February 16, 2018
PRESS OFFICER: Wiktor Krzyzanowski
Phone: +1 202 623-7100Email: MEDIA@IMF.org
Following a slowdown in activity in 2016, growth recovered sharply last year with the help of policy stimulus and favorable external conditions. Such has been the strength of the recovery that the economy now faces signs of overheating: a positive output gap, inflation well above target, and a wider current account deficit. This increases Turkey’s potential exposure to changing global conditions and underscores the need to address vulnerabilities. To lower internal and external imbalances, staff recommends a recalibrated policy mix—further monetary tightening is warranted, as is careful management of fiscal and quasi-fiscal policies, as well as associated contingent liabilities. Macroprudential policies need to be squarely focused on maintaining financial stability and adequate buffers. Targeted structural reform implementation would underpin growth.
Recent developments, outlook and risks
1. Growth was very strong last year, with some moderation expected in 2018. In 2017, a sizeable credit impulse—driven by state loan guarantees—and fiscal policy supported the economy, at a time when domestic demand seemed anemic. Exports increased sharply, due to stronger external demand, against the backdrop of a softer lira. Growth is estimated at about 7 percent in 2017, well above potential. As a result, the output gap now appears positive, with symptoms of associated imbalances. Under staff’s baseline, growth is expected at 4 percent this year, reflecting in part a weaker policy-driven impulse.
2. Inflation is well above target and is expected to remain so without further policy adjustment. Initially fueled by the large lira depreciation, inflation has since increased, in part due to higher demand, rising cost pressures, and rising inflation expectations. Although base effects are likely to see headline inflation fall during the early part of this year, in staff’s view, without further interest rate increases, inflation is likely to end the year once again in double digits.
3. The external current account deficit looks set to stay above 5 percent of GDP. Although exports have performed very well, higher fuel prices, strong demand-led and gold import increases led to a wider current account deficit last year. This was financed mainly by Eurobond issuance, other portfolio inflows, and by reserve drawdowns, with foreign direct investment (FDI) inflows remaining short of desirable levels. Despite strong partner growth and a recovering tourism sector, continued domestic demand strength and higher oil prices are expected to lead to a further widening of the current account deficit this year, with external financing needs remaining large. Reserves remain relatively low, covering only around half of Turkey’s gross external financing needs.
4. Areas of risk could become more apparent should external conditions take a negative turn. Vulnerabilities include large external financing needs, limited foreign exchange reserves, increased reliance on short-term capital inflows, and high corporate exposure to foreign exchange risk. Signs of possible oversupply in the building and construction sector are also emerging. While risk triggers are, by their nature, difficult to project, they could stem from domestic developments or regional geopolitical developments or changes in investor sentiment towards emerging markets.
The Policy Agenda
The main policy challenge is to recalibrate macroeconomic policies in a measured, yet credible, manner that fosters sustainable growth, while protecting the Turkish economy from downside risks. Combined with focused structural reforms to underpin medium- and longer-term growth, this would leave Turkey better placed to handle any possible reversal of global sentiment towards emerging markets.
Monetary and financial sector policies
5. Reining in inflation remains the most important challenge for monetary policy. The Central Bank of the Republic of Turkey (CBRT) effective interest rate hikes of almost 500 bps over the past year have not been enough to contain inflation and prevent inflationary expectations from increasing. This is because all three channels—demand-pull, cost-push, and exchange rate depreciation—have exerted upward pressure on inflation. In staff’s view, as part of a recalibrated policy package, a front-loaded monetary tightening is called for to secure the credibility of the central bank’s inflation forecasts and to move closer, over time, to its 5 percent inflation target. A credible tightening might also allow the CBRT to increase its international reserves against the backdrop of still-favorable global liquidity conditions. Simplification of the monetary framework over time would also be welcome.
6. Recent measures to address foreign exchange (FX) borrowing risks to small- and medium-size enterprises (SMEs) are a step in the right direction. Banks rely heavily on wholesale FX funding and the corporate FX debt burden is high, a source of vulnerability in the economy. Recent calibrated moves to limit FX borrowing of unhedged corporates are welcome and generally aligned with staff’s recommendations in past years. Further tightening of regulations on corporate FX borrowing would mitigate against vulnerabilities stemming from the open FX positions of some large corporates.
7. The authorities’ decision to better target the Credit Guarantee Fund (CGF) is welcome. Last year’s CGF expansion—introduced at a difficult juncture—made a strong contribution to confidence and growth, but it put pressure on bank funding costs and could have been more targeted. Current signs of overheating and the need to reset sustainable longer-term incentives for banks and SMEs argue for a gradual phase-out of this support mechanism, along with the planned targeting of the unused portion of the facility.
8. Macroprudential tools need to keep their focus on preserving financial stability. Macroprudential policy changes should be guided by longer-term considerations of maintaining financial stability and building buffers, rather than for demand management purposes. Policies that eased consumer and corporate borrowing, which began in 2016, should be revisited.
Fiscal policy
9. Turkey’s strong fiscal anchor has played a critical role over the years. However, looking ahead, the authorities need to guard against two sources of pressure: the growing gap between primary spending and tax revenue, amid growing rigidities in the budget; and a narrowing of fiscal space through increasing contingent liabilities. This requires setting fiscal and quasi-fiscal policies carefully, including limiting guarantees for long-term development projects to those that appear most viable.
10. Steady and measured fiscal consolidation would help reduce imbalances and bolster investor sentiment. The expiration of temporary tax breaks and the introduction of new tax measures—such as the corporate income tax rate increase, reductions of income tax exemptions, and an increase in consumption taxes on motor vehicles—are welcome. This has, however, been accompanied by new tax exemptions and employment subsidies and further measures are needed to bring the general and central government balances to primary surpluses of about ½ percent of GDP by 2019. These include broadening the revenue base, raising direct taxation, improving the efficiency of the value-added tax (VAT) system; limiting budget rigidities, principally by not further encumbering the wage bill; strengthening budgetary discipline by containing ad-hoc subsidies and setting credible time limits on such subsidies; and providing transparent and timely costing. The authorities’ ongoing efforts to reform the VAT system are welcome.
11. Fiscal transparency and fiscal risk management reforms are in train but need further improvement. Public-private partnerships (PPP) activity has risen sharply, as have related and other contingent liabilities. Staff welcomes measures by the authorities to strengthen the PPP risk management and reporting framework, which were supported by recent IMF and World Bank technical assistance. Building on this would help preserve fiscal space and underpin long-term debt sustainability. More broadly, the scope and role of extra-budgetary and other non-central government entities, and institutions such as the newly created Turkish sovereign wealth fund (SWF), need to be carefully defined and monitored, with the maximum degree of transparency.
Structural policy
12. Focused structural reforms would help underpin medium-term growth. Total factor productivity growth has been lackluster over the past decade, with economic growth reflecting mainly increased capital and labor inputs. Advantage should, therefore, be taken of current strong cyclical growth conditions to implement needed reforms.
13. Labor market reform is crucial in this regard. There is a skills gap which risks undermining what should be Turkey’s natural demographic advantage. Equally, addressing the improving, but still low, female labor participation rate is important to raise potential growth. Without further reforms in these areas, significant resources will remain untapped. Further reforms could focus on: improving educational outcomes through tertiary level and further supporting vocational training; enhancing opportunities for flexible and part-time work, as well as child-care facilities; and reforming the severance pay system.
14. Other structural reforms could also help growth prospects. These include improving the investment climate and institutional capacity, as well as fostering higher participation in the voluntary private pension system.
Data
15. Some enhancements to further strengthen Turkey’s economic statistics would be helpful. Staff welcomes the authorities’ plans to introduce further refinements to high frequency indicators, and to provide a breakdown between private and public investment in the national income accounts this year. Staff urges swift completion of these refinements, which would help further bolster transparency.
Refugees
16. Turkey’s generosity in hosting refugees serves as a global example. The introduction of work permits for those under temporary protection is very welcome, recognizing that the informal sector has been one of the main modes of employment for refugees. To ensure further formal labor market integration of refugees, the application process for work permits and business creation could be simplified further.
The IMF team would like to thank the authorities and private sector counterparts for their warm hospitality and open and constructive discussions.
