Turkey - Second Post-Program Monitoring Discussions, Preliminary Conclusions
December 17, 2010
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
December 17, 2010
A. Recent Developments, Outlook and Risks
1. The Turkish economy maintained its strong post-crisis recovery throughout 2010. With growth expected to exceed 8 percent this year, output will surpass its pre-crisis level by a comfortable margin, one of the few countries in Europe to achieve this milestone. Employment is also continuing to recover, although higher labor force participation—itself a sign of rapid recovery—is slowing the fall in the unemployment rate. Headline inflation remains highly volatile and elevated, but core inflation recently fell to an historic low partly reflecting temporary factors, including base effects, exchange rate appreciation, and price setting still attuned to the previous phase of the economic cycle, that more than offset the rapidly closing output gap.
2. The current account deficit, dormant during the crisis when external financing was scarce, reemerged assertively this year. Abundant low–cost external savings relaxed residents’ borrowing constraints and, together with the inadequate competitiveness due to structural factors, pushed up imports and suppressed exports. As a result, the current account deficit is expected to more than double in 2010 to nearly 6 percent of GDP. Inadequate competitiveness is also drawing capital away from tradable sectors and into real estate, energy, and retail trade.
3. Push and pull factors are expected to continue to drive short-term capital inflows next year, keeping domestic demand strong and the current account deficit elevated. Low interest rates in advanced countries, favorable near-term growth prospects and healthy balance sheets of the Turkish government and banks, as well as less-leveraged households than in much of Europe, will continue to underpin inflows. Inadequate competitiveness, the rising current account deficit and potentially-volatile short-term inflows highlight Turkey’s continued exposure to market sentiment, including contagion concerns from problems in Europe. Most inflows next year will continue to be intermediated through banks, driving credit, domestic demand, and imports. In all, for 2011, growth is expected to reach 4½ percent, the current account deficit to widen to around 6½ percent of GDP, and year-end inflation to reach 6½ percent.
B. Policy Recommendations
4. Policies that discourage excessive uptake of external savings and limit resource-misallocation and pricing risks will temper the magnitude of the economic correction if capital inflows slow or reverse. The authorities’ policy response during and in the immediate aftermath of the global financial crisis was broadly appropriate and paved the way for the subsequent rapid recovery. However, the external environment has evolved rapidly, and Turkey’s policies should continue adjusting to successfully navigate the challenges ahead. A combination of macroprudential and fiscal tightening, and a rebalancing of foreign currency purchases with liquidity withdrawal, underpinned by structural reforms to improve competitiveness, is warranted. The effectiveness of measures directly targeting the size and composition of cross-border flows erodes over time, hence, they should not be used until all other policy levers have been fully deployed, as detailed below.
Monetary and exchange rate policy
5. Safeguarding systemic financial stability is a sine qua non for consistently achieving price stability, and similar tools can be used to support both goals. Rapid credit expansion that boosts domestic demand and widens the current account deficit can trigger exchange rate volatility that exerts upward pressure on prices and wages, particularly in the nontradable sector. Standard interest rate tools may be less effective at delivering price and financial stability in the context of a huge global pool of yield-seeking liquidity to the extent capital inflows increase. Instead, greater use should be made of instruments that directly control the quantity of liquidity and lower the return from financial intermediation, as communicated by the Central Bank of Turkey (CBT).
6. Several tightening measures have recently been implemented, but liquidity remains excessive. Reserve requirements were raised to pre-crisis levels and remuneration was halted. The CBT’s overnight borrowing rate was drastically cut, in large part to discourage short-term lira conversion through currency swaps. Repo funding was also scaled back and banks remain net demanders of CBT liquidity, consistent with the negative differential between cost of funds and yields on assets. However, much-increased central bank purchases of foreign currency—that might be seen as a response to strengthened capital inflows to more quickly build reserve buffers—have also expanded liquidity, facilitating more and cheaper financial intermediation, including short-term carry trade.
7. Moderating injections and increasing withdrawals would create more appropriate liquidity conditions. Large purchases require aggressive action to soak up injected liquidity that may push sterilization instruments beyond their effective capacity. Hence, large purchases may be perceived as unsustainable, making the exchange rate a one-way bet and encouraging speculative inflows. To limit this possibility and restrain liquidity, foreign currency purchases as a share of financial inflows should be reduced. This would also avoid any misperception that the CBT might be focused on short-term competitiveness while remaining sanguine on the longer-term threat from inflation. Increasing reserve requirements on both lira and foreign-currency liabilities would withdraw liquidity and widen the intermediation wedge. In addition, extending coverage, including to other credit providers and instruments, would encourage longer duration funding and limit circumvention.
8. The option to raise interest rates should be preserved. Conditions requiring an increase in interest rates may arise within the CBT’s policy horizon, including the need to normalize real interest rates, particularly if direct tightening measures are not effective in protecting the credibility of the inflation target or preserving financial stability. Therefore, excessive comfort from the expectation that interest rates will remain low for an extended period should be avoided to discourage the financial and real sectors from lengthening their duration mismatches.
9. Financial sector regulation and supervision should continue to focus on limiting the buildup of risks to systemic financial stability and macroeconomic sustainability. Systemic risk in the financial sector generally arises when the incentives faced by many market participants are aligned, but each one individually ignores the effect of its actions on the entire economy. Systemic risk may be detected in a less timely manner if supervision is focused on individual financial institutions’ health. Further exploiting synergies between supervision and monetary policy would enhance the efficiency of macroprudential oversight and the effectiveness of the policy response.
10. Macroprudential measures should target risk at its source, typically where financial activity is most intense. Crisis-era relaxation of regulations for restructuring loans and general provisioning is no longer necessary and should be withdrawn in full. Moreover, regulatory standards and guidelines should be tightened. In the context of dynamic housing construction, rapid growth of housing loans (including withdrawal of equity), and credit concentration to both developers and end-buyers for the same property pose risks if unchecked. We welcome the BRSA’s decision to establish legal ceilings on loan-to-value for residential and all other real estate loans no higher than required for securitized mortgages. In addition, raising the Resource Utilization Support Fund levy on new housing credits to the level applicable to other loans, and eliminating preferential tax treatment of real estate investment companies would help. To build countercyclical buffers and prevent the accumulation of systemic risk through rapid growth of general-purpose loans and foreign-currency lending to unhedged borrowers, general provisioning requirements on these loans should be raised above the pre-crisis level.
11. Revenue and fiscal balances have rebounded strongly in 2010, but a greater effort is needed to stem macroeconomic pressures. A tighter fiscal policy lessens demand for resources, decreases pressure on prices and imports, and by raising government deposits, supports the CBT’s efforts to absorb liquidity. Saving receipts from the new receivables-restructuring program and privatization in excess of budget forecasts would avoid additional demand pressures, help offset private sector capital inflows, and could create future permanent fiscal space through lower interest payments.
12. While the authorities’ 2010 Medium-Term Program (MTP) appropriately targets a significant reduction in spending and improved debt dynamics, it also includes buoyant revenue derived from a transient import boom These transient revenues should not be relied upon to meet medium-term targets because options to quickly compensate lost revenue are restricted by the high share of nondiscretionary spending (exacerbated by large pension and public sector wage increases budgeted in 2011) and already-high statutory tax rates. The receivables restructuring program may weaken tax compliance, and in turn, future revenue performance. In view of the above considerations, all income in excess of budget forecasts in 2011 should be saved.
13. Removing structural impediments to competitiveness would enhance Turkish firms’ ability to adapt to capital inflows. A more effective labor market and efficient use of imported energy would help raise the domestic content of production and allow Turkey to better compete in global product markets. This calls for better aligning productivity-adjusted formal-sector employment costs with those of regional peers, reducing taxes on labor and business supported by a permanent improvement in tax compliance (through improved audit procedures and avoiding tax amnesties), and sustained uniform application of cost-recovery energy pricing to promote conservation and more efficient generation capacity. Improving existing accounting standards and strengthening currently-weak creditor and minority-shareholder rights would help attract longer-term and more diversified funding for corporates to deepen and strengthen the resilience of financial markets.
We thank the Turkish authorities and our private sector interlocutors in Ankara and Istanbul for their hospitality and informative discussions.