TURKEY’S ECONOMY:

ANNE KRUEGER

First Deputy Managing Director, IMF

Good morning, I am very pleased to be here and to be able to participate once more in the Istanbul Forum. This event has, rightly, in my judgment become an important fixture on the calendar of those who follow the progress in Turkey’s economy and I am especially pleased to be visiting Turkey at a time such excellent economic performance. The country’s progress in recent years has been remarkable. The benefits of the government’s commitment to its economic program are clearly visible and this year’s Forum has a forward-looking theme and rightly so. Much has been achieved since the current reform program has started and the challenge now is to build on those achievements and exploit Turkey ’s potential as a rapidly growing and increasingly sophisticated economy. I want this morning to review some of the recent accomplishments and then say something about the opportunities that lie ahead toward 2023 objectives. One focus of this Forum is the need to prepare for EU membership and that of course is important but the strongest argument for economic reforms going forward is that they will improve the lives of Turkish citizens. The fact that the reforms needed will also help Turkey fulfill the conditions for EU membership is an added bonus. Macro-economic stability has largely been achieved as a result of the reform program of past few years but there is much still to do. What Turkey needs to do now is raise the potential rate of growth of the economy. Structural reforms, reforms that make the economy more flexible and to permit individuals and firms to respond to incentives more rapidly and more flexibly will raise the economy’s growth potential. More rapid growth sustained over a long period will raise standards and reduce poverty without …..to increase the growth potential the growth rate of the past few years will have to slow down because excess capacity has pretty much been exhausted and so it is a question from now on I think pretty much what is the potential growth rate. Turkey ’s recent experience illustrates the need for further continuing on the current path. Mot of us here have vivid memories of the economic problems Turkey faced during watershed years of 1999 to 2001 when the banking crisis precipitated a radical policy shift. Chronic inflation over 25 years had undermined Turkey ’s economic performance. Economic growth had been weak and fragile, worst Turkey ’s growth record was well below the average of successful emerging market economies, persistent resource misallocation one result of the shortcomings of the financial system had reduced the economy’s growth. Nominal and real interest rates were high and unstable and the public debt burden was high and rising. All of this was clearly unsustainable and change was urgently needed and macro reforms were implemented in monetary fiscal exchange rate policies, while structural reforms were implemented in the banking system public finances in other major areas of economic activity. There had of course been reforms in earlier periods at least it laid some of the groundwork. The trade liberalization of 1980’s for example meant that the Turkish economy was better placed to benefit from the more recent series of macro structural reforms then otherwise would have been but as many of us remember previous reform attempts in Turkey had tended to be short-lived or abandoned not too long after they were undertaken even the ambitious reform program in the early 1980’s failed at the end to mark the decisive break with the past which we had all hoped. Trade liberalization was important but the banking reforms in the 1980’s did not go far enough as the crisis 2000 to 2001 clearly showed and macro-economic stability was not achieved in 1980’s reforms either. Chronic fiscal imbalances and inflation prevented the full realization of the potential benefits that might otherwise have float from those structural reforms that were undertaken. From 1980’s on as you know inflation averaged over 60% per year, the crisis from 2000 to 2001 brought things ahead and this time there was a real turning point, Turkey’s citizens had lost patience with economic’s instability and recurring crisis that were only temporarily resolved, there was a strong desire for economic change that confronted the country’s problems in a decisive way but even a greatest optimist could not have anticipated the extend to which the reforms implanted in the past few years have succeeded. Economic policy making has been transformed and so has the Turkish economy and the benefits have been swift to materialize, average real GDP growth over the past 3 years has been close to 8% and it was just short of 10% last year. The inflation rate, which was 70% just 3 years ago, is now down close to 8% is lowest level in 35 years. The primary surplus, which is an essential part of this strategy to reduce public debt burden was almost 7% last year, ahead of government’s 6,5% target, the ratio of public debt to GDP has fallen by 30% points since 2001 peak but further reductions will be necessary to strengthen the resilience of the economy and reduce vulnerability to shifts in world economic conditions. These are striking achievements and they underline the enormous potential of the Turkish economy. the credibility of Turkish economic policy making has been greatly strengthened, pressing on with the reform program now will insure that the full benefits of the reforms already implemented will be realized. Reforms have accumulative beneficial impact, each reform increases the returns to all other reforms and the more successful economic reforms are and are perceived to be the smaller the chance that they can be opposed by narrow interest groups successfully. But let me now mention some of the areas where there is scope for further progress and say something about the contribution further reforms could make to raising Turkey’s growth potential, a result that would benefit all Turkey’s citizens. I want to focus on inflation, fiscal policy and structural reforms. Let me start with inflation, at one point in the not too distant past it had begun to look as if low inflation worldwide was just a distant memory of the past. Inflation seemed to be a chronic in many parts of the world and even in the US it was widely believed among economists as of the early 1970’s that inflation would always be gradually rising. There was a widespread failure to recognize the extend to which inflation resulted and was resulting in an efficient resource allocation and how it does reduce potential growth rates everywhere. Inflation imposes high costs on economies and societies as we are now learning as inflation rates so far, it also disproportionally hearts the poor something which was not recognized earlier on and it creates uncertainty throughout the economy and undermines macroeconomic stability of course but policy makers finally confronted the challenges that inflation pauses, counter inflation policy has become much more successful and with lower costs then was that possible in almost every part of the world. In my view it is not a coincidence that the accelerated growth of the world economy in 1990’s and the global down turn in 2001 to 2002 was more moderate then in any previous slowdown with the more rapid recovery. The low inflation environment played an important role in the accelerated growth and in the moderation of slowdown along with flexible exchange rates and positive real interest rates another factor. Here in Turkey we witnessed spectacular decline in inflation and this has happened in the context of fiscal consolidation that has been achieved in the past few years and during a period of very healthy growth for three consecutive years now the Central Bank has done better that end year target it set itself and the fallen inflation rate has in turn strengthened the credibility of monetary policy. There are now additional gains to be had if the Turkish inflation rate can be brought down further say to the 2 – 4% range, macroeconomic management would be further improved and resource allocation and decision making by businesses can become even more efficient and these are benefits worth having in themselves but low inflation will also help Turkey converge with the industrial economies those are the EU of course but also in countries like the US and Canada. It is clear that the government and the Central Bank recognize this, their commitment to further reductions in the inflation rate can only strengthen the credibility of policy making. The independence of the Central Bank has been an important factor in the policy success so far and the planned introduction of inflation targeting next year should facilitate further drops in the inflation rate that the Turkish economy needs and Turkish policy makers and citizens want.

Let me now turn to the fiscal side, fiscal imbalances and failure to correct them were the root cause of Turkey ’s inflation problem. Bringing fiscal situation under control was therefore essential to end the crisis, to reduce inflation and to bring about macroeconomic stability. The large fiscal adjustment that has been undertaken over a relatively short period has permitted a significant reduction in Turkey ’s public debt burden and a reduction in the risk premium applied to Turkish debt, it has also helped to restore confidence in macroeconomic policy and here too there is a commitment the carry-on and go further. The primary surplus target exceeded last year as I noted is to be maintained. This will make possible further reductions in the debt burden. External debt is more than 50% of GNP and the gross public debt is over 75% of GNP. These are still uncomfortably high levels. Currently a large part of the public debt is indexed to foreign currencies or linked to short term interest rates. Further reductions in the dept to GDP ratio and further smoothing out the debt profile will reduce Turkey ’s vulnerability to rising worldwide interest rates and to exchange rate volatility. I cannot help but note that the substantial fiscal adjustment we have thus far seen has taken place in the context of truly impressive growth performance. The high primary surplus is not inhabited growth any more then has the rapid decline in the rate inflation indeed the opposite is true, it is the macroeconomic stabilization and the resulting stability that has enabled such rapid growth.

Let me turn now to structural reform, of course the pace of growth has to moderate somewhat in the years to come but there is every reason to think that the Turkish economy can continue to grow at a rapid and sustainable pace. The objective now should be to raise the potential rate of growth that can be achieved without fueling inflation. That will accelerate the growth of real incomes of Turkish citizens and also accelerate the reduction in the incidence of poverty. Achieving that objective of higher growth will mean implementing for the structural reforms aimed at making the economy more flexible, more oriented toward market forces and enabling firms and individuals to respond appropriately to economic incentives. Many structural reforms have already been undertaken, I mentioned the trade liberalization and banking early 1980’s since the turn of the century important reforms have been implemented in the financial sector including the regulatory environment for banking in the management of public finances and in the area of business regulation but further reforms in these areas are needed if that higher growth potential I mentioned is to be achieved. Wise reforming policy makers pursue reforms on as many fronts simultaneously as possible and that has been true that Turkish efforts in recent years. Many structural changes take time to work through and the more rapidly such reforms are introduced and implemented the sooner the results will become evident.

Let me mention some specific areas where further structural reforms will help improve Turkey ’s growth potential. The banking crisis prompted significant financial sector reforms, the regulatory framework has been brought closer to international standards and state banks have been restructured and re-capitalized, banks also begun to restructure their portfolios away from government paper thus enabling commercial and consumer lending to rise rapidly so far so good but further reforms are essential if the financial sector is to fill its role in making the economy more productive. Since the 1990’s we have all become increasingly aware of just how important is a sound financial sector is not least in rapidly growing economy. the financial system provides the means by which the resources for investment are allocated, it is in the sense the oil who drives the engine of an economy as an economy grows and becomes more sophisticated efficient credit allocation and assessment of risk becomes increasingly important. The banking system needs to be sound, financial intermediation needs to be increasingly wide and deep. The government itself is cognize end of this currently it has submitted a new banking law to Parliament that in part attempts to correct the weaknesses of the regulatory system that were identified by the e-mark commission report published last August. It also aims to tackle problems with bank intervention and bank resolution encountered during the crisis. The pressure for further reforms in this area is unlikely to ease, the financial needs continuously to evolve if it is to continue to meet the needs of the economy as the economy evolves and expands otherwise the financial sector can act as break on growth because it is unable to allocate credit as efficiently as needed. Inefficient or less then optimal allocation of credit reduces the rate of growth in their foreign piece to growth potential of the economy. Reforms to improve budgetary transparency on the part of the government have already been set in train as have improvements in the tax system and more measures are envisaged. High rates of taxation and complexity encourage participation in the informal sector of the economy but the lower the rates of tax collection and narrower the tax base higher the tax rates needed to maintain government revenues. Streamlining and simplifying the tax system and lowering tax restrates will reduce distortions and simultaneously will help discourage participation in the informal sector thus also generating additional revenues. Broadening the corporate tax base and improving compliance will also help raise revenue. On the expenditure side the need for reform in several areas is becoming more pressing. Reforms to the pension system were introduced in 1999 but spite these the pension deficit widened from 2,5% of GNP in 2000 to 3,5% in 2004 and on current trends without further reforms it could grow to 7% of GNP over the longer term. The overall social security deficit which is you know includes health expenditures will more then double from the current 4,5% of GNP in the long run. Such rapid growth in these deficits would devour government resources away from infrastructure, education and other areas necessary for growth. Plans for further social security reform are already in trend, legislation already submitted to parliament should reduce the annual pension deficit by nearly 1% of GDP over a 10 year period and bring the deficit to below 1% of GNP over the longer term and that is a major step but beyond these key areas there remains a full agenda of expenditure reform, better targeted and more efficiently administered expenditure in areas such as civil service paying employment, health and education spending the judiciary and government subsidies for farmers all offer scope for significant budgetary savings while removing distortions that hamper growth. Resources provide infrastructure spending which are important both to improve the standard of living of citizens and also foster the growth of commercial enterprises can increase these reforms from mid savings elsewhere in the budget. Privatization of government assets will also contribute to an improvement of the functioning both of the economy as a whole to its effect on private sector competition and because it will reduce the burden on the state sector. Competition based on level playing field for only economic actors domestic and foreign is essential for rapid growth and considerable progress has been made in creating much-improved climate for business. The 2003 foreign direct investment law helps level the playing field for foreign and domestic investors, the investment advisory council was established in 2004 and my colleague Rodrigo Devato the funds managing director attended last week’s meeting. The government now has embarked on reforms aimed at cutting red tape, improving the efficiency of the court system and bringing business standards generally more in line with those of the EU. It now takes only 3 procedures instead of 13 to open a business and the average time to register has recently been cut to less then a week, plans are also under way to create a one stop shop system for obtaining business permits. A more flexible labor market would also provide a stimulus for investment, labor market rigidities and high minimum wage act as disincentive to hire new staff, they encourage participation in the informal sector with consequences for tax revenues and export growth since informal enterprises cannot export and labor market inflexibility explains at least some of the stickiness in the unemployment rate. The costs of complying with statutory employment legislation remain high, here in Turkey firms have to pay 112 weeks of wages to lay someone off compared with 40 average in the OECD and on measures such as difficulty of hiring workers the rigidity of working hours Turkey currently supports very poorly in international comparisons yet evidence suggests once employers are free to fire workers they in fact start hiring them. Changes in labor market regulation would greatly improve the business climate and it could do much to foster growth in new areas of economic activity and by helping to reduce unemployment labor market reforms could build greater recognition that economic reforms bring tangible rewards for more and more people in the population. Experience elsewhere, in the EU and beyond shows that countries with structural rigidities in the labor market tend to struggle with high unemployment rates and sluggish growth yet those countries like the US, UK, Australia and Chile where reforms of increased flexibility of the labor market have had the most success in reducing unemployment and increasing employment. Significant enhancements in Turkish wage and price flexibility will facilitate more rapid and sustained growth, they will raise real incomes and the will help reduce poverty. They’re all objectives that we seek and they’re desirable in themselves because they’ll improve the lives of Turkish citizens. They will also help Turkey converge more closely with the EU and other industrial countries and so promote the objective of Turkish membership of the EU as an added bonus but it should not be the main motive for pursuing labor market or any other reforms.

So now let me briefly sum up, the need for structural reform is never ending in a modern global economy. We can see this in the events industrial countries just as much as in emerging market and low-income countries. Firms in many industries and national policy makers are often reluctant to grapple with the implications of changing trade patterns and greater liberalization. They would rather put up barriers and to adapt yet a modern economy has constantly to adapt if it is to remain competitive, rapid advances in transforming communication, technological change effecting manufacturing and service industries including analogy economy being discussed here globalization itself means that economies that fail keep pace with change risk falling behind. Macroeconomic stability is of course the prerequisite for sustained economic growth that can bring about the poverty reduction and rising living standards we all want to see but macroeconomic stability is not sufficient. It is a foundation on which to build thriving market economy, this is true here in Turkey as is elsewhere. Further structural reform offers the chance to accelerate this country’s transformation to a well functioning stable and rapidly growing market economy. Timing is crucial, the prospects for sustained growth are better then they have been in decades. So far progress has exceeded expectations. The Turkish government has pressed on with reforms in the context of an improving global economic climate and economic upturns provide the best backdrop for economic reform programs. The benefits flow more rapidly and costs of adjustment are lower then they would otherwise be. The payoff has already been substantial and as reforms continue the payoff will increase, economic reforms have accumulatively beneficial impact, the one increasing the returns to the others. So much has been achieved as I said before it is wonderful time to visit Turkey and see the fruits of what is already been done, the challenge now is to make the reforms achieved so far irreversible and to maintain the momentum. The price will be higher growth potential and more rapid rise in real incomes that by any measure is a price worth having and it is a price that I believe is well within the grasp of Turkey and its citizens. Thank you very much.