Durmuş Yilmaz: Economic outlook for Turkey
Speech by Mr Durmuş Yilmaz, Governor of the Central Bank of the Republic of Turkey, at a meeting
organised by the Chamber of Commerce and Industry of Malatya and Dünya daily newspaper,
Malatya, 7 September 2006.
* * *
Distinguished industrialists, businessmen, guests and members of the press,
I am very pleased to be in Malatya for this meeting arranged to bring together the Central Bank and
the real sector and to create common ground for exchanging views. I would like to extend my most
sincere thanks to the Chamber of Commerce and Industry of Malatya and to Dünya daily newspaper
for the excellent organization of this meeting.
In today's meeting, I would like to focus on the importance of Central Bank independence and price
stability within the framework of our Bank's monetary and exchange rate policies. Following this I will
talk about the inflation targeting regime and developments in inflation as well as those in floating
exchange rate regime and financial markets and lastly, I will touch upon some of the issues at the top
of the agenda, such as growth, employment and the current account deficit.
The amendment made in the Central Bank Law in 2001 was a turning point for monetary policy
implementations in Turkey because as per this amendment, the Central Bank of Turkey acquired
instrumental independence and the Bank's primary objective was set as achieving and maintaining
price stability. Inflation has been declining since 2001, and historic lows that had not been observed in
the last 30 years were made possible in this process. Independence enables the Central Bank to
shape its policies free from political pressure and daily disputes, and with a medium-term perspective
focusing directly on the targets. The point reached in the fight against inflation and the achievements
so far confirm the importance of an "independent structure" with respect to both the legal framework
and the implementation. Therefore, not merely political circles but all sections of the public are
expected to take this into account - not only as an element of discourse but in their actions as a whole.
It should be borne in mind that controversy over this concept leads to the questioning of economic
policies and the credibility of targets, as these discussions eventually focus on monetary policy. It is
obvious that these controversies may be very costly.
There is no doubt that the Central Bank will show no hesitation to continue utilizing instrumental
independence in order to achieve targets and will be ready to take any risks and provide the
necessary warnings.
It suffices to take a look at the past five years to see why fighting inflation is so important. The high
and chronic inflation led to considerable economic and social losses in Turkey in the last 30 years.
High and chronic inflation culminated in the adoption of short-term approaches, by adversely affecting
expectations, investment and production decisions and deteriorating resource allocation in the
economy, which brought along low and volatile rates of growth and employment and aggravated
injustice in income and wealth distribution.
We have experienced all the damage of inflation in Turkey, so we expect all sections of the public to
support our fight against inflation and defend the achievements we have made so far. It should be
borne in mind that striving for price stability means striving for creating an environment where people
can make a living, make investments and can look to the future with confidence. With this respect,
price stability is a goal that cannot be sacrificed for any other priority or target.
Thanks to the policies implemented by our Bank, great progress was made in the disinflation process:
inflation, which was 73.2 percent at the beginning of 2002, was recorded as 10.26 percent in August
2006.
Within the framework of the fight against inflation, the Central Bank of Turkey adopted the formal
inflation-targeting regime as the monetary policy strategy at the beginning of 2006.
Now, I would like to mention a few points that I believe are important with respect to the adoption of
the inflation targeting regime.
Studies on the inflation targeting regime as a monetary policy strategy were initiated at our Bank in
2000. As of 2002, the "implicit inflation targeting regime" was adopted as a strategy of convergence
with the formal inflation targeting regime and gradually the components of this regime were adopted.
In line with these efforts, some changes were made in our Bank's organization and some new
departments have been established, our set of data has been expanded and the decision-making
processes have been further institutionalized.
By 2005, the monetary policy strategy implemented under the name of the implicit inflation targeting
regime had become a regime covering most of the elements of formal inflation targeting and significant
achievements had been made in the pre-conditions necessary for a successful transition to the formal
inflation targeting regime. In 2006, encouraged by our achievements, the "formal inflation targeting
regime" was adopted on time. The new regime necessitated a more institutionalized structure and a
higher degree of transparency compared to the previous one.
In order to have a more comprehensive understanding of the course of inflation and the policy
decisions of the Central Bank it is essential to have a good grasp of the framework that we have drawn
for the inflation targeting regime. Therefore, I would like to take this opportunity to highlight some
important elements of the formal inflation targeting regime once more in this meeting today.
Under this regime, the Central Bank adopts a medium-term perspective. Accordingly, inflation targets
are announced for a period of three years. The targets pertain to consumer inflation and these "point
targets" are set jointly with the government.
However, with the aim of setting a rule for the Bank's accountability principle in case inflation deviates
from the target or in case a possibility that inflation might deviate from the targets emerges, an
uncertainty band has been set as 2 percentage points in both directions.
In case inflation figures go outside the band or there is a possibility of inflation going outside the band,
the mechanism pertaining to the accountability principle of the Central Bank would be activated and
our Bank would explain the reasons of deviation from the target and provide information on the time
needed for converging to the target again in an Open Letter to the Government. Such an Open Letter
was written and sent to the Government on July 14, 2006 and was also publicized.
A lot of ground has been covered in the fight against inflation since 2002. However, price stability is
yet to be established. It should be borne in mind that this is a long and tough journey. The
developments we have observed in the last few months verify this view and make our efforts even
more important.
Within this framework, in this part of my speech, I would like to talk about the developments in inflation
and the monetary policy responses in the face of these developments since the beginning of 2006 and
touch upon the future inflation outlook.
I am sure you have been following very closely the upward trend in inflation observed since the turn of
the year. Annual inflation became 10.12 percent in June 2006, exceeding the upper limit of the
uncertainty band of the inflation path consistent with the end-year inflation target and this upward trend
continued in July with 11.69 percent.
The factors that played a primary role in the upward move in inflation in the first seven months of the
year were seasonal factors and external developments.
Prices of unprocessed food products started to increase due to adverse weather conditions by the last
few months of 2005 and inflation in this group reached 21.8 percent by July 2006.
Another factor that had an unfavorable impact on inflation was the rise in crude oil and energy prices.
Parallel to the rise in crude oil prices that started in international markets in March, energy prices
started to climb as of the first quarter also in Turkey and continued due to the rise in exchange rates
as of May. The contribution of these increases to July inflation was 0.30 percentage points.
Owing to the fluctuations in international markets and depreciation of the Turkish lira in the May-June
period, prices of gold increased by 72.6 percent annually as of July and had a negative impact on
consumer prices in the first seven months of year.
Meanwhile, depreciation of the Turkish lira due to excessive volatility observed in international markets
in May and June, led to hikes in the prices of petroleum products, consumer durables and the prices of
goods that are set in terms of foreign currencies and prices of imported goods. One of the sub-groups
that are most severely affected by this situation is the transportation group. Petroleum products prices,
which are registered under the transportation group, increased by 5.9 percent and 3.3 percent in June
and July, respectively. Meanwhile, automobile prices registered under the same group increased by
10 percent in April-June 2006. Prices of processed food products, which displayed a limited rise in the
first six months of the year, displayed a higher rate of increase in July due to the lagged effects of the
fluctuations in exchange rates. The contribution of the depreciation of Turkish lira to consumer inflation
in the May-June period reached 1.5 percentage points.
When we analyze inflation under two groups as goods and services, it is observed that inflation in the
services group has decreased throughout 2006 compared to the same period last year, however
especially due to the high rates of increase in house rents and restaurant-hotel prices, annual inflation
in the services group became 11.7 percent annually as of July and maintained its high level. The
20.5percent rise in house rents is remarkable in this group. Meanwhile, compared to the same period last
year, the upward trend in the goods group accelerated due to the rise in unprocessed food products,
international oil prices and the rise in exchange rates. Hence, the annual increase in the prices of
goods reached 12.1 percent annually as of July 2006, surpassing that of services.
Price increases have been observed in all of the special CPI aggregates due to the impact of
exchange rates developments on tradable goods. Within this framework, the annual rate of increase of
the special CPI aggregate (D*) excluding energy, unprocessed food products, alcoholic beverages,
tobacco products and gold, which is calculated in order to measure the general inflation trend, became
7.19 percent in July.
Inflation followed a track consistent with our projections and decreased by 0.44 percent in July, thus
becoming 5.30 percent in cumulative terms in the first eight months and 10.26 percent in annual
terms. The 1.21-percent monthly fall in food and non-alcoholic beverages prices and the 6.92-percent
monthly fall in clothing and footwear prices as well as the disintegration of the base effect in the prices
of alcoholic drinks and tobacco products were important factors in this decline. Especially the
4.43percent monthly decrease in the prices of unprocessed food products became the primary factor in the
decline in the food and non-alcoholic drinks group prices.
When prices of goods and services in August are analyzed separately, it is observed that annual
inflation in these groups are 10.08 and 11.40 respectively, both below those of the previous month.
However, it is observed that the decline in the prices of goods is faster and thus, the services group
inflation is once again higher than the goods group inflation.
Moreover, the annual rate of increase in most of the special CPI aggregates declined in August and
that verifies our projection that the effect of exchange rate developments on inflation would decrease
in August. However, though less intense, the negative lagged effects of the depreciation of the New
Turkish lira on the special CPI aggregate excluding energy, unprocessed food products, alcoholic
beverages, tobacco products and gold persisted and the annual increase in this CPI aggregate
reached 7.8 percent by August 2006.
This improvement in August inflation is very important with respect to attaining single-digits by the end
of the year.
The upward movement in inflation in the first seven months of the year and the high rates of increase
in inflation exceeding expectations especially in April and May, coupled with excessive fluctuations in
international markets and perceptions of uncertainty fuelled by domestic and international
developments have been deteriorating medium and long-term inflation expectations until recently.
Within this framework, inflation expectations over the next 12 months, increased to 8.07 percent in
July from 5.47 percent in April 2006 and expectations over the next 24 months increased to 6.07
percent in July from 4.67 percent in April, that signifies an edging away from inflation expectations.
In response to these developments, with the aim of halting this deterioration both in inflation and
inflation expectations and of attaining medium-term targets, the Central Bank of Turkey has effectively
used the short-term interest rates that are the main policy instruments of the Bank and has exercised
strong monetary tightening, by raising policy rates by 425 basis points to 17.5 percent.
After this strong monetary tightening, the fluctuations in financial markets started to settle and the
medium and long-term inflation expectations started to improve. Thus, in August, inflation expectations
over the next 12 and 24 months declined to 7.94 and 6.02 respectively.
It should be borne in mind that the impact of interest rate decisions on economic activities and inflation
can be observed only with a time lag. It is advisable to take this fact into account while making the
analysis and evaluations.
As for the future inflation outlook, we foresee that the negative effect of the depreciation of the New
Turkish lira on inflation will gradually diminish as was the case in August.
Although we have achieved rapid recovery and relative stability, the environment created by the
fluctuations observed in financial markets in the May-July period are expected to weaken domestic
demand in the second half of the year. Meanwhile, analyzing recent data such as those pertaining to
investor confidence and to the expectations for domestic sales and orders for the next quarter, it is
foreseen that the decline in domestic demand will not be a very sharp one. In other words, the impact
of the fluctuations observed in financial markets in May and June on the consumption tendency is
likely to be of a temporary nature. Therefore, the said impact is expected to lead only to a limited
decline in total demand. Furthermore, it is estimated that the relative depreciation of the New Turkish
lira will boost net foreign demand.
Despite the likely positive impact of the demand conditions observed in the second half of the year on
inflation, it does not seem possible to attain the 5-percent inflation target set for end-2006. However,
as a result of the measures taken by the Central Bank from June onwards, we expect the secondary
effects of the developments in exchange rates and commodity prices on inflation to remain limited, the
likely pressure on 2007 inflation to diminish along with the recovery observed and the downward trend
in inflation to continue.
Parallel to the recovery - albeit limited - observed in inflation expectations in August and the relatively
more favorable course of international liquidity conditions observed recently, the Monetary Policy
Committee stated at its last meeting that the medium-term inflation outlook was much better compared
to previous months and decided to keep short-term interest rates unchanged. However, as the risks
against the disinflation process still persist, the cautious stance of monetary policy will be maintained.
In this framework, if any development that would deteriorate inflation in the medium term arises, the
Central Bank will not hesitate to resort to further monetary tightening.
As I have mentioned earlier, some risks that endanger the continuation of the downward trend of
inflation in the medium term do exist.
The first risk is the continuation of the increases in crude oil prices.
Other main risk factors include the rapid changes in global risk perceptions resulting from the
monetary policies of developed countries and the fluctuations that might occur in financial markets
accordingly. In case such a risk materializes, the Central Bank will act with a medium-term
perspective, as it does today: It will not respond to temporary increases in inflation; however, it will
closely monitor medium-term inflation expectations.
Another risk factor is that by returning to old habits, variables other than the inflation target are taken
as a reference in pricing behaviors. This represents the risk of deterioration in pricing behaviors. In
order to prevent such a risk from materializing, the Central Bank will maintain its cautious stance until
medium-term inflation expectations converge to the targets.
One of the risk factors, which are important in the disinflation process and are closely monitored, is the
price rigidity in the services sector. These sectors require implementations that will increase supply
and competition.
Additionally, the Central Bank carefully monitors the political risks that have come to the forefront more
and more in the recent period. In this scope, in case it is foreseen that political developments in the
country will have a negative effect on inflation, the Central Bank shall take the necessary measures.
It is very important in the fight against inflation and for the attainment of medium-term inflation targets
that tight fiscal policy is carried out decisively. It is observed that the primary surplus targets were, to a
great extent, achieved, in the last four years. In the first six months of 2006, budget surplus was
provided for the first time since 1984 and 78.4 percent of the primary surplus target that was set for
2006 was reached.
It is seen that the resolute attitude towards the continuation of fiscal discipline is still maintained today.
In this framework, in the scope of the disinflation process, it is very important for the Central Bank that
the policies regarding public revenues and pricing are established consistently with the inflation targets
and that any need for any unplanned public price adjustments is precluded by respecting the limits of
budgetary expenditures.
In order for inflation to converge to medium-term targets, it is of critical importance that the structural
reform process is maintained in a resolute manner and without any compromise. These reforms would
enhance the quality of fiscal discipline, improve competition and the investment environment, which, in
the long run, would support an increase in productivity, and would therefore contribute to the
disinflation process.
Now, I would like to underline a point. In our country, expectations may change and go to extremes
very rapidly. Therefore, any kind of implementation, initiative and disclosure that might lead to
deterioration in risk perceptions and expectations affect the disinflation process and macroeconomic
stability in a rapid, harsh and negative way. In this respect, relations with the IMF and the EU are two
important anchors, especially as to medium and long-term expectations. These two factors should
remain as anchors in the upcoming periods, as they bear significance for the enhancement of
confidence in our country, the uninterrupted implementation of structural reforms as planned and the
predictability of our economy in the medium and long-term.
The Central Bank analyzes all kinds of risks in its scenarios designed to foresee inflation and makes
its forecasts accordingly. As I have mentioned earlier, on condition that the cautious stance of
monetary policy, fiscal discipline and structural reforms continue, the targets set for 2007 and 2008
seem to be attainable. The target we set for 2007 and 2008 is 4 percent and all our policies are
directed towards attaining these targets. It is of critical importance that economic agents use these
targets as a reference while drawing up their future plans.
The floating exchange rate regime that is implemented today is the sine qua non of the
inflationtargeting regime.
The basic principle of formal inflation targeting is to target only inflation itself and to make no
commitments other than the inflation targets. Therefore, the Central Bank cannot make any
commitments related to the level of exchange rates in an implicit or explicit manner, nor use the
exchange rate as a policy instrument. It is out of the question and is impossible.
Under these circumstances, the value of the Turkish lira is determined in the short term by short-term
expectations, developments related to foreign exchange supply and demand and the behaviors of
market players, while the said value is determined in the medium and long-term by economic
fundamentals, the course of structural reforms and the medium and long-term expectations.
However, the fact that exchange rates are determined under market conditions does not imply that the
Central Bank will not conduct any transactions in the foreign exchange markets.
The Central Bank basically conducts transactions with two different aims. The first of these
transactions comprises foreign exchange purchase auctions that are held with the aim of building up
reserves. These transactions are conducted via daily, transparent and exchange rate-dependent
mechanisms in the periods where the foreign exchange supply increases in the market and with no
intention of affecting the level of exchange rates. As a result of these transactions, Turkey's foreign
exchange reserves increased by 181 percent in the last four years and reached USD 57 billion as of
25 August 2006.
Nevertheless, due to the decline in foreign exchange supply, foreign exchange purchase auctions
were suspended on 16 May 2006. Foreign exchange purchase auctions would be resumed in line with
our strategy to increase reserves moderately when favorable conditions occurred in the foreign
exchange market.
The second transaction that is conducted by the Central Bank in foreign exchange markets comprises
foreign exchange interventions. They are made in order to prevent any excessive volatility that might
occur in exchange rates and depending on the reasons for this volatility and potential developments.
In this framework, the Central Bank may intervene directly to curb excessive volatility in either direction
and use announcements and warnings.
Let me elaborate on a point related to the excessive volatility interventions. As opposed to the
auctions held in the framework of our strategy to build up reserves, these interventions do not have a
mechanical nature. Each situation is analyzed according to its conditions and the decision for an
intervention is made accordingly. Therefore, such interventions do not have a symmetrical nature.
In this framework, in order to prevent excessive volatility, the Central Bank intervened directly in the
foreign exchange markets 21 times (15 purchase auctions and 6 sale auctions) under the floating
exchange rate regime.
In the framework of both strategies, the Central Bank has made a net purchase of foreign exchange
amounting to USD 43.7 billion from the foreign exchange market since 2002.
In the framework of the exchange rate policy that I have mentioned earlier in detail, developments in
the foreign exchange market are monitored carefully by the Central Bank as they have a direct impact
on inflation and constitute an important part of financial stability. In this scope, I would like to briefly
analyze the fluctuations in financial markets.
In the period between the beginning of May - when fluctuations started - and the end of June, the
Turkish lira depreciated by approximately 29 percent.
What triggered the rapid depreciation of the Turkish lira was the change in international liquidity
conditions against developing countries. Global risk perceptions changed along with expectations that
the central banks of developed countries would tend to increase interest rates, and global liquidity
abandoned developing countries and shifted to developed countries. Along with all developing
countries, Turkey was significantly affected by the changes in international liquidity conditions, as well.
The impact observed in Turkey was stronger compared to other countries because the domestic risk
perceptions about inflation, current account deficit and political issues increased in this period.
As a result of these impacts, capital outflow took place over a two-month period. At this point, it should
be underlined that a major part of the said outflow was met by the foreign exchange sales of residents.
The process of structural change in the Turkish economy, in other words, the background of the steps
taken to strengthen macroeconomic fundamentals and to normalize the economy took only five years.
A 5-year period is very short for the structural achievements made in a country with a 30-year
inflationary past to repair the fragility in expectations in a permanent way.
Therefore, in a period where financial fluctuations were observed in all developing countries, the
shortterm market fluctuations originating from foreigners' exits were perceived to be much more negative in
Turkey, although there was not a permanent deterioration in macroeconomic fundamentals.
As seen in the table in the slide, there have been eight fluctuations since the year 2001 when the
floating exchange rate regime was put into practice, and exchange rates have even surpassed the top
value that was recorded in the recent fluctuation. However, to the extent that the program was
implemented decisively and policies were conducted without any interruption, there had always been a
return to the main trend where the Turkish lira appreciated. It should be kept in mind that this process
is also the process for the Turkish lira to gain credibility. As long as macroeconomic fundamentals are
strengthened and structural reforms are achieved, this process is likely to continue.
Table. Rapid changes in exchange rates*
Standard
deviation
Duration Value at the
Beginning Date Ending Date Top value % Change
(days) beginning
(Daily
change%)
15.04.2002 30.07.2002 106 1.2928 1.6966 31.2 1.11
03.12.2002 09.01.2003 37 1.5200 1.6825 10.7 1.00
03.03.2003 25.03.2003 22 1.5962 1.7548 9.9 1.53
24.09.2003 10.11.2003 47 1.3545 1.5048 11.1 0.80
05.04.2004 24.05.2004 49 1.3076 1.5582 19.2 1.18
20.07.2004 21.09.2004 63 1.4293 1.5388 7.7 0.74
08.03.2005 30.03.2005 22 1.2601 1.3905 10.3 1.14
04.05.2006 26.06.2006 53 1.3167 1.7016 29.2 1.61
* CBRT indicative USD selling rate
In this period of fluctuations, in order to ensure the continuation of the downward trend of inflation, the
Central Bank used policy interest rates effectively on the one hand, and took the necessary market
measures with a view to stopping the fluctuations in the market on the other.
First of all, in order to prevent declining foreign exchange liquidity from increasing volatility in the level
of the exchange rate, the Central Bank suspended foreign exchange purchase auctions and
intervened directly in the market by selling foreign exchange where deemed necessary.
The Central Bank followed an effective liquidity management strategy and started to hold New Turkish
lira deposit purchase auctions with the aim of withdrawing the TL-denominated excess liquidity
gradually. At this point, the excess liquidity has been brought down to such an extent that it does not
require daily auctions.
As a result of these measures, the fluctuation in the markets was restrained. From end-June onwards,
the Turkish lira appreciated by 16.7 percent while the indicative GS (government securities) interest
rates and the average interest rate that is formed in CBRT deposit purchase auctions dropped by 3
points and 3.1 points, respectively. The volatility in both exchange rates and interest rates decreased
significantly.
In this regard, I should say that frankly the impacts of such shocks would have been much more
severe under a fixed exchange rate regime. At present, the floating exchange rate regime is
performing its shock-absorbing function.
This process has shown once more how important it is for economic agents to manage the risks on
their balance sheets under the floating exchange rate regime.
As similar volatilities may be observed in the future under the floating exchange rate regime, all
economic agents should protect themselves in the framework of modern risk management principles,
against interest rate or exchange rate risk on their balance sheets. The Izmir Derivatives Exchange
provides an important opportunity in this respect.
After focusing on the monetary and exchange rate policies conducted by the Central Bank and the
developments in inflation and financial markets, now I would like to talk about the strong growth
performance that has been displayed by the Turkish economy since 2001 and the growth outlook.
As you all know, in the first quarter of 2006, the Turkish economy grew by 6.3 percent in real terms.
Hence, cumulative real growth has been 36.9 percent since 2001. The Turkish economy has been
growing for the last 17 quarters consecutively.
I would like to draw your attention to the first point that is related to this growth process; the dynamics
and actors of growth has changed parallel to the structural changes in the economy.
Today, growing with public resources is no longer the case. The determinant of the growth rates is the
consumption and investment of the private sector.
While private sector real investment expenditures increased by 118.2 percent in the period between
2001 and the first quarter of 2006, the said increase in the public sector was realized as 18.6 percent.
On the consumption side, expenditures of the private sector and the public sector increased by 32.8
percent and 7.5 percent, respectively, during the same period. Meanwhile, machinery-equipment
expenditures of the private sector have increased cumulatively by 217.7 percent since 2001. These
figures underline the fact that investment-based growth has also been increasing.
The main contribution of the public sector to growth no longer comes through its expenditures, but
through the role it undertakes as a strong supervisory and regulatory agent in the framework of good
governance principles and also from its policies focusing on the goal of increasing competitiveness.
The public sector's need for borrowing from financial markets declined due to tight fiscal policies,
which provided the private sector the opportunity to find lower-cost and longer term resources.
Another change observed in growth dynamics in line with the structural transformation in the economy
is that productivity increases have become the most significant factor in growth. The cumulative
productivity increase in the private manufacturing industry for the period between 2001 and the first
quarter of 2006 reached 35 percent.
While the said productivity increases support the growth process on the one hand, they improve the
quality and contribute to the sustainability of growth on the other.
The last issue I will touch on about growth factors has to do with the increased level of integration of
the Turkish economy with the world. In this framework, exports, which rose by 151.5 percent
cumulatively from 2001 to July 2006, made a critical contribution to the rapid growth observed for the
last four years.
Domestic and foreign competition, which increased due to the increased number of firms that took up
export activities and entered international markets as a result of integration with the world, led to a
decrease in profit margins in these sectors. In such an environment, productivity increases become
the main factor in competition. Sectors with the highest productivity increases became the sectors,
which grew most rapidly and increased their exports the most.
Studies to increase productivity and specialization in technology and capital-intensive sectors that
create high value added are more critical for the sustainability of increases in exports in the long term,
than the advantage of exchange rate movements.
In order to be able to persevere in such a strong competitive environment, medium and long-term
strategies - rather than short-term perspectives - are needed. To this e