Public Information Notice No. 02/46

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Turkey

April 19, 2002

On April 15, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Turkey.¹

Background

Turkey is in the midst of a determined campaign to turn around decades of weak performance. Not only has growth been on a downward trend since the 1970s (and inflation on an upward one), it has also become increasingly volatile. This performance reflects pervasive structural rigidities, weak public finances, and low policy credibility. Despite many achievements since the economic liberalization of the 1980s, deep-rooted structural problems remain a drag on growth, and past disinflation attempts have had little success.

The past couple of years have witnessed three major attempts at addressing underlying weaknesses. The first was during 2000 under the three-year Standby Agreement initiated in December 1999. The program instituted strong fiscal adjustment and a preannounced exchange rate crawl to restore debt sustainability and to break entrenched inflation expectations. The program also included a wide-ranging structural reform agenda—especially in banking, social security, privatization, and agriculture—to set Turkey on a higher sustainable growth path. Despite some notable achievements in structural reforms, in turning around the public sector primary balance, and in reining in inflation, a worsening current account and a fragile banking system led in late 2000 to a liquidity crisis which turned into a full-blown crisis, with a large loss of reserves. Prompted by political tensions, this was followed by another speculative attack in February 2001, forcing the government to float the currency amidst high interest rates and a renewed acceleration in inflation.

The second phase was the adoption in May 2001 of a strengthened program aimed at restoring investor confidence by addressing the roots of the crises, with the help of additional IMF support. The authorities' revised program featured a fundamental restructuring of the banking sector (a key source of vulnerability in the past), a commitment to a floating exchange rate (reducing vulnerability to shocks), continued disinflation, substantial fiscal adjustment to underpin debt sustainability, and an enhanced role for the private sector. Just as the revised program was beginning to show results, the events of September 11 triggered a deterioration in market sentiment and a re-emergence of serious financing problems. Meanwhile, Turkey continued to suffer from an inefficient public sector, barriers to private sector development, a banking sector damaged by the earlier crises, and a high public debt burden, fuelled in part by publicly-funded bank recapitalization.

In response to September 11, the Turkish government initiated a new intensified IMF-supported program, both to protect the economy against future crises, and to continue Turkey's ambitious reform agenda. Under the 2002-04 program, the continuation of the float will limit the potential for speculative attacks. Ongoing financial sector reform together with corporate sector restructuring will help strengthen the banking and business sectors, and continued fiscal discipline should foster medium-term debt sustainability. The program's strong structural reform agenda should, once macroeconomic stabilization is achieved, finally set the stage for sustained economic growth.

Developments under the new program have been promising. Financial market conditions have improved markedly from their post-September 11 lows; the benchmark bill rate has fallen sharply, and the Turkish lira has appreciated by more than 20 percent to around TL 1.3 million to the U.S. dollar. Against this background, the trend toward dollarization has diminished, and even shown signs of reversal in recent months, the stock market has risen by over 50 percent in lira terms since mid-September, and the roll-off of external interbank credits has ceased. Short-term concerns about the public debt rollover have also largely abated, allowing a lengthening of maturity of domestic debt and strong demand for new Eurobond issues. Inflation has started to decline, helping to reduce inflation expectations and allowing the Central Bank of Turkey (CBT) to reduce the overnight rate by 14 points (to 66 percent) in three steps over the past two months.

A large number of policy measures have been taken under the new program. In January, the authorities met more than ten prior actions in the fiscal and structural areas needed for the approval of the SBA. Subsequently, all quantitative performance criteria relevant for the first review were met. Base money came in below the end-February ceiling, while Net International Reserves and Net Domestic Assets targets were met comfortably. The public sector primary surplus target of 5.5 percent of GNP for 2001 was exceeded by an estimated 0.4 percent of GNP, and in January the consolidated government sector exceeded its primary surplus target comfortably. Solid progress has also been made in meeting the program's structural conditionality.

Executive Board Assessment

Executive Directors welcomed the Turkish authorities' decisive efforts to address the problems of the past and implement an ambitious economic reform program to lay the basis for sustainable growth. In the past, financial indiscipline and structural weaknesses had prevented Turkey from realizing its economic potential, and had created an environment of highly volatile growth and inflation spanning several decades. These problems had their roots in fiscal laxity, deficiencies in governance, lack of a nominal anchor, and inefficiencies and nontransparencies in the public sector, and were evident in barriers to private sector development and a banking sector damaged by the two recent crises. Directors welcomed the Turkish authorities' progress in addressing these weaknesses and reduce the vulnerability of the economy to shocks through their bold three-year program. They noted that the program represents a further decisive step away from the interventionist policies of the past, and that it would lay the groundwork for a stronger performance in the future.

In this regard, Directors commended the authorities for maintaining the positive momentum of macroeconomic adjustment and structural reform established in response to the events of September 11. Macroeconomic policies have remained prudent; and the government has continued to press ahead with structural reform, notably with respect to the identification of public sector staffing redundancies and the adoption of the legislative basis for improved public debt management. The authorities' efforts have been rewarded by a substantial decline in interest rates, a strong balance of payments position with an associated appreciation of the Turkish lira, and a drop in inflation and in inflation expectations.

Directors noted that, while these positive results should help lay the basis for sustainable growth, there are downside risks. In particular, they emphasized that the strength and timing of the recovery in output are uncertain, and that financial markets have remained alert to the possibility of further shocks. Directors expressed concern that prolonged slow economic growth would have an adverse impact on Turkey's debt sustainability. To boost growth, they emphasized the importance of structural reforms to raise private investment and productivity and to lower real interest rates. Directors stressed that successful program implementation in the months ahead will require the undivided support of the government coalition.

Directors stressed that, although fiscal developments remain on track, strict budget implementation must continue in order to ensure a sustainable debt position. While commending the authorities' commitment to the target of a public sector primary surplus of 6.5 percent of GNP in 2002, they stressed the need to remain mindful of possible downside risks, and urged the authorities to stand ready to take further offsetting measures to safeguard the primary surplus target and maintain external debt sustainability.

Directors noted that, to be sustainable, the achievement of the overall budget targets will need to be underpinned by decisive reforms. They were encouraged by the government's efforts to improve expenditure management, streamline tax policy, and strengthen revenue administration. On the tax side, they stressed the importance of simplifying the tax code. On the expenditure side, they noted the importance of moving expeditiously with the much-needed downsizing of the state economic enterprises and civil service reform.

Directors noted the increasing scope for monetary policy to promote disinflation and enhance confidence. In this regard, Directors were encouraged by the recent decline in current and expected inflation. The introduction of inflation targeting will further anchor inflation expectations. While a number of Directors noted that, with strong efforts by the CBT and the government, the preconditions for introducing formal inflation targeting could be in place by midyear, some other Directors considered that a longer track record on disinflation would be needed for such a framework to be credible. Regarding reserve management, they urged the CBT to continue to make use of the better-than-expected balance of payments developments to build up foreign exchange reserves, which should further improve confidence, and welcomed the authorities' recent move to pre-announced foreign exchange purchase auctions. They urged further development of the money and foreign exchange markets to help ensure a smoother functioning of the floating exchange rate regime, and welcomed the authorities' plans to lower distortionary taxes and reform the system of reserve requirements. They also stressed the need to closely monitor Turkey's external competitiveness in light of the recent appreciation of the Turkish lira.

Directors welcomed the progress in banking sector reform, including the implementation of the bank recapitalization plan, but called for further rapid movement on corporate debt restructuring. Moving forward, Directors stressed the importance of preserving the integrity and transparency of the bank recapitalization process, and of sticking to its announced timetable. They also underlined the need to maintain the independence of Turkey's regulatory institutions. Directors urged the authorities to accelerate privatization now that market conditions are more favorable, noting that inefficiencies in state economic enterprises are a core factor behind Turkey's disappointing growth performance in the last decade. Similarly, Directors urged the government to be forceful in demonstrating its commitment to dealing with deficiencies in the investment environment and promoting transparency and efficiency of public administration both at the central and local levels. Directors welcomed the measures taken to combat money laundering and the financing of terrorism.

Directors commended recent moves to improve transparency and data provision. Although some deficiencies remain in fiscal statistics, they welcomed the recent extensive improvements in fiscal transparency.