TURKISH ECONOMY IN 2006

Turkey has undergone a remarkable and multifaceted transformation in all sectors of the economy in the post-crisis period on account of the substantial structural reform having been implemented by decisive policy actions at the backdrop of political stability.

In response to determinant macroeconomic policy implementations throughout the past five years, a robust growth environment has been established with continuously growing real GDP for twenty quarters. Within the mentioned period, real GDP grew by 7.2 percent on average, making the Turkish economy one of the fastest growing economies in the world. GDP and GNP rose by 6.1 and 6.0 percent respectively in 2006 and Turkey’s per capita GNP has risen to 5,477 USD in 2006.

Private sector investment has been driving force of economic growth in 2002-2006 period. Capital accumulation and total factor productivity have been the major contributors of growth in the past five years. As a result, Turkey’s production capacity has been expanded and potential growth of the country has increased.

Annual CPI inflation accelerated and peaked to 11.69 percent in 2006 July due to the impact of various supply shocks beginning from April. Policy measures taken to ensure the convergence of inflation to the target proved to be effective and annual CPI inflation followed a downward trend in the last quarter of 2006. However, end year inflation for 2006 was realized as 9.65 percent, above the targeted level and the uncertainty band set around the target.

Flourishing investments after 2002, increasing imports of capital and intermediate goods as a result of the shift towards capital and technology intensive products in manufacturing industry and soaring in energy prices after 2004 were the factors affected the current account deficit adversly. In 2006, current account deficit was realized as 7.9 percent of GDP and reached to USD 31.7 billion. Main factors behind the rise in current account deficit were deterioration in the foreign trade balance, decline in tourism revenues and high deficit in the income balance due to interest repayments. Net tourism revenues declined by 8 percent and was realised as USD 14.1 billion, since number of foreign visitors decreased by 8.2 percent year on year.

The composition of capital flows continued to increase in favour of non-debt creating financing instruments with an upward trend in foreign direct investment (FDI). The share of FDI increased to 49.4 percent of total capital inflows in 2006, from its level of 25.7 percent in 2005 and reached to USD 20.2 billion. Privatizations, mergers and acquisitions constituted the largest part of FDI. Considerable portion of these inflows focused on banking sector.

In 2006, fiscal discipline remained to be one of the cornerstones of the ongoing economic program and played the main role in maintaining macroeconomic stability by decreasing debt burden. The rate of public sector primary surplus over GDP, which is one of the main indicators of fiscal discipline, was realized as 6.2 percent in 2005 and estimated to reach to 6.6 percent level in 2006.

Due to financial fluctuations in May-June period, annual compound interest rate of discounted Treasury securities increased from 13-14 percent levels up to 21 percent level. Nevertheless, the increase in borrowing rates affected interest payments of 2006 to a limited extend and the interest expenditures were realized below the appropriation.

Due to robust growth of the economy and fiscal performance achieved by the prudent implementation of tight fiscal policy in 2006, the public debt stock, as a percentage to GDP, continued to diminish. The reduction in net public debt stock stemmed from the decline in both TL and FX denominated debt stocks. Net public debt to GDP declined from its peak level of 90.5 percent in 2001 to 44.8 percent in 2006.

The structure of debt stock is as important as the level of debt burden in dealing with the sustainable debt dynamics. Within the strategy of decreasing the interest and FX rate risks, the share of FX denominated/indexed debt stock descended from 58.1 percent in 2002 to 37.2 percent in 2006 and the share of fixed rate TL denominated debt stock doubled.

After the implementation of “Implicit Inflation Targeting” between 2002 and 2005, Central Bank of the Republic of Turkey (CBRT) shifted to “Explicit Inflation Targeting” in 2006. Favorable course in expectations in 2005 continued at the beginning of 2006 and the risk premium decreased with the effect of positive internal and external conjuncture. Monetary Policy Committee diminished the borrowing interest rates from 13.5 to 13.25 in April. However, increased ambiguity in the monetary policies of the developed countries in May-June period, changed the international liquidity conditions against the developing countries. Risk premium increased and in line with the reduction in foreign exchange supply, the depth of the FX market diminished, resulting in high volatility in the FX rates. As other developing countries did, Turkey was also adversely affected from these circumstances. In this context, in order to avoid any turbulence in financial markets, monetary policy was tightened and overnight borrowing interest rate was increased gradually to 17.5 percent. As a consequence of these measures, financial markets converged to equilibrium. Istanbul Stock Exchange (ISE) National-100 index reached to the level of 39.117 at the end of 2006.

Macroeconomic stability as a consequence of Economic Program increased the financial deepening. The decline in public sector borrowing requirement played an important role in diverting bank resources from public sector securities to the loans. Loan to deposit ratio increased from 61.8 percent in 2005 to 68.3 percent in 2006.

Banking sector has improved its ability to cope with risks and to manage its balance sheet. As an indicator of credit risk, the ratio of non-performing loans to total loans decreased from 18.5 percent in 2002 to 3.8 percent in 2006. Banking sector FX net general position, an important indicator of exchange rate risk, improved significantly and was realized as USD 184 million surplus in 2006 from USD 5.4 billion deficit in 2000. An indicator showing the strength of the system, capital adequacy ratio declined to 18.6 percent in mid year after the fluctuation in financial markets, but with the reduction in interest rates in following months and decline in the amount exposed to risk, reached up to 22.4 percent by the end of 2006.

Turkey has undergone a remarkable and multifaceted transformation in all sectors of the economy on account of the substantial structural reforms having been implemented at the backdrop of political stability.

In response to determinant macroeconomic policy implementations throughout the past five years, a robust growth environment has been established with continuously growing real GDP for twenty quarters. Within the mentioned period, real GDP grew by 7.2 percent on average, making the Turkish economy one of the fastest growing economies in the world. GDP and GNP rose by 6.1 and 6.0 percent respectively in 2006 and Turkey’s per capita GNP has risen to 5,477 USD in 2006.

For the first time since 1990, value added in agriculture sector has grown for three consecutive years. Value added in industry rose by 8.1 percent in 2002-2006 period where remarkable increases has been achieved in the export-oriented sectors. In spite of the negative effects of financial market fluctuations that occurred during May and June, industry sector grew by 7.4 percent in 2006. The capacity utilisation rate for 2006 was 81 percent on average, which is 3 percentage points higher than the average of past ten years.

Value added in services sector increased by 6.6 percent in 2002-2006 period. In 2006, services sector grew by 5.6 percent with the contribution of strong performance in the construction sector.

On the demand side of the economy, private sector investment has been driving force of economic growth in 2002-2006 period. Capital accumulation and total factor productivity have been the major contributors of growth in the past five years. As a result, Turkey’s production capacity has been expanded and potential growth of the country has increased. Following the financial market fluctuations that occurred during May and June in 2006, the rise in interest rates limited the growth in investment expenditures for machinery and equipment. On the other hand, investment for construction increased considerably. In 2006, private sector investments grew by 17.4 percent.

In 2006 government investment contributed modestly to the GDP growth and government consumption increased only slightly with respect to the previous year, confirming the government’s prudent fiscal stance.

In 2006, exports grew by 8.5 percent contributing 3.8 points to growth. As the growth rate of imports was less than that of exports, net external demand’s contribution to GDP growth was positive.

In 2006, fiscal discipline remained to be one of the cornerstones of the ongoing economic program and played the main role in maintaining macroeconomic stability by decreasing debt burden.

The rate of public sector primary surplus over GDP, which is one of the main indicators of fiscal discipline, was realized as 6.2 percent in 2005 and estimated to reach to 6.6 percent level in 2006. Significant improvement in public sector borrowing requirement (PSBR) has been attained in recent years, owing to the high levels of primary surplus realizations. The 0.4 percent surplus in total public sector balance attained in 2005 is estimated to reach to 3.1 percent in 2006.

In 2006, with the enforcement of the Law number 5018, central government budget system has been implemented while before 2006 consolidated budget system involving general budget and annex budget was in force. The new regulation enhanced the scope of the general budget and assembled the budgets of public bodies in general budget, private budget and regulatory and supervisory institutions into the central government budget.

Thanks to the high rate of economic growth, increase in revenues and fiscal discipline, primary surplus of central government budget exceeded the targeted level of 32.3 billion YTL and realized around 42 billion YTL. On the other hand, budget deficit remained 10 billion YTL below the targeted level, and realized as 4 billion YTL. Budget deficit declined to its lowest level, while primary surplus reached to its highest level in real terms since 1994.

Due to financial fluctuations in May-June period, annual compound interest rate of discounted Treasury securities increased from 13-14 percent levels up to 21 percent. Nevertheless, the increase in borrowing rates affected interest payments of 2006 to a limited extend and the interest

expenditures were realized below the appropriation. The ratio of interest expenditures to national income declined from 9.4 percent in 2005 to 8 percent in 2006.

Although additional expenditure-cut measures enforced after May contributed to the expenditure discipline, primary expenditures exceeded their initial appropriation by 1 percent. This excess over allowance is caused mainly by the personnel expenditures, health expenditures mainly due to green card application and transfers to Project for Supporting Infrastructure of Villages (KÖY-DES).

On the other hand, remarkable performance in VAT on imports, tax on the transactions of banking and insurance and other revenues were main factors for the budget revenues to realize over the targeted level. Corporate tax rate was reduced from 30 percent to 20 percent by enforcement of Corporate Tax Law in May, comprising the profits of year 2006. With the new regulation, the excess amounts collected in 2006 were deducted from the following payments. This application resulted in a slowdown in corporate tax collection.

Due to robust growth of the economy and fiscal performance achieved by the prudent implementation of tight fiscal policy, the public debt stock, as a percentage to GDP, continued to diminish in 2006. The reduction in net public debt stock stemmed from the decline in both TL and FX denominated debt stocks. Net public debt to GDP declined from its peak level of 90.5 percent in 2001 to 44.8 percent in 2006.

Source: Undersecretariat of Treasury

The structure of debt stock is as important as the level of debt burden in dealing with the sustainable debt dynamics. Within the strategy of decreasing the interest and FX rate risks, the share of FX denominated/indexed debt stock descended from 58.1 percent in 2002 to 37.2 percent in 2006 and the share of fixed rate TL denominated debt stock doubled.

Since the Turkish economy has been improving and becoming much more resilient, the confidence of domestic and foreign investors to TL instruments has been increasing. Consequently, the average nominal and real interest rates of securities diminished sharply while maturities lengthened. However, the average maturity of domestic borrowing decreased in July and August aftermath of the fluctuation in May-June period. Together with the re-stabilization of the markets, maturity of borrowing increased and reached to 27.5 months as of 2006. The descending trend in the interest rate of domestic borrowing was also adversely affected from the fluctuation in financial markets. The annual compound interest rate of discounted Treasury Auctions for government securities increased from 16.3 percent in 2005 to 18.1 percent in 2006.

Exports increased by 16.1 percent and was realised as USD 85.3 billion whereas imports rose by 17.7 percent and amounted to USD 137.4 billion in 2006. Increase in productivity, shift in the composition of exports from labor intensive products to high value added-capital intensive ones, entrance to new markets and high growth rates in EU countries were the main driving forces of high growth performance of exports in the year 2006. On the other hand, the main factors that affected the high demand for imports were the surge in energy prices, high domestic demand and demand for intermediate products due to the structural change in the manufacturing industry directed to the production of high value added goods.

In the previous years, Turkey’s export performance was quite sensitive to global and domestic conjuncture together with developments in the exchange rates. However, high fixed capital formation in the recent years has increased firms’ competitiveness while diminishing sensitivity of exports to cyclical developments in the world economy. As a matter of fact, export performance of high value added goods such as motor vehicles and trailers, electrical machinary and apparatus, boilers, machinery and mechanical appliances has been distinctive. This is mainly due to the shift in exports composition from traditional sectors to technology intensive sectors. In 2006, highest contributions to the growth in total exports came from motor vehicles (3.15 point), iron and steel (1.77 point), boilers, machinery and mechanical appliances (1.72 point), mineral fuels and oils (1.26 point) and electrical machinary and equipment (1.22 point).

Although, EU has sustained its position of being Turkey’s main export market, its share decreased from 55.5 percent to 47.9 percent in 2006. On the other hand, the share of Russian Federation and Middle Eastern countries in total export increased in 2006. Export performance to USA, which has been another important market of Turkey was below the overall exports performance mainly due to the decline in textiles and wearing apparel exports.

In 2006, main import items according to their shares in total imports were energy, boilers, machinery and mechanical appliances, motor vehicles, iron-steel and electrical machinery and apparatus. Growth of intermediate goods imports maintained its high levels, mainly due to high energy prices. Imports of intermediate goods, which is almost 72 percent of total imports, increased by 20.4 percent and reached to USD 98.4 billion.

The composition of imports changed extensively by the effect of financial turbulence occurred during the May-June period in 2006. High demand for capital goods imports which was sustained in 2002-2005 period slowed down in the second half of 2006. In the second half of the year consumption goods import slowed down as well. Decline in consumption goods imports mainly stemmed from the descending trend in automobile imports. On the other hand, imports of durable and semi-durable consumption goods remained their high levels.

Flourishing investments after 2002, increase in imports of capital and intermediate goods as a result of the shift towards capital and technology intensive products in manufacturing industry and the increase in energy prices after 2004 were the factors adversely affected the current account deficit adversely. In 2006, current account deficit was realized as 7.9 percent of GDP and reached to USD 31.7 billion. Main factors behind the rise in current account deficit were deterioration in the foreign trade balance, decline in tourism revenues and high deficit in the income balance due to interest repayments. Net tourism revenues declined by 8 percent and was realized as USD 14.1 billion, since number of foreign visitors decreased by 8.2 percent year on year.

Capital inflows, which were above the current account deficit, increased by 69.2 percent and reached to USD 34.7 billion in 2006. Central Bank reserves increased by USD 6.1 billion and total capital inflows reached to USD 40.8 billion.

The composition of capital flows continued to increase in favour of non-debt creating financing instruments with an upward trend in foreign direct investment (FDI). The share of FDI increased to 49.4 percent of total capital inflows in 2006, from its level of 25.7 percent in 2005 and reached to USD 20.2 billion.

Privatizations, mergers and acquisitions constituted the largest part of FDI. Considerable portion of these inflows focused on banking sector. In 2006, another important part of FDI, net real estate purchases by the foreigners, increased by 58.7 percent. The candidacy of EU, favorable global liquidity conditions and robust macroeconomic environment helped to increase confidence of foreign investors and the level of capital inflows and thus have underpinned both the level and the quality of capital inflows.

Public sector, has been net debt payer since 2003. Maturity structure of external financing of the General Government lengthened considerably in this period. Thanks to the improved maturity structure and favorable outlook in foreign markets, Eurobond issuance by the Treasury reached to USD 5.8 billion whereas total principle repayments amounted to USD 2.5 billion in the year 2006. Meanwhile, IMF and long term credit drawings was realized as USD 5.4 billion and repayments reached to USD 10.7 billion.

Banking sector increased its long term foreign credits by 79.2 percent and stayed in net payer position in short term credits in 2006. Meanwhile, banks’ foreign exchange reserves reached to its peak level with USD 10.3 billion.

In 2006, most of the total capital inflows were realised by non-bank private sector. Non-bank private sector’s borrowing reached to USD 19.7 billion, which amounted to nearly 48.4 percent of total capital inflows. Although most of these funds were directed to trade and investment activities, some portion was used for privatization payments in 2006.

In 2006, non-residents’ purchases of equities and domestic government debt securities sustained their high levels. Non-residents sold a great deal of their equities and domestic debt securities during May-June turbulance and afterwards.

The upward trend in direct foreign capital investments, long-term credit utilization, the downward trend in short-term borrowing and strong reserve position under the flexible exchange rate regime indicate that higher current account deficit will not be a major threat to the sustainable economic environment.

Annual CPI inflation accelerated and peaked to 11.69 percent in 2006 July due to the impact of various supply shocks beginning from April. Policy measures taken to ensure the convergence of inflation to the target proved to be effective and annual CPI inflation followed a downward trend in the last quarter of 2006. However, end year inflation for 2006 was realized as 9.65 percent, above the targeted level and the uncertainty band set around the target.

Depreciation of currency during financial turbulence in May and June and rise in energy prices in June-July period had an adverse effect on inflation. Strengthening currency and falling crude oil prices in the rest of 2006, supported downward trend in inflation in the last quarter.

In the first half of 2006, buoyant domestic demand was another factor that contributed to the rise in inflation. In the second half of the year demand pressure on inflation moderated together with the policy measures.

In 2006, the highest price increase was realized in housing sub-item. Rigidity in actual rent prices was the main determinant of high housing prices. Moreover, rising energy costs in May-July period contributed to price increases in housing sub-item.

Restaurant and hotels, miscellaneous goods and services, food and beverages and transportation prices were other sub-items that rose above the CPI inflation. High level of accommodation prices and rise in catering prices driven by the negative developments in food inflation mainly determined 13.54 percent increase in restaurant and hotel prices.

Rising international gold prices in the first seven months of 2006, led to higher miscellaneous goods and services inflation, but pressures moderated in the rest of the year.

Annual inflation in transportation, housing, house ware and entertainment and culture sub-sectors were negatively influenced from the depreciation in the currency after the financial turbulence in May and June. The strengthening in currency after July led to a correction in referred sub-items.

Annual growth rate in the H denoted core CPI aggregate which excludes unprocessed food, energy, tobacco-alcohol and gold prices, rose in May-October period mainly due to exchange rate pass through effects. After November, annual rate of change in the H denoted core CPI aggregate decelerated together with appreciation of the currency.

The price rigidity in services sector continued in 2006. Housing, transportation along with entertainment and culture sub-sector prices were the main determinants of this rigidity. Rising annual inflation in health and entertainment and culture also had a negative impact on services sector prices. On the other hand, various supply shocks, which the Turkish economy faced in 2006, led to an acceleration of inflation in the goods sector. Therefore, the gap between services sector and goods sector inflation closed in 2006.

In 2006, PPI inflation was realized as 11.58 percent. Higher price in manufacturing sector was the main determinant of the PPI inflation.

Depreciation in New Turkish Lira in May-June period and rising international oil prices led to higher annual inflation in manufacturing sector throughout 2006. In the second half of the year, manufacturing prices were positively influenced by the appreciation of the currency and decline in the oil prices.

Arrangements about electric and natural gas prices by TETAŞ and BOTAŞ respectively, led to an acceleration of annual energy inflation.

After the implementation of “Implicit Inflation Targeting” between 2002 and 2005, Central Bank of the Republic of Turkey (CBRT) shifted to “Explicit Inflation Targeting” in 2006. Favorable course in expectations in 2005 continued at the beginning of 2006 and the risk premium decreased with the effect of positive internal and external conjuncture. Monetary Policy Committee diminished the borrowing interest rates from 13.5 to 13.25 in April. However, increased ambiguity in the monetary policies of the developed countries in May-June period, changed the international liquidity conditions against the developing countries. Risk premium increased and in line with the reduction in foreign exchange supply, the depth of the FX market diminished, resulting in high volatility in the FX rates. As other developing countries did, Turkey was also adversely affected from these circumstances. In this context, in order to avoid any turbulence in financial markets, monetary policy was tightened and overnight borrowing interest rate was increased gradually to 17.5 percent. As a consequence of these measures, financial markets converged to equilibrium.

Increasing lending rates with the fluctuation in May-June period decelerated the credit volume mostly in housing and automotive sectors. The credit volume of deposit banks increased by 41 percent and reached to 170.6 billion YTL. The expansion in credit volume originated from the rise in consumer and commercial credits.

Macroeconomic stability as a consequence of Economic Program increased the financial deepening. The decline in public sector borrowing requirement played an important role in diverting bank resources from public sector securities to the loans. Loan to deposit ratio increased from 61.8 percent in 2005 to 68.3 percent in 2006.

It is essential to monitor closely the credit risk in the period of high credit expansion. Banking sector has improved its ability to cope with risks and to manage its balance sheet. As an indicator of credit risk, the ratio of non-performing loans to total loans decreased from 18.5 percent in 2002 to 3.8 percent in 2006.

Banking sector FX net general position, an important indicator of exchange rate risk, improved significantly and was realized as USD 184 million surplus in 2006 from USD 5.4 billion deficit in 2000. An indicator showing the strength of the system, capital adequacy ratio declined to 18.6 percent in mid year after the fluctuation in financial markets, but with the reduction in interest rates in following months and decline in the amount exposed to risk, reached up to 22.4 percent by the end of 2006. Capital adequacy ratio is fairly above the legal rate of 8 percent.

Istanbul Stock Exchange (ISE) National-100 index reached to the level of 39.117 at the end of 2006. The share of the foreigners in ISE was realized as 65.3 percent in the same period.

Source: Istanbul Stock Exchange

Non-bank domestic residents’ and non-residents’ portfolio preferences increased in favor of foreign exchange in 2006. The share of TL in total portfolio declined from 72.8 percent at the end of 2005 to 69.6 percent at the end of 2006. The share of deposits increased while the share of bonds and bills decreased in portfolio preferences.