IMF Executive Board Concludes 2021 Article IV Consultation with Turkey

Washington, DC: On May 27, 2021, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation[1]with Turkey.

In the years leading up to the COVID-19 pandemic, growth in Turkey became increasingly dependent on externally-funded credit and demand stimulus. This growth was accompanied by large current account deficits, financed mainly by debt, which led in turn to high external financing needs. At the same time, rapid credit growth, led by state-owned banks, and high inflation undermined monetary policy credibility and fueled deposit dollarization. The resulting pressure on the lira contributed to large reserve losses. As a result, Turkey entered the pandemic with lower buffers than most peers.

As in other countries, the human and initial economic toll of the pandemic in Turkey has been severe. Thousands of Turkish lives have been tragically lost and many livelihoods compromised. But while the initial collapse in economic activity was similar to other countries, the recovery has been remarkable, setting Turkey apart from its peers. Large interest rate cuts, rapid credit provision by state-owned banks, administrative and regulatory credit incentives, and extensive liquidity support meant that Turkey was among the few countries to experience positive economic growth in 2020. Employment has partially recovered along with the rebound in economic activity, although labor market conditions remain challenging, particularly among females and the youth. Public debt remains contained, at around 40 percent of GDP, as direct fiscal support—including to workers and vulnerable households—has been relatively modest, with the central government deficit widening only marginally in 2020. Some fiscal space remains available, albeit somewhat limited by contingent liabilities and potential debt rollover pressures.

But the same policies that buoyed growth also exacerbated pre-existing vulnerabilities, with buffers now lower than before the pandemic. Higher inflation, increased dollarization, and a large shift in the current account position increased pressure on the lira and gave rise to heavy foreign exchange sales, which led in turn to steep reserve declines from already-low levels. A shift towards a firm monetary policy stance since the Fall, focused on reining in inflation, was initially well received but its durability has recently been called into question, with the lira standing nearly 40 percent below its pre-pandemic level. Gross reserves are well below the recommended adequacy range, and net international reserves are negative once foreign exchange swaps with the central bank are subtracted. Lira depreciation also added to non-financial corporate and bank balance sheet strains.

Amid heightened uncertainty and increased vulnerabilities, GDP growth is expected to be strong this year, but downside risks have increased. Mainly reflecting a large positive carryover from the sharp activity rebound in the second half of 2020, growth should reach about 5¾ percent this year, before returning to a lower trend from 2022 onwards. Inflation is expected to remain high, and reserves to decline further. With high external financing needs, sizeable domestic foreign exchange deposits, and low reserve buffers, the economy remains vulnerable to shocks and to changes in sentiment at home and abroad. Domestic risks include a premature relaxation of monetary and credit policies or other policy missteps that further erode credibility and buffers. External risks include interest rate increases in advanced economies and higher global risk aversion that could expose vulnerabilities. Other risks include vaccination delays and adverse geopolitical developments.

Executive Board Assessment[2]

Executive Directors noted that, as in other countries, the COVID-19 pandemic has taken a severe toll on Turkey. But while the initial collapse in economic activity was similar to other countries, the recovery has been exceptional. Directors commended Turkey for this remarkable recovery, which was driven by rapid money growth and credit provision by state-owned banks, and extensive liquidity support, while public debt has remained contained. Directors noted that these policies helped the strong recovery, but also fueled inflation and external imbalances, and exacerbated pre-pandemic vulnerabilities notably low reserves, large external financing needs, and dollarization. Going forward, Directors underscored the need to adopt policies to reduce vulnerabilities, mitigate scarring, and improve prospects for durable growth, while also responding to pandemic-related needs in the short term. Directors also strongly commended Turkey for hosting many refugees.

Directors underscored the importance of strongly committing to, and delivering, a firm monetary policy stance to bring inflation towards target. They welcomed the shift in that direction and encouraged a further timely and well-calibrated tightening if inflation expectations increase further. Directors also emphasized the importance of strengthening central bank independence, rebuilding high-quality reserves, further simplifying the operational framework, and improving policy communication.

Noting the relatively tight fiscal targets for 2021, Directors generally saw scope for additional targeted and temporary support in 2021 to help vulnerable sections of society and to minimize scarring. The support should be accompanied by a credible consolidation plan to lower debt over time, to be legislated now and enacted when the recovery is entrenched. At the same time, some Directors saw merit in firm fiscal restraint to reduce persistent imbalances and boost policy credibility. Directors encouraged further steps to strengthen debt management, better monitor quasi-fiscal operations and extra budgetary institutions, and enhance fiscal transparency more broadly.

In the financial sector, Directors called for further reining in and refocusing state-owned bank credit growth, as well as carefully monitoring bank foreign exchange liabilities. They encouraged gradually reversing regulatory flexibility and loan deferrals as the pandemic recedes. Most Directors agreed that, once the pandemic fades, a third-party asset quality review would help in better understanding underlying bank health. Additional reforms to strengthen regulatory, resolution, and AML/CFT frameworks would also help financial stability.

Directors called for focused structural reforms to minimize long-term adverse effects of the pandemic. They recommended focusing on female labor force participation and youth employment, increasing labor market flexibility, and ensuring that viable but temporarily insolvent firms are restructured while winding down unviable firms.