The most striking feature of the IMF report, I think, is the new approach to assessing vulnerability. The IMF considers three areas or sources of vulnerability with respect to external shocks: fiscal, exchange rate and monetary. A vulnerability in one area means a “lack of policy space.” In other words, a vulnerable economy has no room to maneuver in a vulnerable market atmosphere. A fiscally vulnerable economy has a large budget deficit and an unsustainable public debt. An exchange rate vulnerability points to an overvalued currency while monetary vulnerability signifies an inflation rate over the target rate.
According to the IMF, Croatia and Slovenia are vulnerable in all the three abovementioned areas. Estonia and Bulgaria are vulnerable in two areas: Estonia in the areas of exchange rate and monetary while Bulgaria in fiscal and monetary. There are three countries -- Hungary, Serbia and Turkey -- considered to be vulnerable in only one area. Hungary and Serbia suffer from high budget deficits while Turkey has to tackle a high inflation rate, which is over 8 percent though the target is 5 percent.
Let's focus on the state of the economy. Turkey had a budget deficit of under 2 percent in the last two years and enough primary surplus (budget balance excluding interest rate payments) allowing further a reduction of the public debt to gross domestic product (GDP) ratio, which in fact remains around 35 percent. This was achieved despite low economic growth, which has fallen to 3 percent on average in 2012-2013. Admittedly, Turkey has “policy space” in terms of fiscal policy. In other words, public expenditures may be boosted to some extent to help economic activity without jeopardizing fiscal balances.
As for the exchange rate, the sizable depreciation of the lira in the last three quarters positively contributed to the external balance. The real exchange rate index has almost returned to its 2003 level, which is considered as competitive enough to encourage exports and discourage imports. Indeed, the index, fixed at 100 for 2003, was about 102 at the end of March. In April, the nominal exchange rate increased to some extent, appreciating the lira in real terms though the real exchange level still remains well below the threshold of 120, which is implicitly considered by the central bank to be the limit of overvaluation. The economy thus has room to maneuver with respect to the exchange rate as well.
Then, the problem remains inflation. The central bank in its recent inflation report increased its year-end inflation rate forecast from 6.6 to 7.6 percent. Once again, the 5 percent target will be missed by a great deal. In this drift, the depreciation of the lira played a key role. “In order to contain the deterioration in inflation expectations and pricing behavior and to maintain macroeconomic and financial stability,” the report said, the central bank greatly increased its various interest rates at the end of January. As the central bank points out, “after the strong monetary tightening of end-January 2014, the risk sentiment improved, some of the Turkish lira depreciation reversed and the implied volatility fell.” That said, the central bank announced that the “tight monetary policy stance will be maintained until there is a significant improvement in the inflation outlook.”
So far so good! However, as the central bank confessed: “private demand has weakened. In fact, the consumption of durable goods and machinery-equipment investments have declined due to financial conditions and domestic uncertainties.” Meanwhile exports have increased and imports have fallen thanks to a competitive real exchange rate and the current account deficit (CAD) has decreased slightly. In the end we will have balanced growth as desired but it will still be low, over 3 percent at best. Low economic growth is the price Turkey has to pay so long as inflation remains over the target and the CAD is dangerously high.
The economy can get out of this trap only if the structural reforms listed in the medium-term economic program (OVP) are realized. As the central bank underlines at the end of its report, these reforms “remains to be of utmost importance.”