DISINFLATION PROGRAM OF TURKEY:
WHAT WE ARE DOING AND WHY
Gazi ERÇEL
Governor
The
Central Bank of Turkey
JANUARY
25, 2000
Merchant Taylor’s Hall, London
Starting
this year, Turkey has embarked on an ambitious three-year program to disinflate
its economy. I call it ambitious because Turkey has suffered from a high and
persistent inflation for the past quarter of a century, and any program that
hopes to correct such a long-standing problem needs to be ambitious. I will
begin by reviewing this new program, especially the monetary side of it.
But first
I will give you some snapshots, from the past, of the Turkish economy, which I
think will give a clear idea why this was the right time to take action.
The history of Turkish inflation shows that for the last
quarter century inflation has been gradually increasing, never falling below
two digits. The average inflation rate for the whole period was 55 percent.
During the last decade inflation has averaged 72 percent.
Reflecting the uncertainties inflicted on the economy by
this chronic inflation, growth has been volatile and at the low end of the
range of comparable emerging market economies. Turkey's average growth rate
over the last two decades was 4.2 percent. Average growth for the emerging
markets of Asia, where inflation is not a problem, has been much higher.
It is well known that the cause of Turkey's inflation is
fiscal in nature. The last year in which Turkey had a budget surplus was 1970.
The budget deficit increased steadily throughout the last decade, finally
reaching double-digits in 1999.
The fiscal imbalances have also caused difficulties in
financing the deficit. Over the last couple of years the amount of external
financing available for the budget deficit has declined, causing increased
pressure on the domestic financial sector and an increase in the domestic debt.
The ratio of cash domestic debt to GNP grew rapidly during the 1990s, finally
reaching 24 percent of GNP in 1999.
The increases in the deficit and in the level of domestic
debt during recent years are mirrored in the levels of domestic interest rates.
The increasing pressure on domestic borrowing has kept real interest rates at
high levels, hovering around the mid-20s during the 1990s and rising to over 50
percent at frequent intervals.
I think this brief recital of facts should be more than
sufficient to explain why it is high time to face the predicament of the
Turkish economy. A radical program is urgently needed to address Turkey's
deep-rooted problems, and it is my wish today to convince you that the program
we have delivered to deal with them is well prepared and comprehensive.
Let me summarise our goals and the overall strategy by which
this program aims to achieve them. The fundamental goals of the program are:
To eliminate inflation,
To achieve a sustainable fiscal position,
To establish a more equitable and efficient distribution of
resources,
And to increase the growth potential of the economy.
The program will accomplish these goals through a number of
policy reorientations. The primary fiscal balance will shift, in the first
year, from deficit to a surplus position consistent with long-term fiscal
sustainability, and will remain high until the price stability has been
established in the economy.
To reinforce program credibility and support the fiscal
stabilisation, the program's design is front loaded, with most of the required
structural measures being taken at the outset.
A first priority will be to diversify the financing of the
deficit. Net external financing for the public sector will increase, and this,
together with the primary surplus and other measures, will make it possible to
lower the level of real domestic interest rates.
A strong and credible exchange rate policy, established at
the beginning of the program, will break the cycle of the public's inflationary
expectations based on past experience. Both monetary policy and public sector
wage policy are being subordinated to the exchange rate target.
Now let me go into some details of this strategy.
Action to eliminate, quickly and permanently, the high
public sector deficit is among the priorities of the program. Specifically, the
primary balance of the public sector is targeted to shift from a deficit of
2.75 percent of GNP in 1999 to a surplus of 2.25 percent of GNP in 2000. This
primary surplus will increase further to 3.7 percent of GNP in 2001, and will
remain around that level in 2002 as well.
Most of the measures needed to achieve an improvement of
over 5 percent in the public sector primary balance in the year 2000 have
already been taken. It will be recalled that these measures included increasing
the rates of the VAT and of the withholding tax on bank deposits and repo
transactions by two percentage points; increasing the rate of withheld taxes on
income from fixed assets and self employment by 5 percentage points; imposing a
windfall tax on interest earned on government securities; and various one-off
measures, including raising the rates of personal income taxes, corporate
taxes, and property and motor vehicle taxes. These revenue measures were
accompanied by spending cuts as well. For example, the social security reform
law passed by the parliament last fall is expected to save 0.5 percent of GNP
in social security expenditures in 2000.
As a result of the improvement in the primary balance, and
the increase in privatization receipts, some of which can be used to retire
public debt, the cash debt-to-GNP ratio is expected to level off at around 24
percent this year and to begin a gradual decline in coming years.
Privatization proceeds are expected to reach US$17.7 billion
over the program period. A number of important measures have been taken to
ensure that this ambitious goal is met. The constitution has been amended to
allow for international arbitration between the Turkish State and foreign
investors. A streamlining of the regulations governing operations in the energy
and telecommunications sectors is expected to attract privatization, and
Parliament is even now considering the necessary enabling legislation, which
will be enacted very soon.
These actions in the fiscal, privatization and structural
reform areas are a part of the front-loading mentioned above, and the
authorities have already taken most of the measures.
Now let me turn to the program's nominal strategies, most of
which are the responsibility of the Central Bank.
In an economy like Turkey's, where inflation has a long
history, expectations and inertia play important roles in the inflationary
dynamics. This represents a major problem for the program, which needs to be
addressed thoroughly.
Since exchange rates have high public visibility, there was
a broad consensus in Turkey that using the exchange rate as a nominal anchor
would be an effective tool for interrupting the public's inflationary
expectations based on the past. In addition, the openness of the Turkish economy
to capital movements makes the commitment to an exchange rate anchor
particularly effective in affecting nominal interest rates. Accordingly, the
exchange rate regime has been designed to provide clear signals as a basis for
price and interest rate expectations, while avoiding the medium-term drawbacks
experienced in the medium term by some of the other countries pursuing exchange
rate based stabilization.
Here is how exchange rate policy will be conducted during
the program period. We are already announcing to the public the daily value of
an exchange rate basket consisting of US$1 and Euro 0.77 for the coming 12
months. The monthly depreciation rate of the basket adds up to a 12-month
depreciation rate of 20 percent, in line with the WPI target for the
period. At the end of each quarter, we will pre-announce a depreciation
rate for the quarter beginning nine months later, and leaving the pre-announced
rates for the intermediate quarters unchanged. This means that at the end of
every three-month period, the rate of increase in the exchange rate basket for
the next 12 months will be publicly known.
The system will function in this manner for the first 18
months of the program. Then, starting in July 2001, a gradually widening
symmetrical band will be introduced for the preannounce exchange basket. From
this point on, the total width of the band will be 7.5 percent by end-2001, 15
percent by end-June 2002, and 22.5 percent by end-December 2002.
It will be noted that while we are making strong commitment to a pre-announced exchange rate path, we are simultaneously announcing our exit strategy, which should allay concerns about the difficulty of making a smooth exit from such systems.
Of course, there are also some risks created by pre-announcing the path of the exchange rate. But the strength of the fiscal policies implemented so far, and the structural reforms undertaken by the political authorities, should substantially reinforce the chances that our exchange rate policy will succeed.
Our exchange rate policy will receive further support from monetary policy. To promote this, we are moving to a more rule-based monetary policy and away from one based on discretion, especially during the first 18 months. During this period, the Central Bank of Turkey will not increase its stock of net domestic assets. All fluctuations in base money will come from balance-of-payments flows. Accordingly, the ceiling on net domestic assets at the end of each quarter is fixed at TL -1200 trillion (excluding the change in the revaluation account, which is part of the net domestic assets definition). In addition, during this period, net domestic assets will fluctuate within a parallel band whose upper and lower limits will be determined as plus-or-minus 5 percent of previous end-of-quarter base money figures.
In recent years, we have been limiting net domestic assets by decreasing credits to the public sector. This policy will be continued in coming years. In addition, we will also stop sterilising the capital inflows and outflows. This policy of no sterilisation will permit rapid, market-determined changes in money market interest rates, and will create an automatic mechanism for determining Turkey's international reserves, and hence base money.
When there is an excess of demand for foreign exchange, the withdrawal of Turkish Lira from the market will not be offset by increasing net domestic assets. This in turn will increase the demand for Turkish Lira, while decreasing the demand for foreign exchange.
Provided there are no major exogenous shocks to the system during the program period, we expect the Central Bank's net international reserves to remain at comfortable levels. The floors established for net international reserves for the four quarters of 2000 are 12 billion, 12.5 billion, 12.5 billion and 13 billion US Dollar respectively. If for any reason net international reserves threaten to fall below these levels, the Central Bank will take measures needed to counter these trends.
The exchange rate band mechanism will provide greater flexibility for net domestic assets after the second half of 2001. And as a result of this greater flexibility, the contribution of monetary policy to the attainment of the inflation target will grow as the influence of monetary policy on interest rates increases.
Finally, I should explain the changes we are making in the reserve requirement system. We are beginning to implement reserve requirements more flexibly in order to make it easier to meet banks' temporary liquidity needs and enable them to manage their liquidity more efficiently in the course of their operations.
A sound banking system is an essential prerequisite for the efficient implementation of monetary policy. This is all the more true under a rule-based monetary policy regime. We announce the rules of the game clearly to the players in the expectation that they will follow them efficiently and fairly. The Banking Law that was enacted by Parliament in the summer of 1999, and the amendments made during the last month, were aimed at giving the banking system the necessary efficiency and soundness.
In conclusion, let me summarise recent history.
We have been working on this program for the past two years. Its technical excellence accurately reflects well the effort that has gone into it. I do not hesitate to say that the program is "comprehensive," "strong," "ambitious," "bold," and "imaginative," and most of all "achievable."
The willingness of the political authorities to execute this program is clear from the way they have taken the necessary but politically difficult economic decisions: quickly, without hesitation or second thoughts.
The IMF and the World Bank have strongly endorsed the program, the former by approving for Turkey a three-year stand-by arrangement, and the latter by extending project credit.
The prospect of membership negotiations with the European Union pursuant to the Helsinki decision provides an additional strong incentive to implement the program forcefully. There is a strong autonomous ownership of the program. The Government, the Parliament, policymakers, and the social partners all understand the great rewards, particularly in terms of reduced interest costs and stable growth, that will follow the program's successful implementation.
The markets' reactions to the program have also been very positive. Interest rate declined from 100 percent last October to the 30s recently.
I expect that these positive attitudes on the part of all participants in the program will continue until Turkey has achieved the long-sought and much desired goal of durable price stability.
Thank you very much.