Turkey is the most volatile growth economy among emerging markets, says International Monetary Fund. The country’s low level of domestic savings makes it more dependent than others on capital inflows for investment, and because inflows to Turkey are of a less stable nature than flows into other countries, hence increase in volatility.
“Beyond this dependence on foreign financing, economic volatility is exacerbated by higher-than-average policy pro-cyclicality. Despite large volatility, trend growth in Turkey has been remarkably stable at around four per cent, explaining why estimates of potential growth are in that neighborhood,” says IMF. However, average growth of four per cent has been associated with a deteriorating external position. “Barring reforms, we find that the maximum rate of growth consistent with no deterioration in the current account deficit is within the 2¾−3½ per cent range. Alternatively, reaching 4-5 per cent growth without widening external imbalances will require higher domestic savings, attracting more stable sources of foreign inflows, and paying greater heed to the impact of fiscal policy on the economic cycle.”
Overall, the Fund says Turkish economic activity has accelerated, in part thanks to pro-cyclical macroeconomic policies.
With domestic demand stronger, the current account deficit is widening again from a high level, and inflation remains well above target.
Of the biggest challenges is that on current policies, Turkey can only sustain high growth at the expense of growing external imbalances. Short- and medium-run policies should focus on reducing external vulnerabilities, so Turkey can break free of its boom and bust cycles.
Some of the key policy recommendations from IMF are:
* Despite higher interest rates, monetary policy remains too loose given the inflation target. The policy framework should be normalized with a clearer focus on inflation. * Expenditures should be reined in and higher-than-expected revenues saved. The 2014 budget should target a primary balance consistent with a 0.7 per cent of GDP structural improvement. There is room for policy action in case of downside risks, but discretionary stimulus should be applied only if growth is expected to turn negative.
* Increasing national savings and improving competitiveness are central to addressing vulnerabilities. Ambitious medium-term fiscal targets (consistent with a two per cent of GDP consolidation over the next five years) and deepened structural reforms are needed.
* Traction of past Fund advice: The authorities share staff’s view on the need to raise savings, as reflected in the 2014 Medium-Term Plan and their 10th development plan. In addition, they introduced macro-prudential measures to address growing leverage by households in line with Fund advice, and more is under consideration.
However, they have a more benign view of external vulnerabilities, therefore monetary and fiscal policies are looser than what IMF staff recommends. The authorities also concur that lowering inflation is a key objective, but believe their monetary framework serves them well and intend to continue with the normalization of the policy framework.
More proactively, what can Turkey do to achieve four-plus growth without compromising stability? The IMF paper points to some clear priorities:
* Reduce dependence on foreign savings, which will entail raising the low level of domestic savings. Recent reforms of the private pension system are a good step, but they are not nearly enough. With Ricardian equivalence only partial in Turkey (IMF 2012a), the government could play a useful role by targeting more ambitious public savings in the medium-term, akin to those that it was achieving before the global financial crisis.
* Attract more stable sources of external funding. The low level of inward FDI is an important shortcoming in Turkey, all the more considering the potential offered by the country’s strategic geographical location and its large and growing internal market. Again, recent changes to the business code and to the capital markets law go in the right direction, but more is needed in the areas of taxation, labor contracts, and business environment as identified by the Investment Advisory Council.
* Reduce the pro-cyclicality of fiscal policy. Turkey’s fiscal achievements over the last decade are impressive, resulting in much lower public debt and one with a more favorable maturity profile and lower FX risk. With debt sustainability now en trenched, the authorities should pay more heed to the impact of fiscal policy on aggregate demand and the general economic cycle.