Turkey's Challenges to Achieving a Sustainable Catching-up

The Turkish economy has grown by a third since the 2001 crisis. Far-reaching macroeconomic and structural reforms have helped to increase confidence, reduce risk premia and stimulate domestic and foreign investment. However, Turkey was one of the countries most affected by the decline in the risk appetite of the international financial markets earlier this year and a number of challenges must still be addressed to minimize the risk of falling back into a boom-bust cycle and to ensure that strong growth is sustainable. The priorities are to further strengthen fiscal, monetary and prudential policy institutions in order to make the economy more resilient to shocks, and to accelerate the pace of reform in labour, product and agricultural markets and in the social security and education systems in order to overcome the deep dualities which hinder the long-term growth performance 

Following the severe 2001 economic crisis, far-reaching policy and reform initiatives were taken. Initially motivated by the Stand-By Arrangement with the IMF and the National Convergence Programme to the EU acquis, these were later reinforced by the Urgent Action Plan of the current government. In the wake of the opening of accession negotiations with the EU in the autumn of 2005 the government made further strong commitments to continue its reform agenda. As a result of these reforms, and helped by a favourable international environment, the Turkish economy bounced back and has become one of the fastest growing economies in the OECD. At the same time, this growth momentum and the positive interest rate differential led to large capital inflows, a significant real currency appreciation and a deterioration in the current account, creating some concern that - if imbalances continue - the economy could fall back again into a boom-bust cycle. When international market conditions turned less benign in Spring 2006 and the global risk appetite decreased, Turkey indeed experienced significant depreciation of its exchange rate and a strong increase in its risk premium. The extent to which Turkey was affected by the changed international environment highlights Turkey's ongoing macroeconomic vulnerabilities. The main macroeconomic policy challenge is clearly to bolster confidence and prevent a reversion to a boom-bust cycle.

The microeconomic framework conditions for doing business, despite some progress, have still a way to go to match the business sector flexibility of other OECD countries. The formal regulatory framework remains rigid and costly and continues to provide strong incentives for private business to conduct at least part of its activity in the informal sector. As a result, the tax base remains narrow and the tax burden on the formal sector remains high. Furthermore, firms that are forced into the informal sector remain small and have limited access to credit and high quality human capital, thus depressing productivity growth and the pace of catch-up.

Turkey's recent economic performance and outlook

Reaping the first benefits of reforms

The key strength of the economic rebound which has followed the reforms was the fact that it was entirely driven by the private sector. Business investment and household consumption led to a steady increase in demand, while public consumption and investment remained subdued under a strict fiscal consolidation programme. Net exports, initially positive in response to the strong depreciation of the exchange-rate in 2001, turned negative with subsequent strong real appreciation stimulated by large capital inflows. These inflows, which were made up of a significant share of portfolio investment but also an increasing proportion of long-term trade credit and foreign direct investment, contributed directly to the growth of domestic demand. The disinflation process, led by the newly independent Central Bank, remained on track until 2006 in spite of strong growth, though helped by currency appreciation (Figure 1.1).

The strength of domestic demand and real currency appreciation provoked a sharp widening of the current account deficit which reached a record level of more than 6% of GDP in 2005; the sustainability of this external imbalance has raised concern. While capital inflows help to finance investment which enhances growth potential, it is also true that the easier access to credit increased private consumption and household indebtedness at a pace that may be unsustainable. Against this background, a tightening of international capital market conditions in spring 2006 (coinciding with the emergence of some internal political tensions) triggered a sharp exchange-rate depreciation in May and June 2006. Following this depreciation, already looming inflationary pressures increased and inflation expectations surged well beyond the year-end target. The Central Bank reacted with sharp successive increases of its policy interest rate and real incomes, household consumption and business investment are now expected to weaken throughout the rest of the year, despite the stimulus of competitiveness gains in export industries.

Despite the recent volatility, there are signs that the post-crisis reforms, backed with credible external anchors, may have triggered a "structural break" in the long-term capital formation and growth process. Fiscal, monetary, banking and a number of product and capital market reforms, together with the perceived (trend) convergence of economic policies toward OECD and EU benchmarks, have stimulated an acceleration of domestic and international investment. Table 1.1 presents a summary of these key recent and remaining reform areas, as reviewed in this Survey.

Turkey has undertaken this structural reform programme with the help of major international anchors. Conditionality requirements included in successive Stand-By agreements with the International Monetary Fund set commonly agreed objectives, and deadlines, for the reform of fiscal institutions, the independence of the Central Bank and major privatisations. The World Bank contributed technical expertise and funding for the preparation of agricultural and social security reforms. In addition, the process leading to the opening of accession negotiations with the European Union provided a unique opportunity to review and assess a wide range of economic laws and regulations and offered a roadmap and technical assistance for making them converge with European standards. Convergence with the EU Acquis has been particularly important in product market regulations, competition policy, and network industry reforms which are particularly relevant for the functioning of the Customs Union between the EU and Turkey.

Table 1.2 summarises progress on a selection of convergence reforms associated with the start of accession negotiations in October 2005 (in 17 chapters out of 35 for which exploratory and bilateral screenings have been completed). The authorities plan to issue a total of 54 primary and 254 secondary regulations during 2006-07 on these 17 chapters. They plan to complete exploratory screenings on all chapters in Autumn 2006 and prepare reform programmes for the adoption of the acquis in the following years. This agenda is expected to boost the reform process and speed-up the legal-institutional modernisation.

Drawing on a methodology proposed by the International Monetary Fund to identify countries which have implemented important reforms over the past two decades,1 Figure 1.2 shows that reforms in Turkey have triggered a multi-year growth acceleration typical of such transitions. The stimulus went beyond the average results achieved in the first years of such transformations in other countries. Macroeconomic fundamentals and the international risk rating of Turkey also strongly improved during this period, despite important remaining vulnerabilities (Figure 1.3). The perceptions of the international business community about the upgrading of the Turkish business environment have also improved (Figure 1.4).

Where Turkey stands in the resource mobilisation and productivity performance of the economy

Despite this major leap forward in the last four years, the level of labour productivity in Turkey still remains far below that of other OECD countries, other than Mexico, which is also very low. The level of labour mobilisation (labour force participation and the employment rate of the working age population) is also still the lowest in the OECD, as shown in Figure 1.5. Turkey has therefore an immense potential to catch-up in both its labour productivity and labour utilisation performance.

The low average level of productivity does not reflect underperformance across-theboard, but rather hides a very skewed distribution of performance between different parts of the economy. Productivity levels tend to converge with OECD averages in some segments of the business sector, while they lag significantly behind in other, wider segments. The productivity gap is also large between formal and informal enterprises, while "half-formal" firms have achieved a significant catching-up in the past decade and are now at an intermediate level of productivity (Figure 1.6). Agriculture is an exception, as it is almost entirely informal and employs about one third of the workforce at a very low level of productivity. Raising productivity in the least productive sectors and firms would therefore significantly increase average productivity levels. This convergence implies overcoming the deep duality persisting in the labour market as the uneven educational background of individuals determine their degree of participation in the labour force - notably for women - and their ability to work in the formal vs. informal sectors.

Growth potential could further be boosted by fully integrating the growing number of young workers who are entering the labour market in the coming years and by raising the utilisation of existing labour potential. However, so far the labour market has not been flexible enough to fully absorb those entering the labour market or those who have lost their jobs in declining sectors, notably agriculture, despite the strong increase in nonagricultural employment in recent years. As a result, the unemployment rate has stayed above 10% despite higher growth and there is "underemployment"2 (Figure 1.7).

The outlook ahead

The sharp fall in the exchange rate in May-June 2006 amplified the acceleration in inflation which had started in April, pushing up prices above their uncertainty band for this period and lifting inflation expectations for the end of the year well above the official target (see Chapter 2). The Central Bank responded to this serious threat to its credibility with significant interest rate increases. The short-term net impact of this exchange-rate based adjustment and the resulting monetary tightening will be a deceleration in GDP growth, despite the competitiveness gains due to depreciation. While after the past appreciation an exchange-rate adjustment had been expected, the turnaround has been much faster and sharper than anticipated. Before this adjustment there was a risk that the desirable pace of disinflation may come at the cost of a prolonged appreciation of the exchange rate and losses in competitiveness. The main short-term challenge now is to preserve confidence.

Nonetheless, the medium-term prospects of the economy remain strong, provided that the underlying fiscal and monetary policies remain on track and are backed by further progress in structural reform. This will require continued domestic and international confidence in Turkey's ability and willingness to maintain its policies in their mainstream orientation and proceed with an ambitious reform agenda, including preserving a favourable political environment for reforms (Box 1.1).

Managing macroeconomic risks and improving resilience to shocks

Compared with more advanced economies, Turkey remains highly vulnerable to the whims and changing risk appetites of international investors. This is largely a reflection of Turkey's relatively short history of responsible macroeconomic management. Fiscal outturns have been very impressive for several years now, but these are largely the results of strong political will rather than of an overhaul of fiscal institutions. Although fiscal institutions and processes were improved significantly in recent years through new laws, these new measures should be fully implemented and there is still room for further improvement. As a result, the vulnerability "thresholds" for public and external debt remain much lower for Turkey than for more advanced economies. Moreover, recent volatility in the exchange rate, together with the large current account deficit, suggest that Turkey remains susceptible to larger shocks than those seen recently, in which case the recent downward trend in public and external debt ratios could reverse direction.

These risks suggest that Turkey could benefit enormously from further improving the robustness and transparency of the fiscal institutions. In terms of monetary policy, after initially establishing significant credibility, the central bank has recently suffered a set-back in terms of an upward inflation surprise, and expected high pass-through from the recent exchange rate depreciation. It is therefore very important that credibility be re-established by successfully returning inflation to the previously announced disinflation path.

Chapter 2 examines the challenges of macroeconomic stability by discussing in particular the following questions:

* What are the priorities for further improving the transparency, stability and permanence of fiscal institutions and processes?

* How can the credibility record of the Central Bank of Turkey be restored following the 2006 inflation surprise and the recent lira depreciation?

* What role can an acceleration of structural reforms play in assisting disinflation, in particular in the non-tradable sector? To what extent can structural reform also increase the quality of capital flows and improve the resilience of the economy to shocks?

* How can the vulnerability of banks and businesses to exchange-rate fluctuations be limited? Do the present prudential provisions for the banking system need to be strengthened in light of Turkey's high degree of corporate sector currency mismatches?

Deepening structural reforms to sustain a rapid catching-up

A sustainable and rapid catching-up in living standards will require the formal business sector, which generates the high productivity jobs, to expand at its full potential. To achieve this, the entrenched duality between formal and informal sectors must be overcome.

The pace at which resources can be shifted to the formal sector will influence the medium-term growth path of the economy. To illustrate the possible implications for medium-term growth outcomes, Figure 1.9 presents two "what if" scenarios: one based on assumptions about what might result from a relatively slow implementation of structural reforms facilitating formalisation (the status quo scenario) and the other assuming a faster reform process.3 The medium-term growth outcomes are truly different. In the status quo scenario, the average labour productivity level reaches only 36% of the 2005 OECD average within ten years, whereas it approaches 43% of the OECD average in the fast adoption scenario. While the status quo scenario results in a trend GDP growth rate of 4½ per cent per annum, the fast adoption scenario pushes the trend growth rate up to more than 6½ per cent. These are just mechanical quantifications of "what if" assumptions, rather than sophisticated scenarios. They nevertheless show that an acceleration of the formalisation process has the potential to significantly affect medium-term performance (Figure 1.9).

Four policy areas are of particular importance in shaping the required structural adjustment: i) a thorough simplification of business sector regulations; ii) additional changes in the social security system; iii) reforms in the education system; and iv) the pursuit of agricultural reform.

Simplifying business sector regulations

The business sector has been re-invigorated since 2001 with new enterprise creation picking up, private investment soaring and business sector productivity accelerating above trend. However, businesses also face important new challenges in the new environment: i) real currency appreciation weakened the competitiveness of many business activities - even if the exchange-rate depreciation in mid-2006 offset some of these losses; ii) rising competition from low-cost countries increasingly threatens the labour intensive industries; iii) comparatively high labour costs reflect a high minimum wage to average wage ratio and a costly employment protection and severance payment system. Confronted with such costly burdens for doing business, many firms operate informally but this limits their ability to build up human and physical capital, reap economies of scale and build international partnerships.

Chapter 3 examines the conditions for enhancing productivity, competitiveness and employment creation in the formal business sector through assertive regulatory simplification. It addresses the following issues:

* What role do labour market and product market regulations, legal minimum wages, social security contributions and institutional impediments play in preventing firms and workers from participating in the formal economy and how could these impediments be reduced?

* Are constraints particularly costly for dynamic medium-sized firms which contribute prominently to export, output and employment growth? Do these firms face a "glass ceiling" to their further growth because of their semi-formal status?

* Would large-size and highly productive formal sector firms, including foreign direct investment (FDI) firms, have significant additional growth potential if the regulatory environment were to be simplified?

* Could sectors perceived today as "condemned" by competition from low-wage countries be partly revived through such reforms?

Making the pension system less of an obstacle to formalisation

The 2006 pension reform has considerably improved the long-run sustainability of the pension system even if it will continue to run large deficits for decades to come due to continued low minimum pension eligibility ages and the slow transition to the new pension parameters. The recent reform has not, however, addressed the fact that the pension system continues to be an important barrier to a more rapid expansion of the formal sector. There are two strands to the formalisation barrier: first, early-retirement incentives seem to be pushing many middle-aged workers into the informal sector; and second, high net replacement rates require high social security contribution rates which contribute to a relatively high minimum cost of labour, making it unprofitable for firms to employ labour in the formal sector.

Chapter 4 proposes further changes that would make the pension system less of an obstacle to formalisation and focuses on the following questions:

* What additional measures could be introduced to encourage middle-aged people who have already qualified for a pension to remain in, or return to, the formal sector labour force?

* What cost-saving reforms could be implemented to fund a significant cut in the social security contribution rate? To what extent would additional reforms help to fund such a significant cut?

* Should the value of the targeted pension (the pension available for those aged 65 or older without any other income, including former informal sector workers) be increased to the absolute or general poverty line?

* Should formal sector retirement ages converge more rapidly than planned to this "informal sector retirement age" of 65?

Boosting long-term productivity growth by upgrading the education system

The education system produces lower average academic results than other OECD countries. But in the best schools, standards are very high. These results reflect a schooling system that has traditionally focused on providing a good standard of education for the most able students, who receive a good preparation for jobs in the formal labour force. By contrast, the quality of the "non-selective" high schools is poor, and the most binding human capital shortages seem to be in the middle and low-end of the labour market. Although roughly half the workforce is employed in the informal sector, the poor quality of the "non-selective" schools means that many children leave school with low literacy and numeracy skills and a weak human capital structure on which to build further knowledge and productivity through their working lives. Moreover, survey evidence shows that businesses have few problems hiring people with good tertiary-level qualifications but have significant difficulties hiring good staff with mid-range skills. A greater investment in the non-selective education system is therefore required to increase the productivity and employability of the majority of new entrants to the labour force.

Chapter 5 examines the conditions for upgrading the education system by addressing the following questions:

* What features of the education system are resulting in a shortage of human capital in the middle and low end of the labour market?

* Should the funding of schools be done on a per-pupil basis, to ensure a more equitable distribution of educational resources? How else can the quality of the non-selective schools be improved?

* Should the primary purpose of end-primary school and end-secondary school exams be to document pupils' acquired skills for potential employers (including informal sector employers), rather than to sort students according to their abilities?

Improving productivity in agriculture

The productivity of Turkish agriculture and its contribution to growth have been constrained by socio-economic weaknesses in rural areas and a protective regime of subsidization and trade protection, which has created a status quo of highly fragmented, low-skilled, low technology and domestic-market-oriented farming. Important reforms based on cuts in price subsidies and the privatization of the state-owned organizations which dominate the agricultural output and input markets were introduced in 2000-01. This effort should be reinvigorated and backed with additional reforms to stimulate the development of commercial agriculture across the country.

Chapter 6 examines the conditions for improving productivity in agriculture and covers the following questions:

* What are the remaining specific obstacles to the development of productivity growth and commercial agriculture? What is the best way to resume the stalled reform effort?

* Is the existing legal framework adequate to permit the necessary consolidation of small land holdings into more efficient farm sizes?

* Given the much needed irrigation investment and existing fiscal constraints, should policymakers aim at attracting more private investment in irrigation? Would more economic pricing of water help with private investment in irrigation?

* Is the establishment of a formal social safety net for retiring farmers feasible?

Conclusions

The Turkish economy has grown by an average 7.5% per annum since the 2001 crisis, the strongest growth performance among OECD countries. The far-reaching macroeconomic and structural reforms helped to increase confidence, reduce risk premia and stimulate domestic and foreign investment. However, Turkey still faces a number of challenges that it must address to minimize the risk of falling back into a boom-bust cycle and to ensure that strong growth is sustainable. Further strengthening of fiscal, monetary and prudential policy institutions is needed to make the economy more resilient to shocks, and further reforms in labour, product and agricultural markets and in the social security and education system are required to overcome the deep dualities which hinder its long-term performance. Success with reforms would facilitate Turkey's negotiation process with the EU as a country proving its potential contribution to the Union's prosperity and capable of productively employing its growing working age population. The following chapters analyse the challenges outlined in this chapter and develop specific policy recommendations to meet them.