Mission Concluding Statement 

Turkey: Concluding Statement of the 2014 Article IV Mission

October 3, 2014

Turkey’s economy has grown by a remarkable 6 percent on average since 2010. However, low national saving and competitiveness challenges are constraining investment and exports and making it harder for Turkey to meet its ambition to close the per capita income gap with advanced economies. Low saving also contributes to external imbalances that expose the country to the risks associated with international capital flows. The authorities’ immediate priority should therefore be to raise private and public savings. A higher primary fiscal surplus is essential. In addition, monetary policy needs to focus on the inflation target. The macro prudential policies to preserve financial stability should also be reinforced. Determined implementation of the reforms in the 10^th development plan will likewise be essential to help Turkey avoid the “middle income trap”.

1. Turkey’s economy has grown by a remarkable 6 percent on average since 2010. The economy recovered swiftly from the great financial crisis and unemployment reached its lowest level in the last decade. More recently, the authorities effectively contained the fallout from heightened domestic uncertainty and financial market volatility. However, rapid growth has come at the expense of high inflation and a large external deficit. These imbalances are holding back growth potential and need to be addressed with carefully sequenced macroeconomic policies and structural reforms.

2. Growth is set to continue, albeit at a moderate pace. In 2014, GDP is expected to grow at 3 percent, driven by public sector support, net exports, and a mild revival of private consumption in the later part of the year. However, inflation will exceed the authorities’ target once again, reflecting the exchange rate pass through, high food inflation, and partly, premature monetary easing. In addition, the current account deficit—although decreasing—will remain elevated.

3. Without a change in policies, future economic performance is likely to be weaker than that of the recent past. Turkey’s low domestic savings and challenges related to competitiveness are becoming limiting factors for investment and exports. Thus, on current policies and national saving rates, economic growth is expected to slow to about 3½ percent per year in the medium term. The lower growth rate would likely limit inflation and the deterioration of the current account deficit. But it would also mean that Turkey’s income convergence with advanced economies would be slow, potentially leaving Turkey in a middle income trap.

4. The financial system remains well capitalized. Capital adequacy ratios are high on average, and mostly based on high quality capital. Nonperforming loans are low and well provisioned. However, banks have made increasing use of ample and cheap external wholesale funding. In tandem, banks have increased their indirect foreign exchange risk through foreign currency lending to non-financial corporations.

5. The main risk to the outlook is a sharp decrease in capital inflows to emerging markets. Turkey’s external gross financing needs of more than 25 percent of GDP leave the country exposed to sudden shifts in capital flows which could lead to a costly adjustment of the real economy. In addition, as leverage has increased in the private sector, buffers to withstand shocks may have diminished. The longer imbalances are allowed to increase, and the slower the authorities are to create additional policy space to respond to shocks, the more costly such adjustments will become.

Policy Agenda to Rebalance the Economy

6. In the near term, the macroeconomic policy mix has to play a bigger role in rebalancing the economy and addressing imbalances. Turkey’s growth is constrained by its dependence on consumption, slow export growth, and sizable investment needs, against the backdrop of a large external deficit. The challenge of rebalancing the economy can only be met by implementing a stronger macroeconomic policy mix, especially until the authorities’ structural agenda begins to bear fruit.

7. A tighter fiscal stance would contribute to reducing the external imbalance, and relieving pressure on monetary policy. Government non-interest current expenditure, which has been growing faster than the economy, is very stimulative. Moreover, the structural balance has been deteriorating in recent years, although debt sustainability is not a concern. In addition, a tighter fiscal stance would reduce the burden on monetary policy to meet the inflation target. This would help rebalance the economy away from consumption, support private investment, and improve the competitiveness of the tradable sector. Also, a stronger public sector position would create additional policy space to react to shocks as private sector balance sheets become more stretched. Hence, the mission recommends a front-loaded fiscal adjustment to reach a 2 percent of GDP primary surplus by 2017. This should be achieved by containing non-interest current expenditure and preserving investment in economically sound projects.

8. The monetary stance needs to be consistent with the inflation target. The current policy rate is not compatible with reducing inflation to the 5 percent target. Monetary policy should focus on the target by sustaining a positive real policy interest rate to anchor expectations and lower inflation to the targeted rate. The monetary effort to achieve the inflation target would be smaller if the fiscal stance were tighter.

9. Although gross international reserves are adequate, it would be prudent to increase net international reserves. The level of gross international reserves is in line with international standards, although not ample, and still below levels seen in peer countries. Net reserves are low, however, thus providing limited buffers in case of prolonged periods of exchange rate volatility. The central bank should bolster its net international reserves through sterilized interventions, as market conditions permit.

10. The strength of the banking sector must be preserved. Maintaining the standards of supervision and a level playing field is essential, and the authorities could also consider expanding their prudential and macro prudential toolkit. In order to curb foreign exchange risk in the economy, the authorities could, after conducting a careful impact analysis, consider further measures that encourage banks to reduce wholesale foreign exchange borrowing and reduce incentives for the corporate sector to borrow in foreign exchange. Moreover, prudential measures applied to foreign exchange indexed lending should be brought in line with those applied to straight foreign exchange loans.

11. For the medium term, the structural reform policy agenda also needs to be revitalized. Macroeconomic policies can support rebalancing and preserve financial stability in the near term, but improved medium-term growth will also depend on progress with structural reforms aimed at enhancing Turkey’s economic potential. Thus, staff encourages the authorities to accelerate the ambitious reform program included in the 10^th Development Plan. The priority should be to implement the policies that encourage higher private sector savings, and promote lower energy dependence.

The IMF team would like to thank the authorities and our counterparts in the private sector for their hospitality and open and constructive discussions.

¹ An IMF team visited Turkey between September 11 and 24, 2014 for the annual evaluation of the economy as part of the regular consultations under Article IV of the IMF’s Articles of Agreement.