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21/10/2004 - Turkey has started an ambitious reform agenda with far-reaching macroeconomic and structural reforms. If these reforms are fully implemented and further developed there is a good chance that its economy can shift to a stronger and sustainable job-rich growth path. This is the main conclusion of the economic survey. But the survey also indicates that Turkey still faces a number of difficult challenges which must be overcome to achieve a durably better economic performance. Therefore we speak of a window of opportunity which has been opened. If the European Council in December follows the recommendation by the EU commission to start EU accession negotiations, this window of opportunity for Turkey will open further. Nevertheless the challenges which we describe in our report will remain.
With its rising population of working age and its currently low levels of employment and productivity Turkey has a high potential for catching-up. We believe that under favourable conditions the Turkish economy could grow at a trend rate of above 7 per cent per year. In the past Turkey could not use this catching-up potential as economic recoveries were soon followed by deep recessions, the latest in 2001 when real GDP declined by no less than 7½ per cent. The boom-bust cycle and the low trend growth was the result of what we describe in the survey as the three traps in which the Turkish economy was caught in the past:
First, a confidence trap: low confidence in political and macroeconomic stability together with high government deficits and debt levels led to very high real interest rates, bouts of depreciation and inflation.
Second, a governance trap: shortcomings in core public services and institutions undermined the quality of services and the efficiency of enforcement in the public sector.
And third, an informality trap: the adverse environment incited private businesses to shift more activities to the informal sector while an increasing tax burden was imposed on firms and workers that stayed in the formal sector.
These three traps, the confidence trap, the governance trap and the informality trap, reinforced each other and created a vicious circle which prevented a catching-up of the Turkish economy. Overcoming these problems would make it possible for Turkey to enter into a virtuous circle of improved confidence, strengthened governance and increased formalisation that could underpin a sustained period of strong growth.*
The reform agenda following the 2000 01 crisis, based on the National Convergence Programme to the EU acquis and on the Stand-By Arrangement with the IMF, and later reinforced by the Urgent Action Plan of the current government, has addressed these problems.
The short-term effects of these reforms have been very positive although it is too early to claim victory: In 2002 and 2003 GDP recovered by around 8 and 6 per cent respectively and it should rise by more than 8 per cent, perhaps almost 10 per cent in 2004. This greatly exceeds government targets and makes Turkey the fastest growing economy in the OECD. So far output growth has been achieved by large productivity gains while job creation has remained low which is the weak spot in the current recovery. At the same time the rate of inflation - while still higher than in other OECD countries - has declined sharply from 54 per cent in 2001 to 25 per cent in 2003 and to 12 per cent in the first half of this year. It could fall to a single digit annual rate in 2005, for the first time in three decades. While the strengthening of the world economy has helped Turkey to recover, the new policy framework was probably more important. The establishment of the new macroeconomic settings brought fundamental changes in both monetary and fiscal policy-making. Tight fiscal policies, based on a high primary surplus of 6.5 per cent of GDP and strict monetary conditions have significantly improved confidence and have proved to be expansionary. The current recovery is certainly too strong to be sustainable at that rate and it has also led to soaring imports outstripping exports. As a result the current account deficit has widened. Given the strength of the economy and the risk of a further increase of the current balance deficit, the government should resist any temptation to loosen the fiscal stance and use additional revenues from higher growth for debt reduction. At the same time monetary policy should remain focused on the requirements of continuing disinflation and smoothing out erratic exchange rate fluctuations. Thus the short-term task is taming this boom and keeping inflation on a downward trend.
Over the medium-term the same considerations apply. It is of crucial importance that confidence in government policies and fiscal consolidation remains intact so that risk premia and interest rates, which are still high, will continue to fall. Indeed, any rise in risk premia would increase interest payments and the overall fiscal deficit and could undermine confidence. The recent introduction of a more transparent debt management and reporting system will also contribute to better market information and reduce risk perceptions. This reporting system should be fully applied to all general government liabilities and non-guaranteed borrowings of sub-central governments and other public sector entities. If policies remain on track the net debt to GDP ratio will decline significantly in the coming years, from currently almost 70 per cent to 55 per cent or even less by 2008.
Besides the ongoing task of quantitative fiscal consolidation, the "quality of consolidation" has still to be improved, the second major theme in the survey. To date the bulk of consolidation came form tax increases. Many of the "temporary" taxes introduced for short term fiscal consolidation tended to become entrenched. The authorities have now initiated an assessment of the existing tax policy and tax collection procedures. They have also launched a simplification of corporate and indirect taxes, and are projecting an important overhaul of the tax administration. We welcome these efforts.
In our report we have a special chapter on government spending. We show that since a large part of government spending is "mandatory" and therefore politically difficult to curb, spending cuts had been effected elsewhere on an ad hoc basis, including in important public services and infrastructure investment. Indeed, we have identified serious deficiencies in core public services such as justice, education, health, rural development and infrastructure planning and management. These shortcomings in public services have in the past impeded growth. The government has recognized the severity of these shortcomings and is introducing a new public expenditure management system with a functional multi-year budgeting and an integrated general government accounting. This could indeed help to improve transparency and reorient expenditures to areas where they are most needed. But it also requires the necessary training of the administration and an effective auditing and hence more resources put in such activities. But there are unavoidable delays in the full introduction of such an ambitious expenditure management system. We therefore recommend the government to use a similar approach as with the white paper on social security. This means, evaluating the present situation in all core spending areas and outline the reform options.
The government has also decided to introduce an ambitious fiscal decentralisation. This will transfer major spending powers to special provincial administrations, metropolitan municipalities and municipalities and also establish Regional Development Agencies (RDAs) in the 26 newly created regions. Some of these reforms are not yet implemented and are still under discussion and are politically controversial. Overall, we think that these reforms have the potential to better tailor public services to user and local needs but they also involve important risks that should be contained. For example given the small size and limited human capital of many municipalities, diseconomies of scales may be created. In our view amalgamations and service unions between municipalities should therefore be encouraged to exploit scale advantages. However, the most important risk is that the fiscal decentralisation leads to spending drift at the local level and a weakening of the budget constraint, as we have seen in other countries. It is therefore of crucial importance to fully apply the new fiscal and debt management framework to sub-central entities in order to limit their overall borrowing and prevent off-budget and quasi-fiscal spending.
The third major theme in the survey is improving the business environment. In the business sector the large extent of informality is a major policy concern. Unregistered activities account for more than 50 per cent of total employment and lead to a narrowing of the tax base. High labour taxes, in particular social security charges, and stringent regulations constitute barriers to becoming formal which trap firms and workers in the informal economy. There they are deprived of access to public and banking services and cannot reap benefits from economies of scale. Given the large negative effects of informality on fiscal balances, tax wedges and productivity growth and the complexity of the informality phenomenon, an integrated government strategy is required to reduce it. The authorities already envisage strengthening enforcement through a tax administration reform. While effective application of existing laws and regulations is doubtless of importance, we think that more should be done to improve the economic incentives for formalisation. One important element in an overall strategy to reduce informality and tax evasion could be to significantly reduce the social security contribution burden on wages. Indeed, Turkey's labour tax wedges are among the most substantial in the OECD but given the large size of the informal sector government revenues from this source are relatively small. The authorities might, therefore, consider to fund part of the social security charges on labour through other taxes. For example if half of the social security charges would be cut, additional revenues of about 2 per cent of GDP would be needed without considering any second-round effects. In addition, improvements in the conditions of financing of business investment by banks - notably via cuts in financial transaction taxes - would make formalisation more attractive.
Another issue for increasing efficiency in the business sector is privatisation. Advancing privatisation would also help to attract FDI inflows which are still very low. Despite liberalisation efforts in infrastructure industries, competition and private investment in electricity, natural gas and parts of telecommunications remain underdeveloped and services are offered at high costs, especially for business users. We therefore recommend that independent sectoral regulators and competition authorities should enforce competition and facilitate market entry in those industries where monopolistic incumbents prevail.
With respect to the financial sector we find that the bank restructuring following the 2001 crisis improved banking regulation and supervision significantly and there are early signs of improving credit funding for investment. However, ongoing reforms of corporate governance structures should be pursued in order to further improve the integrity of the banking system, and the privatisation of public banks would be an important step in that direction.
Summing up, we think that today Turkey is at a cross roads. In some of the three problem areas of the past which I mentioned, confidence, governance and formalisation, we see significant progress. But progress is uneven so that a virtuous circle between them has not yet emerged.
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Most progress has been made concerning macroeconomic policy and confidence.
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Important steps have also been made concerning governance, but more has to be done to improve core public services which are impeding long-term growth, in particular in the areas of education and property rights i.e. the justice system.
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Concerning the reduction of the informal sector, which is the third problem area, we also think that more should be done. Our suggestion to significantly reduce social security contributions - as part of an integrated strategy and financed in a revenue-neutral way - could be a major step towards formalisation.
Overall, despite recent achievements with macro stabilisation and structural reform important challenges still remain. It is therefore of crucial importance that confidence in government policies remains intact and that the new policy framework is fully implemented and completed. It is certainly encouraging to see that this far-reaching reform agenda, which could fundamentally change economic conditions in Turkey, is widely supported and has been agreed by two consecutive governments; political stability is also supporting this process.
Further information on the study is available at www.oecd.org/eco/surveys/turkey
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