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CHAPTER 11: MACROECONOMIC CONTEXT Despite many advantages ranging from its strategic location to its dynamic population, Turkey has not achieved the stable high growth o f leading emerging market economies.’ Nor has it matched the growth rate o f European Union (EU) accession countries such as Hungary and Poland, or the fast-growing cohesion counties such as Spain and Portugal (Figure 11.1). Turkey’s per capita income level declined from 26 percent o f the EU average in 1991 to 22 percent in 2002.9 During the same period, Poland and Hungary made significant progress in reducing the per capita income differences with the EU. On average, the Turkish economy grew slightly under 3 percent per year over the past decade-respectable, but well below the best-performing emerging economies (Figure 11.2). Figure 11.1. Per Capita GDP at PPS: 1991-2002 Compared to EU Average v1 a a c .- 0- z II 3 W 90 T- Spain 80 70 Portugal An _ _ 50 40 30 20 Hungary Poland Turkey Source: World Bank Figure 11.2. GDP and GDP Per Capita Growth Rates in Emerging Economies (1965-2001) 10 8 -6 s -4 2 0 I .. . Source: World Bank This chapter draws on “Turkey: Country Economic Memorandum-Towards Macroeconomic Stability and These figures do not reflect the informal economy, which is likely to be substantially larger as a percentage of 8 Sustained Growth,” July 28, 2003, World Bank Report No. 26301-TU. GNP in Turkey relative to the EU average. 14
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CHAPTER 11: MACROECONOMIC CONTEXT

Despite many advantages ranging from its strategic location to its dynamic population, Turkey has not achieved the stable high growth o f leading emerging market economies.’ No r has it matched the growth rate o f European Union (EU) accession countries such as Hungary and Poland, or the fast-growing cohesion counties such as Spain and Portugal (Figure 11.1). Turkey’s per capita income level declined from 26 percent o f the EU average in 1991 to 22 percent in 2002.9 During the same period, Poland and Hungary made significant progress in reducing the per capita income differences with the EU. On average, the Turkish economy grew slightly under 3 percent per year over the past decade-respectable, but well below the best-performing emerging economies (Figure 11.2).

Figure 11.1. Per Capita GDP at PPS: 1991-2002 Compared to EU Average

v1 a a c .- 0- z II 3 W

9 0 T-

S p a i n 8 0 7 0 P o r t u g a l An _ _ 5 0

4 0 3 0

2 0

H u n g a r y

P o l a n d

T u r k e y

Source: World Bank

Figure 11.2. GDP and GDP Per Capita Growth Rates in Emerging Economies (1965-2001)

1 0

8

- 6 s - 4

2

0

I

.. .

Source: World Bank

This chapter draws o n “Turkey: Country Economic Memorandum-Towards Macroeconomic Stability and

These figures do not reflect the informal economy, wh ich is l ike ly to be substantially larger as a percentage of

8

Sustained Growth,” July 28, 2003, Wor ld Bank Report No. 26301-TU.

GNP in Turkey relative to the EU average.

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A. MACROECONOMIC INSTABILITY HAS HELPED KEEP GROWTH BELOW POTENTIAL

Analysis suggests that macroeconomic instability-among many factors-has played an important role in Turkey’s inabil ity t o realize i t s full growth potential. Cross-country comparisons and analytical work suggest that countries that grew faster than Turkey did so in part because they achieved a greater degree of macroeconomic stability, accumulated physical capital faster, invested more in human capital, and did more to improve government effectiveness and the business climate. Of a l l these factors, the contrast in the degree of macroeconomic stability stands out. Turkey has suffered from an exceptional degree of macroeconomic instability characterized by chronically high inflation and sharp swings in the business cycle. Many emerging market countries have experienced large fluctuations in either growth or the real effective exchange rate (REER), but Turkey experienced instability in both (Figure 11.3). Repeated attempts to stabilize the economy fel l short, and high growth was never sustained for long. Inflation was higher and growth lower, o n average, in the 1990s than in the 1980s. Income volati l i ty doubled during the 1980s and 1990s as the standard deviation o f real GDP growth increased f rom 2.7 percent t o 5.5 percent. The boom-bust cycle has continued into the new decade, with a record contraction o f real gross national product (GNP) o f over 9.5 percent in 2001, followed by a strong recovery, with estimated growth o f 7.9 percent in 2002.

Figure 11.3. Turkey: REER and GDP Growth, 1990-2000

1 2 + 10 -

5 s 2 S 6 > 4

2

0

U

+ T u r k e y

T h a i l a n d

C h *

0.5 0 . 1 5 1 1 . 2 5 1.5

C V : G D P ( C h % )

g r o w t h rates o f t h e v a r i a b l e s v a r i a t i o n a p p l i e d to S o u r c e s : W o r l d B a n k , JPM o r g a n ; v o l a t i l i t y m e a s u r e d b y c o e f f i c i e n t o f v a r i a t i o n a p p l i e d to

B. FISCAL IMBALANCE HAS BEEN THE ROOT OF CHRONIC MACROECONOMIC INSTABILITY IN TURKEY

The 2000 Country Economic Memorandum (World Bank 2000a)” demonstrated that fiscal imbalances are key to understanding Turkey’s macroeconomic instability. Unsustainable fiscal pol icy has repeatedly put pressure o n the TL, fueled inflation, and undermined financial stability. Fiscal pol icy has been unable to act as a smoothing influence on the business cycle. When crises have hit, contractionary fiscal and monetary policies have been required to restore a semblance o f financial stability, worsening the real impacts o f internal and external shocks. The impact o f unsustainable fiscal pol icy o n macroeconomic stability has been magnified by Turkey’s open capital account and, until recently, its poorly regulated

lo “Turkey: Country Economic Memorandu-Structural Reforms for Sustainable Growth,” September 15, 2000, Report No. 20657-TU, World Bank.

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banking system. Short-term capital f lows have fluctuated widely as investors responded to the boom- bust cycle driven by unstable macroeconomic conditions. The causal linkages between fiscal imbalances and instability in Turkey, as in many other emerging markets, suggest that the key to macroeconomic stability lies in sustained fiscal adjustment underpinned by credible structural reforms (Figure 11.4, data f rom Wor ld Bank 2003a).

Figure 11.4. Adjusted Public Sector Borrowing Requirement (YO of GNP)

I 25

20

~ 15

10

5

0

I

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

C. TURKEY'S EXCHANGE RATE-BASED DISINFLATION PROGRAM

In 2000, an exchange rate-based disinflation program was launched in Turkey in a bo ld attempt to rid the economy o f inflation. The centerpiece o f the program was a crawling peg exchange rate regime to act as the nominal anchor. The peg was supported by front-loaded fiscal adjustment. K e y structural reforms in social security, infrastructure, agriculture, privatization, and banhng were initiated. In fact, fiscal pol icy was significantly tightened in 2000, and inflation began to fall, dropping to 39 percent by the end o f the year. These included establishment o f an independent banking authority; passage o f legslation for an electricity market; reform of the public pension system; a constitutional amendment to al low intemational arbitration; launch o f an ambitious agriculture reform; establishment o f a telecommunications regulator; and a serious, although short-lived, acceleration o f privatization. However, these impressive achievements were insufficient to avoid a crisis, given the extent o f Turkey's underlying fiscal and financial sector weaknesses built up over decades o f instability and delayed reform.

Turkey also carried out significant structural reforms under the program.

Internal factors combined with unfavorable external developments started to undermine the exchange rate peg by mid-2000. On the external side, rising o i l prices and a prolonged slide in the Euro contributed to a softening o f Turkey's extemal accounts. On the internal front, the disinflation program was confronted with deep-rooted structural fiscal problems and a fragile banking sector burdened by huge contingent liabilities. A sharp drop in interest rates fo l lowing the onset o f the crawling p e g 4 r i v e n in part by a resurgence in short-term capital inflows-fueled a surge in demand. The economy soon began to overheat. Whi le falling, inflation did not come down as quickly as anticipated, generating a significant appreciation o f the real exchange rate under the peg. Imports increased sharply as consumption boomed, contributing to a deterioration in the current account, which recorded a deficit o f 4.9 percent o f GNP in 2000. Domestic banks took advantage o f the peg to borrow cheap foreign exchange in order to finance their expanding domestic operations, including growing purchases o f government securities and consumer

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lending. The expansion in domestic credit contributed to the consumption boom as banks quickly built up large open foreign exchange positions and aggravated maturity mismatches in their portfolios. Bank restructuring got off to a slow start, and the state banks continued to be burdened with the costs o f large “duty losses” f rom government-mandated subsidized lending to agriculture and small and medium enterprises (SMEs). The average maturity o f Turkish L i r a (TL) deposits remained extremely short because confidence in the TL remained fragile.

A first bout of financial instability hit Turkey in November 2000, presaging the full-fledged currency crisis o f early 2001, which short-circuited the exchange rate-based disinflation program. A s banks came under increasing pressure f rom shrinking profit margins o n government securities and growing liquidity needs, isolated speculative attacks emerged in November 2000, which soon plunged the banking system into a struggle for survival. Desperate for liquidity, certain banks engaged in fire sales o f government paper, causing interest rates to skyrocket and international investors to exit the market. The result was a liquidity crunch, aggravated by the Central Bank’s inabil ity to inject additional liquidity into the system under the quasi-currency board rules added to the disinflation program just pr ior to launch o f the crawling Peg.

The situation stabilized temporarily in December 2000 when the International Monetary Fund (IMF) acted to prevent a financial meltdown by announcing an additional US$ lO b i l l ion in financial assistance. This additional financing was conditioned o n the Government’s commitment to strengthen the p r o g r a m in particular, to accelerate financial sector restructuring and privatization. The Government introduced an explicit blanket guarantee effectively covering a l l banking liabilities, excluding capital. Whi le designed to contain systemic risks in the banking system, the blanket guarantee highlighted the potentially enormous fiscal costs in case o f a systemic failure, and made explicit this contingent fiscal liability. In the wake o f these events, interest rates declined and a precarious degree of financial stability returned, but this proved to be a temporary respite. In early 2001, persistent doubts about the peg and underlying fiscal sustainability led to a full-blown speculative attack against the currency. Interest rates shot up to several thousand percent, forcing the Government to abandon the crawling peg and float the L i ra on February 21, 2001. The L i ra immediately lost 40 percent o f i t s value in a single day.

D. EXCHANGE RATE-BASED DISINFLATION PROGRAMS ARE VULNERABLE IN A GLOBALIZED WORLD

The reliance on a pegged or f ixed exchange rate in an environment o f free capital f lows and an unreformed banlung system entails risks. Exchange rate anchors-while generally successful in setting inflation o n a downward long-term trend in chronic-inflation countries-have often been associated with currency crises. Many of the exchange rate-based stabilization programs in the 1980s encountered currency crises at some stage, and the economic crises that broke out in the second ha l f o f the 1990s occurred in countries with fixed or managed exchange rate regimes. Currency attacks have often been accompanied by banking crises (for example, Chile, Mexico, and East Asia). The Asian experience shows that, with limited capital mobility, even a weak banking system can function reasonably wel l and support economic growth. However, such a system may not be able to handle massive entry and exit o f short-term capital induced by capital account liberalization in the context o f globalization. Exchange rate-based stabilization also generally results in sizable real exchange rate appreciation and a deterioration o f the current account, which can undermine investor confidence. International experience has shown that early moves to introduce exchange rate flexibil i ty can minimize the extent o f subsequent currency crises, as in Israel. Turkey’s program featured a predetermined transition to a widening exchange rate band 18 months after the launch of the peg. However, this preannounced exit-unique among pegged exchange rate systems-did not prevent the collapse o f the peg after only one year.

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E. THE GOVERNMENT RESPONDED QUICKLY TO THE 2001 CRISIS

The Government announced a strengthened economic program in M a y 2001 in response to the crisis following the collapse o f the crawling peg and subsequent devaluation. The key structural and social elements o f the program were: (a) a macroeconomic framework designed to restore financial stability and ensure public debt sustainability-principally through a further tightening o f fiscal policy; (b) rapid restructuring o f the banking sector-especially o f state banks and insolvent private banks intervened by the regulatory authority, the Banlung Regulation and Supervision Agency (BRSA)-based o n large resource transfers f rom the budget; (c) a more ambitious program o f public sector reforms centered on deeper structural and institutional reforms to improve fiscal management and public governance; (d) a renewed privatization drive-in combination with further liberalization measures focused o n energy, telecommunications, and agriculture-and strengthening o f independent regulatory bodies to improve the private investment climate; and (e) enhanced social assistance to help low-income groups adversely affected by the crisis.

F. TURKEY’S CRISIS RESPONSE PROGRAM INCORPORATED THE EXPERIENCE OF OTHER EMERGING MARKETS

Turkey’s crisis response program benefited f rom the lessons learned by other emerging market countries facing crisis (Liviatan 2002; Brahmbhatt 2001). Immediate fiscal measures were introduced to shore up the primary surplus and strengthen confidence in the sustainability o f the public debt. A front-loaded program of bank restructuring was launched, backed by extensive fiscal resources. Bank restructuring was complemented by additional structural reforms in the financial sector designed to further strengthen prudential regulation, adopt internationally accepted financial reporting standards and practices, and enforce compliance. In parallel with accelerated financial sector reform, a comprehensive public sector reform program, including institutional reforms, was introduced to tackle the structural roots o f Turkey’s chronic fiscal imbalance. Strengthened financial and public sector reforms were placed within a medium- term programmatic framework in an effort to bolster investor confidence by demonstrating the Government’s intent t o address the core structural causes behind the crisis, and not just the immediate symptoms.

In i t ia l outcomes under the crisis response program were mixed as the Government struggled to contain the fallout f rom the crisis and reestablish i t s pol icy credibility. The immediate financial turmoil arising f rom the crisis was fairly quickly contained, but at the price o f a sharp increase in the public debt as the costs o f bank restructuring were bome by the budget. The price spike fo l lowing the in i t ia l devaluation in February 200 1 was contained, but inflationary pressures persisted, with inflation reaching 69 percent by the end o f the year (Table 11.1). Fol lowing the decision to abandon the peg, uncertainty about exchange rate pol icy persisted for some time because the Government was slow to confirm i ts commitment to the float, and the Central Bank repeatedly intervened in the foreign exchange market. Interest rates were brought down from their post-crisis peaks, but remained we l l above the projected program path throughout 200 1, mainly due to the need to r o l l over large amounts of short-term public debt in the face o f a slower-than-expected recovery in investor confidence. The primary surplus target o f 5.5 percent o f GNP for 2001 was met, but doubts continued about the medium-term sustainability o f the fiscal adjustment. The economic recession turned out much deeper than projected as real GNP shrank by an estimated 9.5 percent for the year. A major factor in the recession was the sharp turnaround in the current account driven by capital outflows. The current account recorded a surplus o f 2.4 percent o f GNP in 2001. The combination o f high real interest rates, devaluation, the huge fiscal cost o f bank restructuring, and deep recession caused the stock o f public debt to rise significantly. The ratio o f net public debt to

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GNP increased from 58 percent of GNP at the end of 2000 to an estimated 94 percent of GNP by the end of 2001 (Figure 11.5).

Table 11.1. Key Economic Indicators

Actual 21 Est. 21 Prop. 31 1999 2000 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4

iMAIN M A C R O I N D I C A T O R S G N P Growth C P I Inf lat ion (Dec-Dec) Nomina l Interest Rate Real ex ante Interest Rate 4/ Unemployment Rate U n i t Wage Index (1997 = 100)

P U B L I C SECTOR Primary Balance (% GNP) Overal l Def ic i t (% GNP) Ne t Public Debt (% GNP) I /

Privatization ($ bn)

E X T E R N A L B A L A N C E Current account balance (% GNP) Exports (fob, S bn) 51 Tourism (% bn) External Debt (% GNP) C B T Foreign Exchange Reserves ($ bn)

o f which net external debt (% GNP)

-6.1 68.8

106.2 32.0

7.7 113.7

-0.2 22.3 61.0 20.1 0.1

-0.7 28.8

5.2 55.0 24.3

6.3 -9.5 7.9 39.0 68.5 29.7 38.0 99.1 63.5

6.5 8.4 10.3 103.0 73.9 73.1

-9.5 35.5 30.3

2.7 5.5 4.1 18.9 21.1 12.1 58.3 93.9 78.8 19.0 37.7 32.1 3.3 2.8 0.5

-4.9 2.4 -0.8 30.7 34.4 40.1

7.6 8.1 8.5 59.0 79.0 71.3 23.2 19.8 28.1

5.9 5.1 18.4 12.1 44.1 29.1 28.6 11.: 10.5 86.3

6.1 6.: 9.9 6.1

70.1 65.' 22.2 20.'

0.3 3.1

-3.4 -3.4 51.2 55.

61.1 48. 35.2 32.

13.2 9.8

G N P ( T L quadrillion) 78.3 125.6 176.5 275.0 356.7 415. I/ IMF, includes government securities issued to recapitalize SDIF and state banks. 2/ Government figures as adjusted by I M F and W B estimates. 2002 and 2003 G S P figures are as announced by S I S in A p r i l 2004. 31 Updated as o f t h e 7th I M F review. 4/ Average o f monthly nominal interest rate divided b y 12-month ahead C P I inf lat ion. 5 / Includes shuttle trade. Sources: Government, IM F and W B estimates.

Figure 11.5. Total Net Public Debt (YO of GNP)

I "^"- " I " ^ - ^

Cost o f rertructurmg 100

80

60

40

20

o f state banks

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 ~- ~- _ ~ -~

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G. STRONG RECOVERY HAS BEEN UNDER WAY SINCE EARLY 2002

Economic activity rebounded strongly in 2002 and the recovery continued into 2003. Real GNP growth reached 7.9 percent in 2002, exceeding program projections by a wide margin (Figure 11.6). The recovery was led by robust export performance and exceptionally large inventory rebuilding in the f i rs t ha l f o f the year. The recovery was further buoyed by a sharp rise in public consumption and investment during the second semester, reflecting accelerated government spending ahead of early elections held in November 2002. An increase in agricultural output estimated at 6.9 percent was another factor. Overall, stock building accounted for some 90 percent o f 2002 growth, with private consumption and government spending making significant contributions to offset declines in private investment and net factor income. The impact o f strong export performance in the 2002 growth accounting was offset by even faster growth in imports as the recovery gained steam. Importantly, private consumption and investment led the way for the f irst t ime since the crisis, recording increases in 2003 o f 6.6 percent and 20.3 percent, respectively. Whi le stronger-than-expected growth has been due in part to base effects f rom the recession, the genuinely positive news i s that the recovery has been export led, with exports in US. dollar terms increasing by some 30 percent in 2003. Strong export performance, buoyant tourism, and renewed capital inflows have eased the pressure on the balance o f payments, even as imports have expanded rapidly with the economic recovery. The modest current account o f about 1 percent o f GNP in 2002 was easily financed. The extent of the recovery, and i t s basis in export growth, place Turkey squarely in the category o f rapid-recovery, post-crisis countries, such as Mexico in 1995 and Korea in 1999. Turkey's recovery began three quarters after the crisis trough was reached, in l ine with the fastest recoveries worldwide over the past decade.

Figure 11.6. GNP Growth

In contrast with the real-side recovery, financial outcomes were mixed in 2002. On the positive side, inflation fell sharply. Consumer prices increased 29.7 percent over the course o f 2002, wel l below the program target o f 35 percent. The fa l l in inflation was helped by the rebound o f the nominal exchange rate f rom i t s crisis lows. The strengthening TL did not hurt export performance because it was counterbalanced by a very sharp drop in real wages. More problematic were slippages in the fiscal program during the run up to the November elections. A gap o f about 2.5 percent of GNP emerged with respect to the 2002 primary surplus target o f 6.5 percent o f GNP. Contributing factors included: (a) cost overruns in the social security system; (b) pre-election spending (new agriculture support purchases and

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c i v i l service wage increases); (c) an unexpected drop-off in tax revenues, driven by expectations o f a post-election tax amnesty; and (d) unplanned spending through earmarked accounts lef t over fo l lowing closure o f the extrabudgetary funds. A series o f stopgap fiscal measures were identified in late 2002 to close the fiscal gap, but were left largely unimplemented. Despite the fiscal slippage, the stock o f net public debt fe l l t o an estimated 80 percent o f GNP by the end o f 2002, helped by the rebound in the real exchange rate after the 2001 overshooting* and higher-than-expected growth.

The new Govemment's grace period with the financial markets was short l ived as concems about a slow start on economic reform, hints o f political tension, and the looming threat o f hostilities in neighboring I raq started to weaken investor confidence in mid-December. Ad hoc increases in pensions in early January and other populist measures raised concems about the Govemment's political wil l to implement tough economic reforms. The average yield o f the benchmark government paper moved up to the 60 percent range, and the L i ra came under some pressure. Financial market volati l i ty continued during the f irst quarter o f 2003. However, the winding down o f hostilities in Iraq and approval by the U.S. Congress in early April o f a scaled-down assistance package for Turkey (a grant equivalent o f US$l billion, potentially convertible to up to US$8.5 b i l l ion in loans) eased some o f the market tension once again.

H. MACROECONOMIC OUTCOMES IN 2003 WERE FAVORABLE

The Turkish economy continues to grow at a fast pace. Economic growth reached 5.9 percent in 2003 fol lowing 7.9 percent growth in 2002. The major contributing factor to the favorable growth outcome in 2003, because o f i t s weight in the national accounts, was private consumption growth. However, showing much faster rates o f growth was private sector capital formation. This augurs wel l for sustaining growth, with capacity utilization levels reaching historic highs. Exports continued to play an important role in the recovery. The current account deficit widened to almost 3 percent o f GNP, but was easily financed by short-term capital inflows, public sector borrowing abroad, and reverse currency substitution. Inflation fe l l to 18.4 percent in 2003, and the latest data suggest that inflation i s fall ing toward the important single- digit level for the f i rs t time since the 1970s.

Employment declined in 2003 following public and private sector restructuring, which, together with three years of decline in real wages, helped preserve competitiveness in spite o f strong currency appreciation. Aggregate unemployment remained stable at around 10 percent, but this was helped by a temporary s h n k a g e in the labor force. In urban areas, the unemployment rate approached 15 percent, and unemployment o f educated youth rose above 30 percent at the end o f 2003. With a trend increase in the labor force o f at least 1.8 percent per year, further reforms are needed to strengthen j o b creation.

I. TURKEY HAS ACHIEVED SIZABLE FISCAL ADJUSTMENT

Strong fiscal performance has been the comerstone o f the economic program. Fiscal gains were significant in 2003, and the primary surplus rose f rom 4 percent o f GNP in 2002 to over 6 percent o f GNP in 2003, close to the programmed 6.5 percent target. Nevertheless, the overall fiscal deficit remained considerable at 9.9 percent o f GNP. Although the 2004 budget passed in December was consistent with the 6.5 percent primary surplus target, a sizable fiscal gap quickly emerged. The Govemment announced above-inflation increases in minimum wages, and cut contribution rates for social security to reduce the additional costs to employers. In addition, the Govemment increased pensions by 21 percent, wel l above the inflation target. These initiatives, together with revenue shortfalls relative to the budget, created a

" A 10 percent move in the real exchange rate causes a 4 to 5 percentage point adjustment in the public debt-to- GNP ratio. The real exchange rate path i s given in Table 11.1,

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financing gap o f close to 1.7 percent o f GNP. The Government introduced a fiscal package in March to close the fiscal gap. This package has two main components: a supplementary budget and revenue measures. The supplementary budget passed in March cuts discretionary expenditures by 13 percent across a l l ministries. The Government also introduced measures to increase tax revenues by adjusting excises o n petroleum, alcohol, tobacco, and natural gas. Whi le the Government has demonstrated a willingness to undertake action to meet the fiscal target, good public expenditure management and delivery o f services to citizens will require less reliance o n ad hoc, short-term measures, and a focus o n sustainable fiscal adjustment.

Monetary pol icy followed a policy of implicit inflation targeting, with the Central Bank occasionally intervening in the foreign exchange market t o dampen what was deemed to be excessive fluctuation in the exchange rate. The decline in inflation, which was aided by the strength o f the TL, led to a commensurate decline in interest rates f rom a nominal 60 percent in the f i rs t quarter o f 2003, to about 25 percent early in 2004.

On the external front, despite appreciation o f the TL, rising productivity and declining labor costs helped sustain external competitiveness and export growth. Exports grew sharply in 2003. Texti le and vehicle exports were best-performing sectors. One encouraging sign i s the growing importance o f new export markets. I raq has already become a large export market for Turkey, and there was strong growth in exports to China, Russia, and Central and Eastern European countries. Imports also grew rapidly, with oil, increased imports o f machinery and equipment, and rising demand for imported consumption goods being major contributors. Intermediate and capital goods accounted for 86 percent of the increase in imports during 2002 and 2003. Consumption goods also rose sharply in the second h a l f o f 2003, and continued in early 2004. M u c h o f the increase in consumption goods imports was driven by automobile imports, which benefited f rom a temporary tax credit o n automobile purchases introduced in August 2003. Tourism receipts were maintained in 2003 despite the Istanbul bombings and uncertainty caused by the Iraq war. The current account deficit increased to 3 percent o f GNP in 2003. Continued market confidence has spurred an improvement in capital inflows, although green field investment has remained low. These inflows easily financed the current account deficit and allowed the sharp increase in international foreign exchange reserves to US$33 billion, equivalent to 5 months o f goods and services imports.

The combination o f strong real and financial market performance had a favorable impact o n the public debt burden. The net public debt-to-GNP ratio fe l l sharply during 2002-2003 from i t s end-2001 peak o f 93.9 percent o f GNP. Helped by declining real interest rates, strong fiscal performance, the recovery of economic growth and, above all, by the continued appreciation o f the real exchange rate, Turkey’s net public sector debt i s estimated to have fallen to about 70 percent o f GNP at end-2003. The decline would have been larger without the issuance o f new debt (o f TL 6.8 quadrillion) for the takeover o f the fail ing Imar Bank in July 2003. With capital f lows increasing, and a growing appetite for Turkish Government paper, the Treasury had n o problem servicing the debt. Nevertheless, the high rollover rate, 88 percent in 2003, indicates the continued dependence on market sentiment, and thus vulnerability to external developments.

J. DETERIORATION IN EXTERNAL BALANCE HAS CREATED VOLATILITY IN DOMESTIC FINANCIAL INDICATORS

The deterioration in global financial indicators in early M a y 2004, combined with the higher-than- expected current account deficit figures, has l ed to a sharp weakening in domestic financial indicators. Whi le the TL depreciated about 14 percent, taking i t to i t s late-2002 level, the stock market plunged by 18 percent, although from an all-time-high level, and the benchmark Treasury bond rate reached a high o f 30

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percent by mid-May from 22 percent in early April. Turkey’s Eurobond spreads widened by over 200 basis points to 525 basis points during the same period. The excess volati l i ty in the foreign exchange market was curbed to some degree by the Central Bank’s intervention. It appears that some relative stability has been achieved in domestic financial markets. These recent developments have underlined Turkey’s exposure to shocks f rom the external environment. Whi le the depreciation o f the TL i s an adjusting factor to the deteriorating current account balance, it i s also l ikely to affect inflationary expectations and domestic interest rates. Higher domestic interest rates, together with the impact o f the TL’s depreciation, would influence the overall fiscal deficit and economic activity. Spillover f rom global liquidity tightening, and rising spreads, are l ikely to increase the cost of external borrowing. Such developments, if persistent, could disrupt the virtuous cycle that the economy has experienced over the last year and a half.

K. ONGOING STRUCTURAL REFORMS ARE EXPECTED To STIMULATE GROWTH

In response to market pressures, the Govemment has shown a renewed commitment to program implementation. Sustaining the momentum o f the ongoing recovery and the confidence o f markets continues to be the challenge facing policymakers. Under stable domestic and international conditions, Turkey could repeat or improve o n last year’s macroeconomic performance in 2004. Growth should again meet the 5 percent target. Inflation i s already running below projections. Carryover f rom the strong increase in industrial output in 2003, and a more normal harvest in the agriculture sector in 2004, should deliver the growth target f rom the production side. On the demand side, confidence indicators are strengthening, and lower interest rates and easier credit are providing stimuli to private investment and consumption. Despite firm domestic demand, there are strong prospects of meeting the inflation target o f 12 percent, which would outperform targets for the third year in succession.

Medium-term projections demonstrate that sustained implementation o f economic reform i s necessary i f Turkey i s to attain i t s macroeconomic stability and growth objectives. Under the structural reform program, the economy i s expected to grow about 5 percent during 2005-2006. Specific factors underlying stability and sustained growth include: (a) greater confidence in the pol icy framework; (b) improved macroeconomic stability and declining real interest rates-which would stimulate private investment and consumption demand; (c) an increase in productivity resulting f rom structural reforms; (d) stronger exports performance-which would permit faster import and output growth; and (e) higher external inflows, including sizable foreign direct investment. Under the sustained reform scenario, fiscal adjustment will y ie ld a permanent reduction in the public sector borrowing requirement f rom about 10 percent o f GNP in 2003 to 5 percent o f GNP in 2006.

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