June 26, 1998

1. Chronic high inflation has plagued Turkey for over two decades. Past programs designed to fight inflation have never been successfully carried through, or were subsequently reversed. Inflation imposes a heavy burden on the economy and society, worsening the inequality of incomes, exacerbating social tensions, and distorting the planning horizons of investors and savers. In consequence, the economy operates under the constant threat of instability, discouraging foreign and domestic investment. Even worse, the chronic weakness in the public finances, resulting from an inflation-eroded tax base, has limited spending on basic education, health, and infrastructure.

2. Large budget deficits lie at the heart of the inflation process. The financing of these deficits has accelerated money growth, as well as imposing high real interest rates. The pressure of government borrowing, in turn, has locked in inflation expectations and projected them forward in the form of high interest rates. Basing increases in public sector wages and agricultural support prices on past inflation has contributed to inflation inertia. The policy of safeguarding the real exchange rate and expanding the money supply in line with expected inflation further reinforces the process. Changing this entrenched pattern of behavior requires concerted action on many fronts.

3. Since taking office, the government has applied measures to rebalance the economy and reduce inflation, and has devised a three-year program that is designed to bring down inflation on a lasting basis. With the announcement of the 1998 program, and in light of the first and second quarter results, we are confident that the program is operating as designed. The autonomy of the central bank is fully respected. The Treasury has ceased to borrow from the central bank, and the central bank, Treasury, and the Ministry of Finance have published their respective quarterly program targets. To date, all targets have been met and in some cases surpassed. Support for the program from the private sector and the labor and employers' unions continues, with an ongoing dialogue maintained at all times. The government is strongly committed to ensuring transparency and adhering to market policies.

4. The government's three-year program will reduce wholesale price inflation from over 90 percent at end-1997, to 50 percent by end-1998, 20 percent by end-1999, and single digits by end-2000. Our program is already beginning to show results: cumulative wholesale price inflation during January-May was reduced to 24.4 percent, lowering the twelve month rate to 80 percent. This memorandum explains the framework of the disinflation program, and the policies being employed to reach our targets.

5. The main policies to achieve the planned reduction in inflation are: (i) an increase in the primary surplus of the budget, that will be sustained during the disinflation process; (ii) a shift in the management of key variables such as public sector wages and agricultural support prices so that they are raised in line with targeted, rather than past, inflation; (iii) a supportive and closely coordinated monetary policy; (iv) structural reforms to ensure the progressive strengthening of public finances over time; and (v) stepped up privatization to lower the domestic borrowing requirement and enhance economic efficiency.

6. The yields demanded on government securities reflect inflation expectations and a high premium to protect investors from the risk of an increase in inflation. In a process of disinflation, when expectations lag and the risk premium remain high, the real interest burden rises sharply with falling inflation, increasing the size of the primary fiscal adjustment needed to keep the overall deficit on a downward path. For this reason, it is essential to lower inflation expectations quickly as well as to use alternative ways of domestic borrowing to minimize this effect and reduce the need for additional primary adjustment.

7. In the area of fiscal policy, the primary surplus of the budget will be increased to above 4 percent of GNP in 1998, from near balance in 1997. This increase is needed to face the heavy burden of interest payments that is now unavoidable, as was already evident in the budget submitted to parliament last October. Because of the bulge in interest payments, the overall fiscal deficit in terms of GNP will remain about unchanged from 1997, despite the strengthening in the primary balance. This is why achievement of the targeted improvement in the primary balance is essential to the success of the disinflation effort.

8. Improved tax revenue performance is a key element strengthening the primary fiscal position in 1998. In the first five months of 1998, tax collections have been strong, with real tax revenue increasing by 18 percent (to Tl 3,260 trillion by May); for the whole year, tax revenue is targeted to increase to at least Tl 9,350 trillion (17.7 percent of GNP). The introduction of the withholding tax on interest income and better tax administration have contributed to the improvement in tax collections. To reduce evasion, tax identification numbers have been introduced for motor vehicle purchases and real estate transactions. By the end of 1998, tax identification numbers will also be required for all bank accounts.

9. A tax reform bill was submitted to parliament early this year. This bill will shorten the lag between the accrual of tax obligations and their payment, while lowering tax rates in expectation of a widening of the tax base. These aspects of the tax reform are expected to be applicable as from the beginning of 1999, and will have an initial effect in boosting revenue because of the reduction in collection lags. There is a danger that the lowering of tax rates could jeopardize the achievement of the program targets unless compliance improves. In view of the key importance of fiscal restraint to the success of the anti-inflation effort, the government will not accept any retroactive tax cuts affecting the programmed level of revenue and will delay rate cuts in 1999 and beyond if tax compliance and revenue performance fall short of the targets. Additional measures will be taken, as necessary, to ensure the achievement of the programmed revenue targets.

10. In implementing the budget, the government will strictly restrain primary outlays to ensure the attainment of the targeted improvement in the primary surplus. Non-interest expenditure will be limited for the year as a whole to no more than Tl 9,255 trillion (17.5 percent of GNP). Transfers will be much lower this year than last, reflecting the lower need for transfers to the extrabudgetary funds, tight controls on agricultural subsidies, and the one-off nature of the capital injections to state banks made in 1997. For the first time in many years, there will be no supplementary budget in 1998.

11. In a major shift in policy, public sector salaries and agricultural support prices are now being adjusted in line with the targeted reduction in inflation. Public sector salaries were adjusted by 30 percent in January, and will be increased by no more than 20 percent in July. Agricultural support prices were increased by 60 percent for wheat, 64 percent for tea and 71 percent for tobacco, in line with projected average inflation in 1998. These policies will continue to be applied in the remainder of 1998, in 1999 and beyond.

12. With the high level of built in interest payments from the domestic debt contracted on conventional terms, and the stickiness of long-term interest rates, the financing of the budget deficit is of critical importance. As already noted, the effective interest burden rises as inflation falls. This effect is compounded if inflation expectations lag. To minimize this effect and reduce the interest burden for 1999 and beyond, the Treasury plans to step up its reliance on inflation-indexed and foreign exchange-indexed securities to around one third of new domestic borrowing in the remainder of 1998, as market conditions allow.

13. Privatization has a key role to play in the disinflation strategy. Major progress has already been made, with a total of US$1.8 billion in privatization proceeds already realized through the sale of GSM licenses, shares in IS Bank, and other operations. Before the end of this year, we plan to sell share holdings in POAS, Turkish Airlines, Erdemir, and a number of other companies, with substantial additional sales scheduled in 1999. The Council of Ministers has given approval for the sale of 49 percent of Turk Telekom, a transaction that will be completed in 1999. Once the approval of the High Administrative Court (Danistay) has been secured, it will be possible to move quickly in finalizing the transfer of operating rights for the generation and transmission of electric power, covering an initial 9 power stations (estimated revenue of US$1.2 billion) and the first 15 of the eventual 20 distribution districts (estimated revenue of US$1.7 billion, payable in instalments over three years). The transfer of operating rights for several additional power stations and the remaining 5 distribution districts should become possible in the course of next year. The aim is to generate receipts of at least US$3 billion this year, and at least a further US$3.6 billion (and very possibly well over US$5 billion) in 1999. In 1998, some US$2 billion of privatization proceeds will be used for debt reduction. In 1999, at least US$3 billion will be used for this purpose, with a maximum of US$2 billion over this amount available to finance additional investments, provided that the overall disinflation program is progressing as planned. In line with the goals on privatization, the government will introduce international pricing for petroleum products effective July 1 and, by end-December 1998, will submit to Parliament an appropriate regulatory framework for the telecommunications and energy sectors.

14. A sweeping reform of the social security system is obviously needed. The Turkish economy can simply not afford a system that permits workers to retire in their forties. And retired workers cannot afford to live on the benefits now provided by the system. The government will continue its efforts to forge a consensus for major reforms that would eliminate the deficit of social security within a relatively short period through appropriate increases in the minimum retirement age and minimum contribution period, and an expansion of the reference period for calculating pension benefits coupled with an increase in the ceiling on wages subject to contributions. As a first step, the government will request early parliamentary approval for raising the minimum retirement age for existing workers to 50 for women and 55 for men, and to 57 for women and 60 for men for new entrants to the labor force, while requiring that new entrants contribute a minimum of 7,200 days for women and 9,000 days for men to be eligible for full benefits. Also, before the end of 1999, improved cost controls and wider application of user fees will be introduced in the health care system.

15. Monetary policy will be directed at sustaining the disinflation effort and, in the second half of 1998, the exchange rate will be managed in a manner consistent with the target of 50 percent wholesale price inflation by end year. Given the difficulty of projecting the behavior of demand for base money in a period of disinflation, the monetary framework under the program will place greater emphasis on control over the growth of net domestic assets of the central bank. The expansion of this aggregate will be kept under tight restraint, including the continuation of our policy that the central bank not extend credit to the public sector. The end-December 1998 target for net domestic assets will be negative Tl 1,500 trillion. The central bank plans to intervene less aggressively in managing day-to-day liquidity, allowing short term interest rates to move more freely. The foreign exchange surrender requirement has been suspended for two months starting in June 1998. The central bank will consider extending this suspension in light of market developments.

16. The government will take measures to strengthen the banking sector and supervision through more stringent enforcement of capital adequacy requirements and of the ceiling on banks' net open foreign exchange positions. In addition, it intends to effect a phased reduction of the net foreign exchange exposure ceiling from 50 percent of capital to 30 percent by end-December 1998. In order to reduce distortions, the government plans, before the end of the year, to subject repos to the same reserve requirements as bank deposits, and to equalize the taxation of interest income from repos and deposits. The gap between the average cost of funds and the average rates charged by the agricultural bank (Ziraat Bankasi) on its loans to the agricultural sector has been substantially reduced over the past year, and the recent further decline in deposit rates will make possible a reduction of 5 percentage points in the average rate charged on agricultural loans as from July 1, 1998. Thereafter, interest rates on agricultural credits will not be lowered until they are equal to Ziraat's average cost of funds, and from that point on will be kept in line with funding costs.

17. The Draft Law for Regulation and Supervision of the Financial Markets was submitted to the Cabinet of Ministers on June 18, 1998. The aims of the draft law are: (i) to bring the regulation and supervision of banks, insurance and re-insurance companies, and other financial institutions under a single set of rules and a single law; (ii) to strengthen the financial structure of financial institutions; (iii) to strengthen and increase the efficiency of the supervision and oversight authority; and (iv) to keep supervision standards in line with international norms. The draft law was prepared taking due account of the laws and regulations of the European Union and other accepted international practice. The government intends to secure passage of the draft law as soon as possible.

18. Under the three year program, the government is committed to cutting inflation further in 1999 to 20 percent. To this end, it will continue to follow a tight fiscal policy to generate an adequate primary balance, forward indexation of public sector wages and agricultural support prices, a closely coordinated and supportive monetary policy, further structural reforms and stepped up privatization. In line with this framework, it is envisaged that the primary fiscal surplus in 1999 will be increased to 4 3/4 percent of GNP and that public sector salaries and agricultural support prices will again be increased in line with targeted inflation. We expect growth to remain at about 4 1/2 percent in 1999 and inflation to continue to decline strongly. The external current account deficit in 1999 is expected to remain manageable and foreign reserves will continue to be ample.

19. It is important that our policies are fully understood both inside Turkey and abroad, so that all can see that our program is consistent and will produce its intended results. In this spirit, the government has already begun the practice of announcing quarterly targets for the budget, domestic borrowing, privatization, and the expected behavior of base money. This policy memorandum takes this process a step further by explaining the broader context of the program, and how the inflation targets will be achieved, not only in 1998, but further in the coming year. This program will also be monitored on a quarterly basis by the IMF staff over the next 18 months. In this context, a detailed quarterly macroeconomic framework for the budget, the monetary accounts, and the balance of payments in 1998 has been established and will serve as a guide to policy for the remainder of this year (Tables 1 and 2). Indicative annual objectives for 1999 have also been identified. The detailed quarterly program consistent with achieving the government's macroeconomic objectives for 1999 will be discussed in the fourth quarter of 1998. The main policy actions remaining to be undertaken in 1998 and 1999 are attached. The staff of the IMF will monitor each quarter the implementation of the program in light of the policy actions and targets detailed in these tables, as well as the progress in lowering inflation. The findings of the staff will be made public, and the authorities will remain at all times in close communication with the IMF staff.

• Limit the July 1998 public sector salary increase to a maximum of 20 percent; and public sector wage increases in 1999 to targeted inflation.
• Limit agricultural support price increases in 1999 to targeted inflation.
• Pass tax reform bill to apply the provisions on rate reductions as from January 1, 1999, with no retroactive tax reductions.
• Use privatization proceeds of US$2 billion for debt reduction in 1998 and at least US$3 billion for debt reduction in 1999. Once US$3 billion in privatization proceeds has been applied to debt reduction in 1999, no more than US$2 billion may be used to fund investment, with any additional amounts raised through privatization allocated to further debt reduction.
• Require tax identification numbers for all bank accounts by end-December 1998.
• Increase the proportion of inflation indexed and foreign exchange indexed bonds as from July 1998 to around one-third of domestic borrowing, as market conditions permit.

• Implement a monetary and exchange rate policy consistent with reducing inflation to 50 percent by end-1998 and 20 percent by end-1999, observing ceilings on the expansion of the central bank's net domestic assets.

• Submit to Parliament a regulatory framework for the telecommunications and energy sectors by end-December 1998.
• Introduce international pricing for petroleum products on July 1, 1998.
• Raise the minimum retirement age for new entrants to the labor force to 57 for women and 60 for men, and require a minimum contribution period of 7,200 days for women and 9,000 days for men to be eligible for full benefits. For existing workers, increase the minimum retirement age to 50 for women and 55 for men.
• Introduce user fees and cost control measures in the health care system by end-December 1999.
• Strictly enforce existing prudential regulations on the banking sector.
• Reduce the ceiling on the open foreign exchange position of banks to 30 percent of net worth by end-December 1998 and to 20 percent by end-September 1999.
• Reduce interest rates on credits to the agricultural sector extended by Ziraat Bankasi by no more than 5 percentage points on July 1,1998; hold lending rates unchanged thereafter until they are equal to its average cost of funds, and keep them at least at that level.
• By end-December 1998, apply to customer repos the same reserve requirements and withholding tax on interest earnings that are imposed on deposits.