IMF Concludes 2022 Article IV Consultation with Turkey, 2023

Washington, DC: On January 18, 2023, the Executive Board of the International Monetary Fund concluded the 2022 Article IV Consultation with the Republic of Türkiye. [1] This press release summarizes the views of the Executive Board as expressed during its January 18, 2023 consideration of the 2022 Article IV and the 2022 Financial System Stability Assessment staff reports.

Türkiye made impressive economic gains over the past two decades. In the early 2000s, broad-based macroeconomic and structural reforms supported income catch-up towards advanced economies, poverty reduction, and marked disinflation. This moved Türkiye firmly into the upper middle-income bracket, while lifting nearly 30 percent of the population out of poverty. In recent years, however, as reforms waned, productivity gains slowed, and growth became increasingly dependent on externally-funded credit and demand stimulus. The newly-adopted Türkiye Economic Model-comprising low interest rates as well as a complex set of regulatory measures to direct credit to selected sectors and promote greater use of the lira in the economy-has exacerbated vulnerabilities.

Driven by the lagged effects of an outsized credit impulse in 2020, the relaxation of mobility restrictions, and robust external demand, Türkiye's output rebounded by more than 11 percent in 2021-a much stronger recovery from the pandemic than in most countries-and robust growth carried over into the first half of 2022. GDP is now significantly above its pre-pandemic trend and the rates of unemployment and labor force participation have more than fully recovered.

Despite strong growth and inflation four times above target, policy rates were cut aggressively in late 2021, leading to significant pressure on the lira, which was relieved only through large foreign exchange intervention and the introduction of an FX-protected deposit scheme.These moves were followed by an increasingly distortionary and complex set of macrofinancial measures to encourage the holding of lira assets. Inflation has accelerated sharply, reaching a 24-year high of 85 percent in October, among the highest in large EMs. External imbalances have widened, aggravated by the war in Ukraine, and reserve buffers remain low, despite increasing somewhat in recent months.Public debt declined to under 40 percent of GDP, but spending pressures and fiscal risks, including from contingent liabilities from Turkish Lira FX-protected deposits and exposure of public debt to FX shocks, are rising. Financial risks are also high and rising owing, among other things, to a strong FX liquidity nexus between the central bank and the banks, while the recent credit slowdown is driven by increasingly distortionary measures. Non-financial corporations showed resilience through the pandemic, but leverage and FX mismatches remain large.

Reflecting lower growth carryover, weaker external demand, especially in Europe, binding external financing constraints, and squeezed real incomes, growth is expected to decline to 3 percent in 2023 from about 5.5 percent this year. Inflation is expected to fall to about 70 percent by end-2022, and to fall further, to 36 percent, by end-2023-driven by fading exchange rate passthrough, favorable base effects, and expected lower commodity price pressures. But inflation is expected to remain much higher than the target and than in peer countries, given loose policies, inflation inertia, and un-anchored inflation expectations. Near-term growth may surprise on the upside, as unexpected sources of external financing could allow the continuation of pro-growth policies and a wider current account deficit, but, overall, risks are skewed to the downside and, with limited buffers, vulnerabilities remain acute.On the domestic front, doubling down on pro-growth policies without enough external financing could weigh on confidence and fuel pressures on the lira, hurting bank and corporate balance sheets, with spillovers to the public sector. Meanwhile, external risks have also intensified, including from larger- or faster-than-expected tightening by advanced market central banks, escalating geopolitical tensions, higher commodity prices, higher global risk aversion, and weaker global growth.

Türkiye's FSSA found that financial stability risks are high and growing. In particular, FX liquidity risks have risen given the tightening bank-central bank nexus and scarce readily available central bank FX reserves. Also, banks could face capital adequacy pressure should rapid credit growth resume, and uncertainty over banks' asset quality and capital adequacy remains. The authorities' idiosyncratic macrofinancial policy mix has introduced distortions in financial price formation, with some measures working at cross purposes or diverging from international standards. Operational autonomy has been eroded in key agencies, while policy and resource pressures have resulted in banking supervisory practices and a regulatory framework that require critical enhancement. Several gaps in the crisis management framework identified in the last FSAP remain.

Executive Board Assessment [2]

Executive Directors agreed with the thrust of the staff appraisal. They commended Türkiye for its remarkable recovery from the pandemic, noting the contribution of stimulative policies and a dynamic private sector. However, the policies that buoyed growth also exacerbated vulnerabilities. Directors noted that the policy rate cuts in late 2021 led to significant pressure on the lira, and measures to relieve those pressures, while helping, did not address the root causes of Türkiye's economic problems, with the lira remaining under pressure for much of 2022, inflation reaching multi-year highs, and core reserves remaining deeply negative. The spillovers from Russia's invasion of Ukraine also exacerbated Türkiye's external imbalances and added to inflation pressures.

With high inflation at risk of becoming entrenched, Directors stressed that prompt and sizable interest rate hikes are needed, complemented with steps to strengthen central bank independence. They also emphasized the importance of carefully phasing out regulatory measures, allowing the policy interest rate to act as the primary monetary policy instrument. Directors welcomed the authorities' aim to replenish international reserves as conditions allow.

Directors acknowledged that Türkiye's public debt burden remains low and commended the authorities' commitment to fiscal discipline. Nonetheless, Directors cautioned against rising fiscal risks from growing spending pressures and contingent liabilities, including from FX-protected schemes. They recommended maintaining a tight fiscal stance to preserve buffers and contain domestic demand, while focusing on targeted measures to support the most vulnerable. Directors welcomed the authorities' progress in enhancing fiscal governance but encouraged further steps to increase transparency and strengthen debt management more durably.

In the financial sector, Directors underscored the importance of phasing out regulatory measures to minimize distortions to price formation and capital allocation, while reducing the role of the state in credit provision. They shared the emphasis on strengthening prudential standards and encouraged reversing regulatory forbearance measures to improve asset quality and capital adequacy transparency. Directors recommended integrating crypto assets into the supervisory framework, while taking any further required steps to fully implement the FATF action plans. Directors also broadly supported recommendations in the FSSA, in particular, the importance of increasing attention to FX liquidity monitoring and contingency planning. They underscored the need to strengthen banking supervision, including by adequately resourcing supervision activities. Directors also encouraged reforming the emergency liquidity assistance framework and strengthening the crisis management framework.

Directors called for targeted structural reforms to foster stronger sustainable growth and increase the economy's resilience to shocks. They welcomed the focus of the consultation on female labor force participation and climate change. Improving the business and regulatory environment, labor market flexibility, and the quality of human capital will be important, as well as closing labor market gender gaps. A comprehensive strategy would help meet Türkiye's climate goals.

Background: IMF Executive Board Concluded the 2022 Article IV Consultation with Türkiye on January 18, 2023.