Inflation Drops Sharply in Turkey. Goal is 10 Percent Yearly Inflation by 2001.

The inflation rate in Turkey will drop from 91 percent in 1997 to some 50 percent in 1999, the lowest level of the decade, mainly due to the reduction of inflationary expectations, improvement in the fiscal management of public debt and effective exchange rate policies, according to a new analysis by the Central Bank of Turkey.

To a lesser extent, the slowdown in the Turkish economy has contributed to lower inflation. The national output started contracting in the second quarter of 1998, with the growth of gross national product (GNP) falling to 3.8 percent last year. By the first quarter of 1999, the economy was operating well below potential of 4 percent, and Bank analysts expect GNP growth for the year to reach just 0.5 percent.

“We are well on our way to achieving our goal of a 25-percent inflation rate in 2000, and a 10-percent rate by the end of 2001,” says Gazi Erçel, Governor of the Central Bank.

Over the past two decades, Turkey has suffered from chronically high inflation that has hampered economic growth and foreign investment. In 1995, inflation hit 156.8 percent on an annualized basis. Central Bank economists estimate that once inflation falls to a ten percent annual rate or less, the national economy will double its growth rate.

“While considerable progress has been made, a new and more comprehensive effort is now needed to complete the battle to uproot inflation,” Gov. Erçel says.

The recent main factors that are contributing to reducing inflation:

  1. The implementation of a tight fiscal policy, which reduces demand and increases the primary surplus of the budget.
  2. The government raised public sector wages and agricultural support prices in line with targeted or expected inflation rates.
  3. Structural reforms in the tax system increased revenues and was in line with the Government’s tight fiscal policy.
  4. Capital outflow from the private sector, due mainly to the belief that Turkey would be adversely affected by the Russian political and economic crisis, which exploded in August, 1998.
  5. The contraction of world demand, which started with the capital outflow from almost all developing countries, sparked by the 1997 Southeast Asian financial crisis;

“The earthquake will cost the Turkish economy 2 to 3 percent of GNP which calculates into five to seven billion dollars,” says Governor Erçel. “As terrible as the earthquake was in human suffering, it will have a small longterm effect on the huge 200 billion dollar a year Turkish economy.”

Bank analysts say that the latest monthly activity and demand indicators suggest that recessionary forces eased in the second quarter of the year, with indicators of industrial production, exports and imports showing some rebound. Because of this, inflation has shown some incipient increase in the second half of 1999, up from March’s figure of 48 percent at an annualized basis, primarily because of the increase in international oil prices.

“The disinflation process during the rest of this year is unlikely to proceed as rapidly as in 1998,” Gov. Erçel says. “However, guided by the macroeconomic policies that the Bank envisages for the second half of 1999, the consumer price index (CPI) inflation should continue to edge down, while the wholesale price index (WPI) will probably remain unchanged.”

Ending Inflationary Expectations — The Central Bank estimates that about 40 percent of wholesale price inflation derives from expectations about coming price hikes. The variables affecting inflationary expectations are the changes in public sector prices, excess demand in the economy, foreign exchange rates and public expenditures.

“Over the past three years, we have broken the expectation cycle by wringing excess demand out of the economy by cutting public expenditures and stabilizing foreign exchange rates,” Gov. Erçel says.

The Central Bank says that the developments of 1998-99 clearly indicate that the need to reinvigorate the adjustment effort through a comprehensive program of fiscal and structural reform, with the goals of disinflating the economy, lowering real interest rates and sustaining growth.

In the long run, The Government’s structural reform agenda is far-reaching and will have an impact on inflation. Government promises a fast implementation schedule. The steps include:

  • A new Banking law, which has already been passed by Parliament. It establishes an independent bank regulatory and supervision agency, which represents an important step in reforming and strengthening the financial sector;
  • The ceiling on net foreign exchange positions of banks will be lowered to 20 percent of net worth by the end of September 1999; these regulations will be rigorously enforced;
  • Reform of the social security system is a top priority on the government’s agenda. The social security system’s deficit will reach 3 percent of GNP in 1999, mainly because of the high number of relatively young retirees;
  • Attracting foreign productive capital, promoting economic efficiency and raising revenues to contain public debt are essential goals of the government’s privatization program;
  • Important government shifts in agricultural support policies. The aim is to reform the agricultural support system to avoid waste, reduce the fiscal burden, and make the system more equitable.

Foreign Exchange Rates — In 1998, the Central Bank tried to apply a consistent foreign exchange policy that moved with the predicted inflation rate. The Bank was able to take advantage of high reserves of $19.7 billion and low foreign exchange demand in the private sector. Investors put their money in high yielding government debt instruments, versus speculating in foreign exchange. The lower returns on exchange rate speculation resulted from the Central Bank’s decision to change the exchange rate of the Turkish lira only to meet expected future (lower) inflation increases, rather than past, higher increases.

During 1998, the cumulative growth rate of the foreign exchange basket was 58 percent and the growth rate of the wholesale price index (WPI) was 54 percent. In the first half of 1999, the foreign exchange basket increased by 26 percent and the WPI rose by 23 percent.

The interest rate problem

The Treasury auction rates were lowered in the first half of 1998, stemming mainly from the decrease in inflationary expectations. The auction rates then rose in the second half of the year, due mainly to uncertainty concerning the capital outflow after the Russian crisis in August of that year and the depreciation of the Japanese yen against the U.S. dollar; other factors driving the increase were the possibility of devaluation in China and uncertainties in the markets arising from the new tax regulations for the banking sector regarding revenues obtained from securities and forthcoming early election.

In 1999, the real annual returns on Treasury auctioned debt was 40 percent which is still very high but, less than 48 percent last year.

The Central Bank analysis says that external economic fluctuations, the earthquake as well as political instability have exacerbated the problem of high real interest rates over the past 12 months, particularly at the end of 1998.

Turkey’s high interest rates reflect the long-standing weakness of the fiscal and quasi-fiscal accounts and the uncertainty arising from high and volatile inflation and devaluation rates, both of which are related to the structural weakness of the public finances, the Bank says.

“It is essential that we address this weakness in order to disinflate the economy and bring real interest rates down to more desirable levels,” Gov. Erçel says. “A growing consensus of all sides of the government coalition are determined to undertake the difficult choices required to achieve a strong fiscal adjustment and structural reform.”

The new government plans to bolster the disinflation effort by reversing any policy slippages and by placing the adjustment on a stronger and more durable footing, the Bank says.

The Bank estimates that, depending on the distribution of the adjustment across different components of the public sector, the primary surplus of the central government will range between 4-5 percent of GNP.

Starting in late 1998, fiscal policy was progressively relaxed and, without offsetting measures, the primary surplus would decline to 2 percent in 1999.

An increase in the primary surplus is good for Turkey because it shows that the Government’s non-interest expenses are lower than non-interest revenues, an indicator of fiscal discipline.

“All the departments of the government are working together and finally we are seeing some real improvement on the inflation front”, says governor Erçel. “We are hearten by our progress. It is a great start. I’m optimistic.”

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