Central Bank of Turkey Conference: Macroeconomic Policies for EU Accession, Speech by Anne O. Krueger, First Deputy Managing Director, IMF
May 6, 2005
Speech by Anne O. Krueger
First Deputy Managing Director
International Monetary Fund
Friday, May 6, 2005
It is especially good to be in Turkey at a time of such strong economic performance. Progress here has been striking in recent years. The government's continuing commitment to its economic reform program is impressive. The strength of this commitment has underpinned the government's request for a new $10 billion standby arrangement with the IMF. This is intended to support a three year economic program that aims to sustain growth, deliver price stability, and move towards convergence with the EU economies. The Fund's Executive Board will consider this program next week. We are confident that the economy will strengthen and continue its progress over the life of the program.
As the government builds on the success achieved so far, so attention is turning to the policy framework that will be needed if the accession negotiations between Turkey and the European Union are successfully concluded: hence this conference.
The economic agenda is a challenging one, as I'm sure your discussions this morning highlighted. But as the experience of recent years has already demonstrated, the potential rewards are great.
I want today to assess what has been achieved in the past few years; and to look ahead to the policy challenges of the future. First, though, let me say something about the context of the economic reform agenda.
The prospect of EU membership has certainly focused thinking on the further progress needed. It is important to remember, though, that the principal reason for pushing ahead with further reforms is that they will bring great benefits for Turkey and its citizens regardless of EU membership. Achieving macroeconomic stability has already made possible higher growth rates over a sustained period: this raises real incomes and helps to reduce poverty.
The best reason for undertaking economic reforms anywhere, and at any time, is that they make sense in themselves because they improve the lives of citizens. Turkey's economy has achieved macroeconomic stability. But strengthening the economy further to reduce its vulnerability to risks of external shocks and to permit room for maneuver with countercyclical policy is still needed. The fact that, in Turkey's case, further economic progress will be achieved if the full benefits of prospective EU membership are reaped is an added bonus.
Progress so far
The recent transformation of the Turkish economy has been remarkable. It is difficult, now, to remember quite how difficult was the situation at the time of the 2000-2001 crisis. Inflation was a chronic problem, having been at more than 60% a year from the 1980s onwards, in large part because successive governments had failed to achieve fiscal control. Reforms that had been implemented earlier—such as the trade liberalization of the early 1980s—delivered less than they might otherwise have because of macro instability. The consequence was an economy that lurched from crisis to crisis. Short-lived booms were followed by bust.
The crisis of 2000-2001 brought things to a head. Here was a country with enormous potential, a potential that was not being fulfilled. There was a clear appetite for making a break with the past and getting to grips with the country's problems once and for all. The overriding motive for change was to achieve an underlying and sustained improvement in Turkey's economic performance.
Turkish economic policymaking and the Turkish economy have been transformed in a remarkably short period. The numbers speak for themselves. Average real GNP growth over the past three years has been close to 8%: last year it was just short of 10%. That contrasts with average growth of 2.3% between 1995 and 2001. Even more remarkable, that acceleration in growth has been achieved in the context of sharply declining inflation and fiscal consolidation. The inflation rate has fallen from 70% three years ago, to close to 8% now—its lowest level for 35 years. The primary surplus was almost 7% of GNP last year-above the 6.5% target. And the public debt to GNP ratio has fallen by 30 percentage points of GNP since the peak in 2001. As I will discuss further in a moment, however, the debt to GNP ratio is still a source of vulnerability and needs to be brought down further.
The success of counter-inflationary policy has been exceptional, and has surpassed expectations. The skillful implementation of monetary policy by the Central Bank has, of course, been crucial. For three consecutive years, the CBT has outperformed its end-year inflation target. This has greatly strengthened the credibility of monetary policy. And this sharp decline in inflation has been achieved in the context of rapid growth.
This is a major achievement that brings widespread economic benefits. Inflation distorts resource allocation in the economy. It hurts the poorest members of society disproportionately. It creates uncertainty and it arbitrarily redistributes income and wealth. It undermines macroeconomic stability and it makes sustained rapid growth impossible to achieve.
Getting to an inflation rate of 8% or thereabouts is, as I say, an impressive turnaround in such a short time. There are significant additional benefits to be had from lowering it still further, say to the 2% - 4% range. This would greatly reduce, if not eliminate, the inefficiencies associated with inflation; and Turkish inflation would converge with inflation rates in the main industrial economies, including those in Europe.
It is clear that the authorities recognize the gains to be had from pursuing further reductions in inflation: a continuing decline in inflation remains a central objective of policy. The independence of the central bank has certainly been important in maintaining downward pressure on the inflation rate, and will continue to be so. And the move to inflation targeting planned for next year should facilitate a further decline in the inflation rate.
The chronic fiscal imbalances of earlier years were the root cause of persistent inflation. Bringing the fiscal situation under control was therefore essential to the success of counter-inflationary policy and to the macroeconomic stability that Turkey currently enjoys. The fiscal adjustment undertaken thus far has permitted a significant reduction in the debt burden, reduced the risk premium on Turkish debts and helped restore confidence in macroeconomic policy. The government is committed to maintaining the primary surplus so that the debt burden can be reduced further. In spite of the reductions already achieved, external debt is still more than 50% of GNP, and gross public debt is over 75% of GNP. A large part of the public debt is indexed either to foreign currencies or linked to short-term interest rates
Further debt reductions are important if Turkey's vulnerability to rising worldwide interest rates and exchange rate volatility is to be reduced. Experience in other emerging markets suggests that anything above 30% - 40% is in the risky zone.
Of course, a continuing primary surplus of 6.5%, to which the government remains committed, will make possible further reductions in debt vulnerabilities. And the government's objective of gradually moving to something close to overall fiscal balance will help strengthen the macroeconomic policy framework still more, and free resources for essential infrastructure and other programs. It is important to remember that the economy has grown rapidly during the period when the government has been meeting, and even exceeding, its primary surplus targets. Moreover, growth performance has far exceeded expectations in the context of rapidly falling inflation rates.
The pace of growth is likely to moderate a little in the coming years, as the excess capacity in the economy has largely been absorbed. There is every prospect that growth will continue to be relatively rapid and sustained over a long period, provided the reform momentum is maintained. In the next phase of Turkey's expansion, structural reforms will inevitably come to the fore. Indeed, they will be essential if Turkey's potential growth rate is to be raised and its transformation to a well-functioning and stable market economy is to be accelerated. Such a transformation is in the interests of all Turkey's citizens because it will contribute to the rising living standards we all want to see. Without structural reforms, countries experiencing rapid growth soon run into capacity constraints and, with them, inflationary pressures. If action is not taken to alleviate bottlenecks, with reforms that make the economy more flexible and more efficient, and so raise its growth potential, growth soon starts to slow, or the inflation rate starts to tick up very rapidly.
Reforms have already been introduced in a number of areas. There were trade and banking sector reforms in the early 1980s. Since the crisis of 2000-2001, many other reforms have been implemented: in the financial sector, in response to the banking crisis that precipitated the radical shift in economic policy; in the management of the public finances; and in the area of business regulation. But further reforms in these areas are needed if the economy's growth potential is to be raised. As you know, many structural reforms have long time lags. The sooner reforms are introduced, the sooner the results will start to show.
Let me mention briefly a few areas where further structural reforms would improve the economy's growth potential.
First, the financial sector. The banking crisis led to important reforms in this area. 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 start growing more normally. 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 recognized just how important a sound financial sector is-not least in a rapidly-growing economy. The banking system needs to be sound, and financial intermediation to be increasingly wide and deep. Efficient credit allocation becomes increasingly important as an economy becomes increasingly sophisticated.
The government recognizes this. It has already 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.
But the reform process cannot stop there. 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 credit is allocated less efficiently than desirable. Inefficient or less than optimal allocation of credit reduces the rate of growth and therefore impedes the growth potential of the economy.
Next let me say something about reforms in management of the public finances.
Reforms to improve budgetary transparency are under way, as are improvements to the tax system; 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, generating additional revenues in the process.
There is scope, and pressing need, for reform on the expenditure side, too. In spite of earlier pension reforms, 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. And 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.
Finally, a couple of comments on reforms aimed at creating a more hospitable business climate. The 2003 Foreign Direct Investment Law helped level the playing field for foreign and domestic investors. The government has now embarked on reforms aimed at cutting red tape; improving the functioning and predictability of the judicial system; and bringing business standards generally more into line with those of the EU.
A more flexible labor market is also badly needed. 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 and on measures such as the difficulty of hiring workers, and the rigidity of working hours, Turkey currently scores poorly in international comparisons. Liberalizing labor market regulation would greatly improve the business climate and increase 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 that are desirable in themselves. They will also help Turkey converge more closely with the EU and other industrial countries, and so promote the objective of Turkish membership of the European Union. But that is an added bonus-not the main reason for pursuing labor market or any other economic reforms.
Let me conclude. The turnaround in Turkey's economic performance has been remarkable. There is every reason to expect further rapid growth, sustainable over a long period. That will raise real incomes, deliver rising living standards and further reduce poverty: objectives we all endorse. But this can only happen if the economy's growth potential is raised by pursuing further structural reforms.
Timing is crucial. 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. This is a strong argument for continuing now, while the global outlook remains favorable, and while the reform momentum can be maintained.
The payoff from reforms 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.
Now is the right moment to press ahead, to extend the scope of the reforms: while the world economy is growing at a healthy pace and when there is the opportunity to ensure that growth can be sustained over a prolonged period. This will help Turkey converge with the European Union. More importantly, it will benefit all of Turkey's citizens.