising living standards that we all want to see. But macroeconomic stability is not sufficient. Rather, it is the foundation on which to build a thriving market economy.

This is true here in Turkey as elsewhere. Further structural reform offers the chance to accelerate this country's transformation to a well-functioning, stable and rapidly-growing market economy.

Timing is crucial. The prospects for sustained growth are better than they have been in decades. So far, progress has exceeded expectations. The Turkish government has pressed on with reforms in the context of an improving global economic climate. Economic upturns provide the best backdrop for any reform programs. The benefits flow more rapidly, and the costs of adjustment are lower than they would otherwise be.

The payoff has already been substantial. As reforms continue, the payoff will increase—economic reforms have a cumulatively beneficial impact, the one increasing the returns on all the others.

So, much has been achieved. As I said at the outset, this is a wonderful time to visit Turkey and to see the fruits of what has already been done beginning to show. The challenge now is to make the reforms achieved so far irreversible and to maintain the momentum.

The prize will be a higher growth potential and a more rapid rise in real incomes. That, by any measure, is a prize worth having. It is a prize that I believe is well within the grasp of Turkey and its citizens.

Thank you.