COMMENT: Turkey needs to target grey economy

By bne IntelliNews March 23, 2010

Professor Fatih Özatay of the University of Economy and Technology -

Given that Turkey was one of the countries severely affected by the global economic crisis, why did the government's policy response - at least up to the second half of 2009 - remain so limited? And how should the government address the current problems?

The crisis hit Turkey through four channels. First, having enjoyed large amounts of capital inflows in the 2004-2008 period, the banking and corporate sectors became a net debt payer to the rest of the world. Second, the decline in foreign demand caused a sharp contraction in exports. Third, the banking sector cut its credit lines to the corporate sector and households. Fourth, business confidence declined considerably. In this environment, the rate of unemployment increased by 3 percentage points and output declined by 5.5%.

Despite the fact that recessionary forces had been at play since the last quarter of 2008 and extraordinary measures were taken elsewhere in the world, economic policymakers in Turkey waited for a considerable time before taking fiscal stimulus measures. Plausibly, the absence of sharp interest and exchange rate movements and fire sale of reserves as in the "old" crises created the illusion that this wasn't a crisis.

But the delay was not the only problem; the magnitude of fiscal stimulus measures ended up being low as well. According to International Monetary Fund (IMF) estimates, among G20 countries Turkey provided the lowest fiscal stimulus, closely followed by Brazil and India. Why? Several possibilities come to mind. First, the negative impact of crisis on Turkey was not properly judged, not ex-ante but even as late as the beginning of March 2009. This is evident both from the speeches of top officials and the 2009 budget that assumed GDP growth of 4%. Second, reasonably, the low tax base problem might have restricted the fiscal room for manoeuvre for policymakers. Third, the authorities' reluctance for countercyclical polices can partially be linked to the "fear of punishment" by the markets.

Short-term outlook for the Turkish economy

The likely path that the Turkish economy is going to follow in the short term depends mostly on two external factors.

Despite the fact that Turkey's national savings rate is comparable to that of Central and Eastern Europe, it is much lower than that of the Asian and Middle East economies. This shortcoming has led to a need for foreign savings in high-growth periods. Hence, the first factor that is going to shape the short-term outlook is the magnitude of capital inflows. Given the developments in the global financial markets, one shouldn't be too optimistic over the contribution of this factor to a sound recovery. Export performance will be another important determinant, and the developments over the last four months are encouraging. However, the risk is still on the downside: almost half of Turkish exports are to EU countries, which are having problems getting back to robust growth.

Turning to domestic factors, one should note the recent positive developments in domestic credit. After a significant contraction during the last quarter of 2008 and the first quarter of 2009, the volume of banking sector credit started to increase from mid-2009. On the other hand, various measures indicate a rise in business and consumer confidence, though a clear trend is still not visible.

These factors, together with the low base effect, indicate that the Turkish economy could grow around its potential growth rate of 4.5% in 2010. However, closer examination shows that things are not so certain. Various estimates show that the unemployment rate only starts to decline above a threshold growth rate of 4.3%; that is to say, in the baseline scenario the unemployment rate is going to remain at a high level. And there is another important source of risk that could blur this picture further: political risk has been rising in recent months. Given that a general election is going to take place in 2011 - or maybe even 2010 - and followed by the presidential election in 2012, tensions could further rise, which might undermine confidence.

This evidently gloomy picture could change into a more promising one. How? First, Turkey has to minimize the risk of "business as usual before the elections." This necessitates creating confidence about the government's commitment to maintaining fiscal discipline. The current buzzword is the drawing up of a medium-term "fiscal rule," but whatever the appropriate term is, any credible commitment will serve just as well.

Second, a medium-term reform programme should be announced. Given the increasing polarization of society, this should not be an ambitious agenda, but a focused one trying to address the main problem of Turkey: the tax base in Turkey has been too narrow, an obvious reflection of a relatively large grey economy, which has two important consequences. First, Turkey is one of the OECD countries that have very low tax revenues relative to its GDP. Second, the composition of tax revenues has shifted significantly toward indirect taxation in the last decade. Addressing this problem will decrease the dependence of Turkish growth performance on capital inflows.

Hence, the reform programme should aim at attacking the grey economy. Doing so would also create necessary fiscal room for future rainy days and render the "fiscal rule" more credible.

Fatih Özatay is professor of economics at the University of Economy and Technology in Ankara, and a former deputy governor of the Turkish central bank

COMMENT: Turkey needs to target grey economy

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