Mission Concluding Statement 

Turkey: Staff Concluding Statement of the 2021 Article IV Mission

January 25, 2021

As in all other countries, the pandemic has inflicted a heavy human and economic toll on Turkey. The policy reaction, which focused on monetary and credit expansion, led to a strong rebound in growth after the initial shock, but at the same time exacerbated pre-existing vulnerabilities. This left the economy more susceptible to domestic and external risks. The recent policy pivot away from rapid money and credit growth is welcome. Buffers could be rebuilt more quickly if this pivot persists, and is combined with additional pandemic-focused fiscal support that is temporary and targeted, a credible plan for medium-term fiscal consolidation, as well as focused financial sector and structural reforms. Structural reforms should focus on mitigating the risk of long-term adverse effects of the pandemic, and should include targeted measures to support the most vulnerable, encourage labor market flexibility and facilitate corporate debt relief.

The Covid-19 Shock: Impact and Policy Response

1. Turkey entered 2020 with pre-existing vulnerabilities. Growth over the past decade has been driven in large part by externally-funded credit and demand stimulus. As a result, elevated external financing needs, declining reserves, high inflation, and increasing dollarization set Turkey apart from many of its emerging market peers.

2. The pandemic exacted a painful human and economic toll. Almost 25 thousand Turkish people have died and 2.4 million have been infected. Virus containment measures helped prevent an even steeper toll, but at the same time led to an unavoidable steep fall in economic activity and employment in the second quarter of 2020.

3. The initial policy response to the pandemic led to a sharp rebound in GDP. The early stimulus relied primarily on rapid monetary and credit expansion, including policy rate cuts, cheap and rapid lending growth by state-owned banks, and administrative and regulatory measures designed to boost credit. Despite some fiscal space, direct fiscal measures amounted to just 2.5 percent of GDP, mainly in the form of tax deferrals, but also including employment support. These combined measures helped economic activity rebound strongly in the third quarter to above pre-pandemic levels, with Turkey among the few countries estimated to have posted positive overall growth in 2020.

4. But this policy response also exacerbated vulnerabilities. Inflation remains well above target, further weighing on policy credibility. Increased dollarization, relatively high imports, and financial outflows triggered large-scale foreign exchange intervention in an attempt to stem lira depreciation.

5. The recent policy pivot, to tighten monetary policy and slow credit growth, is welcome. From late-2020, monetary policy tightening, the easing of ad hoc regulatory measures, and a marked slowdown in state-owned bank lending helped contain the pressure on the lira and rebuild confidence. Gross reserves have since broadly stabilized, but at a level well below the recommended range, and well below most peers. While net international reserves (NIR) remain positive, once foreign exchange (FX) swaps with the central bank (CBRT) are subtracted, the net position is negative.

Outlook—A Recovery, but with Significant Risks

6. The economy is expected to see continued positive growth in 2021. With the roll-out of a vaccine, and recovery of trading partner growth, and also mainly reflecting large positive growth carryover from 2020, Turkish GDP is expected to expand by about 6 percent in 2021. From 2022 onwards growth is projected to settle back to trend (about 3½ percent). Inflation is expected to fall modestly by end-2021, and remain well above target; and the current account deficit is expected to fall to 3½ percent of GDP, in large part reflecting lower gold imports and a modest recovery of tourism. Employment is expected to continue to recover slowly as the pandemic subsides.

7. But low buffers mean that vulnerabilities will remain elevated. Low foreign exchange reserves, coupled with high external financing needs and high domestic foreign exchange deposits, leave the economy vulnerable to shocks and changes in sentiment, both at home and overseas. Under the current set of policies, buffers will be rebuilt gradually.

Policies—A Further Shift in the Policy Mix is Needed

8. A further rebalancing of policies that is sustained over time would underpin more durable medium-term growth. Building on the welcome policy pivot, demand management policies need to continue to be carefully calibrated in the coming months. Maintaining a firm monetary stance, accompanied by additional pandemic-focused fiscal support that is temporary and targeted, would achieve a broadly neutral, but better calibrated, policy stance. Such an adjustment would help rebuild credibility and buffers, while also responding to the human and economic needs arising from the pandemic.

Monetary Policy—Strengthening Credibility and Buffers

9. A firm monetary policy stance should be maintained, with further measured monetary policy tightening likely needed should inflation expectations fail to stabilize. Furthermore, any premature easing should be avoided, in line with recent CBRT forward guidance, to better anchor inflation expectations, sustain capital inflows and address dollarization. These actions would pave the way for a stronger lira and higher reserves, especially when combined with broader reforms, including steps to underpin CBRT independence and a timely technical review of the monetary policy framework.

10. A transparent reserve accumulation strategy should be developed and implemented as conditions allow. This reserve buildup should increasingly take place through transparent reserve purchase auctions and be accompanied by consistent and clear communication. Remaining administrative measures designed to support the lira could also be gradually removed as conditions allow.

Fiscal Policy—Addressing Pandemic-Related Needs

11. To address immediate needs related to the pandemic, additional targeted and temporary fiscal support should be deployed this year. Turkey has some fiscal space to expand support in 2021, possibly in the order of 1 percent of GDP. Additional social transfers to vulnerable households and informal workers would help support those most affected by the pandemic. And further support should be considered if economic conditions deteriorate.

12. In parallel, a credible and detailed plan for fiscal consolidation should be outlined now, to be enacted when the post-pandemic recovery is well under way. This would help strengthen Turkey’s important fiscal anchor. Specifically, consolidation of about 1.5 percent of GDP over the medium term should help put debt again onto a declining path. The consolidation plan, which could be legislated now, and enacted from 2022 onwards, might include further efforts towards streamlining VAT exemptions and rationalization of ad hoc transfers and subsidies, as well as rationalizing investment incentives. Importantly, further efforts to find efficiencies in spending would complement these efforts.

13. Fiscal structural reforms would support consolidation and mitigate fiscal risks. Fiscal transparency and credibility would be further bolstered by publishing a fiscal risk statement and comprehensive information on the quasi-fiscal operations of all SOEs. Furthermore, ongoing efforts to strengthen oversight and management of Public Private Partnerships (PPPs) should be finalized, including by publishing a monitoring report and finalizing a new PPP law. It would be important for this legislation to ensure that PPPs are fully integrated with the overall budgetary process, including their appraisal and authorization. Finally, efforts to continue to strengthen budget execution would also be helpful.

14. Further monitoring of extra budgetary institutions would also be helpful. The scope and role of extra-budgetary and other non-central government entities and institutions need to be carefully defined and monitored, with the maximum degree of transparency and a strong governance framework. In this regard, Turkey Wealth Fund’s governance structure could also be refined to limit potential conflicts of interest.

15. Debt management should continue to be strengthened by lengthening borrowing maturities and lowering reliance on domestic FX borrowing. Recent moves along these lines are welcome.

Financial Sector Policy—Rein in Credit and Strengthen Balance Sheets

16. The continued normalization of credit growth is a positive development. Credit growth has slowed as policy rates have increased and regulations incentivizing lending have been removed. While credit provided through the Credit Guarantee Fund (CGF) was expanded beyond SMEs during the pandemic, going forward, such credit should be limited to SMEs, in line with the CGF’s original mandate.

17. Legacy issues on banks’ balance sheets could be recognized more fully over time. As the pandemic recedes, prudential standards should be strengthened to incentivize the recognition of loan losses, proactively drawing down on capital and liquidity buffers. Phasing out forbearance measures and loan deferrals by banks would further encourage debt restructuring. As the economy recovers from the pandemic, a comprehensive third-party asset quality review, and ensuing stress tests, would strengthen confidence and help develop the market for distressed assets. In addition, delays in proposed revisions to the Banking Law to strengthen Banking Regulation and Supervision Agency (BRSA) independence, and to reform resolution frameworks should be avoided. We welcome the authorities’ intention to proceed with a new Financial Sector Assessment Program in 2021.

18. Bank FX liabilities warrant careful monitoring. While banks’ regulatory requirements are met, foreign exchange liquidity risks should continue to be monitored carefully. Furthermore, regulatory limits on open FX positions should be strictly enforced.

Mitigating Long-Term Effects of the Pandemic

19. Risks of long-term adverse effects of the pandemic on labor markets and non-financial corporates should be addressed through targeted measures. The Turkish economy is flexible and entrepreneurial, which bodes well for adapting to the post-pandemic economy. Nevertheless, policies that help labor market flexibility, while providing a sufficient safety net, would support resource re-allocation and job creation. Particular emphasis on female labor force participation, youth unemployment, and informality is needed. As elsewhere, cases of corporate debt distress are expected to increase as a result of the pandemic. Viable but temporarily-insolvent firms need to be quickly restructured as ‘going concerns’; while unviable firms need to be efficiently wound down. In current circumstances, the role of ‘out-of-court’ restructuring mechanisms is key. Taken together, these policies would provide the basis for a more durable and inclusive recovery.

The IMF team is grateful to the authorities and private sector counterparts for their collaboration and helpful discussions.