Public Information Notice No. 04/87

Public Information Notice: IMF Concludes 2004 Article IV Consultation with Turkey

August 10, 2004

On July 30, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Turkey.¹

Background

After the collapse of the 2000 exchange rate-based disinflation program and the floating of the lira in February 2001, the banking system experienced heavy losses, inflation soared and the economy contracted by nearly 10 percent. Public debt climbed to over 90 percent of GNP in 2001, partly owing to the costs of bank restructuring.

Since then, strong fiscal consolidation and disinflation efforts have laid the basis for a rapid and powerful recovery. High primary surpluses, reaching more than 6 percent in 2003, contributed to bringing public debt on a sustainable and declining path. The debt-to-GNP ratio declined to 70 percent in 2003 and the market risk premium on Turkish debt fell significantly.

The adherence to a strict monetary program under the floating exchange rate regime helped establish the Central Bank's credibility and facilitate a dramatic decline in real interest rates as confidence recovered. In this environment, real GDP grew by close to 8 percent in 2002 and 6 percent in 2003, and it is projected to grow by at least 5 percent in 2004. At the same time, inflation has fallen to its lowest levels in decades, and is on track to reach its annual target of 12 percent in 2004.

These favorable developments notwithstanding, the Turkish economy faces a number of risks. Domestic demand has started to increase rapidly, and the current account deficit is widening as a result. The high size of the government debt, its short maturity, and its currency composition is also a major source of vulnerability.

For the medium term, the authorities' main challenge is to implement policies that achieve the goals of sustained growth and low inflation. With its commanding majority in Parliament and with new elections not needed for another three years, the government has an unprecedented opportunity to implement the difficult structural reforms needed to achieve this.

Executive Board Assessment

Executive Directors welcomed the opportunity to take stock of what had been achieved over the last few years and to gauge Turkey's challenges and reform priorities ahead. Directors commended the authorities for the impressive economic performance, with macroeconomic conditions at their best in decades. They were particularly pleased to note that the authorities' strategy of disinflation and rapid debt reduction is delivering striking results. Growth has been sustained and rapid, while inflation has been lowered dramatically to single digits. Large primary surpluses have helped reduce government debt ratios and improved market confidence, leading to a significant reduction in real interest rates, an end to decades of continuous exchange rate depreciation, and a markedly improved resilience to shocks.

Despite these considerable achievements, Directors noted that vulnerabilities remain. The size of the public debt, its short maturity and large foreign currency component make Turkey vulnerable to exchange rate and interest rate shocks. In addition, the quality of fiscal adjustment needs to be improved and the pace of structural reform intensified, if the achievements to date were to be sustained and be carried forward in the form of robust medium-term growth.

With regard to short-run challenges, Directors noted that domestic demand growth is exceptionally strong, contributing to the widening of the current account deficit, and they commended the authorities for their efforts to dampen domestic demand. Fiscal policy had been kept tight, with the primary surplus targets exceeded, tax incentives for certain consumer purchases had been reduced, and state banks had reined in their lending. Despite these efforts, Directors saw the need to continue to monitor the rising current account deficit carefully. Against this background, Directors urged the authorities to save this year's fiscal overperformance, at least until the outlook for the current account stabilizes, and to stand ready to tighten fiscal policy further if domestic demand continues to be strong. Directors regretted the repeated increases in minimum wages, but welcomed the authorities' strong efforts in restraining government sector wages, which would help contain domestic demand pressures.

Looking to medium-term prospects and policies, Directors emphasized that continued fiscal consolidation would be central to maintaining Turkey's impressive economic performance and strengthening medium-term growth prospects. They noted that the success in fiscal consolidation had resulted in a reduction in real interest rates and had boosted growth, while providing the Central Bank of Turkey (CBT) greater freedom to gear its monetary policy to reducing inflation. Against this background, Directors urged the authorities to resist calls to relax next year's primary surplus targets, as any benefits would likely be far outweighed, even in the short run, by higher real interest rates, which will slow growth. Continued high primary surpluses in a predictable medium-term framework would also help the authorities meet the considerable public debt repayments coming due and help strengthen market confidence.

Directors stressed the importance of adopting high quality measures to help sustain this fiscal consolidation. This should include reform of the social security system, which, despite high contribution rates, remains in large deficit, and reform of tax administration to combat widespread tax evasion. Further large increases in current spending should also be resisted; this will also make room for increased public investment. Looking ahead, Directors saw scope for a more fundamental tax reform aimed at simplifying the system and broadening the tax base. To guide fiscal policy over the next few years and to help ensure debt sustainability, Directors encouraged the authorities to cast their plans within a multi-year debt reduction plan.

Directors commended the CBT and the government on their success in reducing inflation to single digits. The end-2004 inflation target of 12 percent is clearly achievable. The CBT's skilful use of monetary policy has been central to this achievement, supported by fiscal discipline and public sector wage restraint. Directors noted the importance of preserving the central bank's independence for keeping inflation low, backed by continued supportive fiscal and incomes policies. They also encouraged the CBT to enhance its monetary framework and increase its transparency. As first steps, this could include giving the monetary policy council more of a role in advising the Governor on interest rate decisions, and timing these decisions to coincide with monetary policy council meetings.

Directors noted the many achievements that had been made in financial sector reform. Creation of an independent Banking Regulation and Supervision Agency (BRSA), tightening of supervisory practices, recapitalization and restructuring of the state banks, and the triple audit and recapitalization of the private banks had each made the banking system much stronger. Directors welcomed the authorities' commitment to implementing the considerable reform agenda that still lies ahead, including accelerating recoveries from bad assets, privatizing the state banks, lowering distortionary taxes on financial intermediation, and legal reform, including passage of a new Banking Act.

Directors welcomed the authorities' commitment to stimulating growth by improving the investment climate, which would lead to more foreign direct investment inflows and boost jobs. Creation of more stable macroeconomic and financial conditions had already brought large benefits here, and would need to be sustained. Looking ahead, Directors urged the authorities to quickly put in place the steps recommended by the inaugural Investment Advisory Council meeting in mid-March 2004. Given that unemployment remains high, despite strong growth, Directors encouraged the authorities to press ahead with labor market reforms.

Turkey faces a historic opportunity. Directors encouraged the authorities to seize this unique opportunity to secure sustained growth and reduce vulnerabilities; press ahead with fiscal, financial, and structural reforms; and thereby put Turkey firmly on an irreversible path toward convergence with European economies.