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Maintaining the Momentum: Policy Priorities for Turkey June 2007 Hugh Bredenkamp International Monetary Fund Outline The turnaround in the Turkish economy since 2001 has been impressive But policymakers cannot rest on their laurels Growth is slowing and vulnerabilities remain Further reforms will be needed over the next five years to consolidate financial stability and raise potential growth Growth is easing after the post-crisis rebound... Real GNP growth (y-o-y, in percent) 12 12 10 10 8 8 6 6 4 4 2 2 0 0 -2 -2 -4 Annual Growth -4 -6 2002-2005 average -6 -8 -8 -10 -10 2000 2001 2002 2003 2004 2005 2006 2007 ...and becoming merely “average” Growth in Turkey and Emerging Markets (in percent) 20 15 10 5 0 Turkey Maximum Minimum Median -5 -10 -15 2002 2003 2004 2005 2006 Disinflation has become more difficult … CPI inflation (in percent) 68.5 39.0 ay .0 7 20 06 9.7 M 7.7 20 05 12.7 9.4 20 04 20 03 20 02 29.7 20 01 20 00 75 65 55 45 35 25 15 5 9.2 Jan.05 Feb.05 Mar.05 Apr.05 May.05 Jun.05 Jul.05 Aug.05 Sep.05 Oct.05 Nov.05 Dec.05 Jan.06 Feb.06 Mar.06 Apr.06 May.06 Jun.06 Jul.06 Aug.06 Sep.06 Oct.06 Nov.06 Dec.06 Jan.07 Feb.07 Mar.07 Apr.07 May.07 … running well above the 4 percent target Headline CPI inflation and end-year CPI targets (in percent) 14 12 10 8 6 4 2 Turkish exports have gained market share… Turkey's export shares, 1997=100 (Turkish exports/region's total imports) 170 160 World EU Germany US 150 140 130 120 110 100 90 80 2000 2001 2002 2003 2004 2005 … but booming imports and adverse terms of trade widened the current account deficit Current account balances (in percent of GNP) 10 8 6 4 2 0 -2 -4 -6 -8 -10 Total Non-oil 2000 2001 2002 2003 2004 2005 2006 Labor force participation is still low and unemployment high... Labor participation and unemployment rates (in percent) 90 12 80 10 70 60 8 50 6 40 30 4 20 2 10 0 0 Turkey Emerging Markets EU 10 Advanced Economies Men Activity Rate Women Activity Rate Unemployment Rate (right scale) lip pi ne s l a FS U/ CE E La t. Am . As i Th ai la nd Ph i Br az i Re p. In do ne sia Hu ng ar y Ar ge nt in a Ko re a Po la nd M ex ico M al ay si a Tu rk ey Ro m an ia Bu lg ar ia Cz ec h ...informality remains a drag on growth potential Informal economy 1999/2000 (in percent of GDP) 55 50 45 40 35 30 25 20 15 10 01-Mar-06 08-Mar-06 15-Mar-06 22-Mar-06 29-Mar-06 05-Apr-06 12-Apr-06 19-Apr-06 26-Apr-06 03-May-06 10-May-06 17-May-06 24-May-06 31-May-06 07-Jun-06 14-Jun-06 21-Jun-06 28-Jun-06 05-Jul-06 12-Jul-06 19-Jul-06 26-Jul-06 02-Aug-06 09-Aug-06 16-Aug-06 23-Aug-06 30-Aug-06 06-Sep-06 13-Sep-06 20-Sep-06 27-Sep-06 04-Oct-06 11-Oct-06 18-Oct-06 25-Oct-06 01-Nov-06 08-Nov-06 15-Nov-06 22-Nov-06 29-Nov-06 06-Dec-06 13-Dec-06 20-Dec-06 27-Dec-06 03-Jan-07 10-Jan-07 17-Jan-07 24-Jan-07 31-Jan-07 07-Feb-07 14-Feb-07 21-Feb-07 28-Feb-07 07-Mar-07 14-Mar-07 21-Mar-07 28-Mar-07 ... and Turkey is particularly vulnerable to financial market volatility The lira-dollar rate and global volatility 25 1.75 YTL/$ (left scale) VIX Index (right scale) 1.65 1.45 1.25 23 21 19 1.55 17 15 13 1.35 11 9 The task ahead Strong policies are needed to put Turkey in the ranks of the fastest growing EM economies... ...while reducing vulnerability to external shocks Strategy for high sustained growth needs: Inflation in the low single digits Lower public debt and a stronger reserve position A more efficient tax structure A more flexible labor market More developed financial markets More competitive product markets The importance of low inflation Cross-country evidence suggests that keeping inflation in the low single-digits helps growth The median EM country is at that point, and Turkey needs to “join the club” by persevering with tight monetary and fiscal policies Inflation in Turkey and Emerging Markets (in percent) 50 40 Turkey Maximum Minimum Median 30 20 10 0 -10 2002 2003 2004 2005 2006 The decline in public debt should continue Bringing the net debt/GNP ratio down to around 30 percent over the medium term would reduce exposure and create greater fiscal room for maneuver over the cycle Gross public debt (in percent of GDP) 80 70 60 50 40 30 20 10 0 110 100 90 80 Russia Czech Rep. S. Africa Poland Turkey Hungary Brazil 70 60 50 2000 2001 2002 2003 2004 2005 2006 Reserve coverage of external debt is still low Raising coverage of short-term debt to at least 100 percent would help bolster market confidence Reserves to short-term external debt (in percent) 250 200 150 100 50 Russia S. Africa Czech Rep. Hungary Poland Brazil Turkey 0 Further tax reform is a high priority Need to create fiscal room to lower taxes through sustained spending discipline and social security reform Focus should be on those taxes most out of line with Turkey’s competitors First candidates could be taxes on labor and financial intermediation Social security reform is essential Social security system's financial balance (in percent of GDP) -2% -3% 2074 2070 2066 2062 2058 2054 2050 2046 2042 2038 2034 2030 2026 2022 2018 -1% 2014 0% 2010 0% 2006 1% 2002 1% -1% -2% No reform May-2006 reform -3% -4% -4% -5% -5% -6% -6% -7% -7% Turkey has one of the most restrictive labor market regimes in the OECD... Overall employment restriction legislation (OECD Employment Outlook) Portugal Turkey Spain France Greece Sweden Germany Italy Netherl. Poland Korea Slovak Czech Denmark Japan Hungary Australia Ireland Canada UK US 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 ...with high severance pay Severance pay in OECD countries (in monthly wages) 25 20 after 9 months 15 after 4 years 10 after 20 years 5 Slovak Rep. Czech Rep. Australia Denmark Ireland Canada UK Japan France Greece Spain Turkey Portugal 0 Spain Latvia US Romani Slovak Lithuani Czech Bulgaria Hungary Portugal Ireland Poland Slovenia Greece Netherl. UK France Turkey Estonia ...high minimum wages Minimum wage in 2006 (in percent of GDP per capita) 90 80 70 60 50 40 30 20 10 0 Ireland Mexico Korea Luxemb. New US Iceland Australia Switzerl. UK Canada Japan Portugal Slovak Norway Netherl. Denmark Czech Spain Austria Finland Greece Italy Hungary France Belgium Germany Turkey Sweden Poland ...a high tax wedge on labor Labor tax wedge including employer's social security contributions (average rate, 2005, in percent) 45 40 35 30 25 20 15 10 5 0 ...and limitations on temporary employment Restrictiveness of temporary employment regulations in OECD countries (2003) 6.0 5.0 4.0 3.0 2.0 1.0 US Canada UK Slovak Rep. Czech Rep. Ireland Australia Hungary Netherl. Poland Japan Denmark Sweden Korea Germany Italy Portugal Greece Spain France Turkey 0.0 Financial sector development has a long way to go: bank intermediation is low... Private credit to GDP (in percent) EM-Latin America Turkey EMEurope Emerging Markets EU-12 EM-Asia 70 60 50 40 30 20 10 0 ...the mortgage market is in its infancy Mortgage (housing) loans as a share of total loans (end-2003, in percent) 40 35 30 25 20 15 10 5 0 ...and there is no active corporate bond market 7 Outstanding domestic debt securities by corporate issuers (in percent of GDP) 6 5 4 3 Emerging markets 2 Emerging markets Europe (incl. Turkey) Turkey 1 0 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 A rich agenda for financial sector reform implement new mortgage and insurance laws eliminate remaining financial intermediation taxes improve accounting standards privatize state banks continue strengthening supervision Finally, product markets need to be liberalized Sectors with high/sticky inflation could be prime candidates: e.g. agriculture, services Intensity of product market regulation in OECD countries (2003) 3.0 2.5 2.0 1.5 1.0 0.5 Australia UK Iceland US Ireland Denmark New Canada Sweden Luxemb. Japan Finland Belgium Netherl. Austria Slovak Germany Norway Korea Portugal Spain Switzerl. France Czech Greece Italy Hungary Mexico Turkey Poland 0.0 To summarize... Turkey has made great strides over the past five years But to sustain strong growth, a new push on reforms will be needed Goal should be to raise potential growth while reducing vulnerabilities to external shocks Policy priorities: Continued fiscal and monetary discipline to reduce inflation and bolster market confidence Broad-based structural reforms to make the economy more flexible and competitive