Country Report October 2003

Turkey Turkey at a glance: 2004-05

OVERVIEW The Economist Intelligence Unit believes that the huge parliamentary majority of the Justice and Development Party (AKP) and the absence of alternatives should enable it to stay in power during the forecast period. However, a change of government or an early election should not be ruled out, given the risk in the medium term of another financial crisis, the secular establishment’s deep distrust of the AKP because of its Islamist roots, the AKP’s inexperience in government, and the existence of factions in the party. GDP growth will slow to about 4.5% in 2003, mainly because of a higher baseline. In 2004 a contraction is forecast, triggered by a sharp devaluation of the lira that will help to push the current account back into surplus. Economic growth will rebound in 2005. Inflation will ease to end 2003 close to the IMF-agreed target of 20%, but further reductions will be hard to achieve. A sharp devaluation of the lira will cause inflation to surge in 2004, before easing again in 2005.

Key changes from last month Political outlook • At the end of September Turkey’s highest court of appeal upheld charges of electoral fraud against the pro-Kurdish Democratic Peoplers Party (Dehap). This has sparked speculation that the Supreme Electoral Board might cancel the election result, forcing a rerun. We believe that this is unlikely because of the authorities’ concerns that political instability could trigger financial turmoil. Economic policy outlook • An IMF agreement to postpone repayments scheduled for 2004 and US loans worth US$8.5bn have eased concern about the government’s ability to meet its financing requirement in 2004. Although our assessment of the risk of a debt default is now below 50%, the sheer size of Turkey’s government debt burden means the country will remain vulnerable in the medium term. A burgeoning current-account deficit and real exchange-rate appreciation make a sharp fall in the lira likely. Our forecast assumes this occurs in 2004. Economic forecast • We still expect GDP to contract and inflation to rise in 2004 as a result of the lira devaluation. GDP is forecast to decline by 4% and the year-end rate of inflation to rise to about 60%. October 2003

The Economist Intelligence Unit 15 Regent St, London SW1Y 4LR United Kingdom The Economist Intelligence Unit The Economist Intelligence Unit is a specialist publisher serving companies establishing and managing operations across national borders. For over 50 years it has been a source of information on business developments, economic and political trends, government regulations and corporate practice worldwide. The Economist Intelligence Unit delivers its information in four ways: through its digital portfolio, where the latest analysis is updated daily; through printed subscription products ranging from newsletters to annual reference works; through research reports; and by organising seminars and presentations. The firm is a member of The Economist Group.

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Contents

3 Summary

4 Political structure

5 Economic structure 5 Annual indicators 6 Quarterly indicators

7 Outlook for 2004-05 7 Political outlook 9 Economic policy outlook 12 Economic forecast

15 The political scene

23 Economic policy

32 The domestic economy 32 Output and demand 33 Sectoral trends 36 Employment, wages and prices 39 Financial indicators

42 Foreign trade and payments

List of tables 12 International assumptions summary 13 Gross domestic product by expenditure 15 Forecast summary 24 Revised schedule for IMF reviews 24 Turkey’s repayment schedules 25 Consolidated central government budget 29 Central government debt 30 Domestic debt 32 Yields on Treasury bills and government bonds at auction 32 Gross domestic product 33 National accounts by sector 34 Industrial production, quarterly index 36 Tourist arrivals 37 Workforce and unemployment 38 Real hourly wages of production workers in manufacturing 39 Inflation: consumer and wholesale prices 40 Exchange rates 41 Selected financial indicators 42 Foreign trade

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43 Current account 44 Capital account 45 Foreign-exchange and gold reserves 46 External debt stock

List of figures 15 Gross domestic product 15 Consumer price inflation 25 Consolidated central government finances 31 Treasury-bill yields and consumer price inflation 33 Real gross domestic product 40 ISE general index 42 Trade balance

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Summary October 2003

Outlook for 2004-05 The Economist Intelligence Unit believes that the huge parliamentary majority of the Justice and Development Party (AKP) and the absence of alternatives should enable it to stay in power during the forecast period. However, a change of government or an early election should not be ruled out, given the risk in the medium term of another financial crisis in Turkey, the secular establishment’s deep distrust of the AKP because of its Islamist roots, the AKP’s inexperience in government, and the existence of factions in the party. GDP growth will slow to about 4.5% in 2003, mainly because of a higher baseline. In 2004 a contraction is forecast, triggered by a sharp devaluation of the lira that will help to push the current account back into surplus. Economic growth will rebound in 2005. Inflation will ease to end 2003 close to the IMF-agreed target of 20%, but further reductions will be hard to achieve. A sharp devaluation of the lira will cause inflation to surge again in 2004, before easing in 2005.

The political scene Turkish-US ties have improved since the incident at Suleimaniyah in northern Iraq in early July. The US has requested Turkish troops to help in Iraq, but the proposal faces obstacles. A law approved at end-July has failed to persuade militants of the Kurdistan Workers’ Party (PKK) to give themselves up. Changes at the top of the armed forces should reduce military opposition to government policies. Tension, however, has continued between the president, Ahmet Necdet Sezer, and the government. At end-September the highest appeal court upheld charges of electoral fraud against a pro-Kurdish party, increasing political uncertainty.

Economic policy Following a delay, the IMF released a credit tranche of US$476m in August. Postponement of some IMF repayments from 2004-05 to 2005-06, and US loans worth US$8.5bn have eased concerns about the government’s ability to meet its financing requirements next year. However, domestic government debt has continued to rise, pushing up total government debt to US$185.4bn in July, from US$148.5bn at end-2002. The Central Bank of Turkey cut interest rates four times in July-September, helping to lower domestic government borrowing rates.

The domestic economy GDP rose by 5.8% year on year in the first half of 2003, but growth slowed sharply in the second quarter. Industry, particularly the automotive sector, and services have grown rapidly. Agriculture and construction remained depressed. Tourist arrivals rose in June-August, after falling by 19% year on year in March- May. The economic recovery has failed to boost employment so far. Annual consumer price inflation fell to 24.9% in August with the help of the strong lira.

Foreign trade and payments The trade deficit on a balance-of-payments basis was US$5.5bn in the first half of 2003, compared with a deficit of US$3.2bn in the same period of 2002. This contributed to a widening of the current-account deficit to US$4bn in January- June 2003, compared with a deficit of US$1.4bn a year earlier. Editors: Robert OrDaly (editor); Merli Baroudi (consulting editor) Editorial closing date: September 30th 2003 All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule

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Political structure

Official name Republic of Turkey Form of state Parliamentary republic Legal system Based on European models and constitution of 1982 National legislature Unicameral Meclis (parliament) of 550 members directly elected for a five-year term Electoral system Universal direct suffrage over the age of 18. Only parties gaining more than 10% of the national vote are eligible for seats in parliament National elections November 3rd 2002; next election due by November 2007 Head of state President, elected by an absolute majority of the Meclis for a seven-year term. Current president is Ahmet Necdet Sezer, elected in May 2000. Next election is due in May 2007 National government The government coalition led by Bulent Ecevit, comprising the Democratic Left Party, the Nationalist Action Party and Motherland Party, was heavily defeated in the November 3rd election. The new government was formed by the Justice and Development Party Main political parties Islamist: Justice and Development Party (AKP) and Prosperity Party (Saadet, SP), both successors to the former Virtue Party, which closed in June 2001; centre-right: Motherland Party (Anap), True Path Party (DYP); centre-left: Democratic Left Party (DSP), New Turkey Party (YTP); Republican People’s Party (CHP); nationalist right: Nationalist Action Party (MHP); independent pro-Kurdish: Democratic People’s Party (Dehap, formerly Hadep). AKP and CHP were the only parties to enter parliament in the November election. A deputy elected as an independent joined DYP, giving it one seat The Council of Ministers Prime minister Recep Tayyip Erdogan Deputy prime minister & foreign affairs minister Abdullah Gul Deputy prime minister & minister of state Abdullatif Sener Deputy prime minister & minister of state Mehmet Ali Sahin Ministers of state Mehmet Aydin Ali Babacan Besir Atalay Guldal Aksit Key ministers Agriculture Sami Guclu Defence Vecdi Gonul Education Huseyin Celik Employment & social security Murat Basesgioglu Energy & natural resources Hilmi Guler Environment Kursat Tuzmen Finance Kemal Unakitan Forestry Osman Pepe Health Recep Akdag Housing & public works Zeki Ergezen Industry & trade Ali Coskun Interior Abdulkadir Aksu Justice Cemil Cicek Tourism & culture Erkan Mumcu Transport Binali Yildirim

Central Bank governor Sureyya Serdengecti

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Economic structure

Annual indicators 1999a 2000a 2001a 2002a 2003b GDP at market prices TL trn 77,415 124,583 178,412 276,003 357,455 GDP US$ bn 184.9 199.3 145.6 183.1 235.8 Real GDP growth (%) -4.7 7.4 -7.5 7.8 4.6 Consumer price inflation (av; %) 64.9 54.9 54.4 45.0 26.0 Population (m) 67.2 68.3 69.3 70.3 71.3 Exports of goods fob (US$ m) 28,842 30,721 34,379 39,827 45,209 Imports of goods fob (US$ m) -39,326 -53,131 -38,916 -48,194 -64,356 Current-account balance (US$ m) -1,360 -9,819 3,396 -1,540 -7,410 Foreign-exchange reserves excl gold (US$ m) 23,346 22,488 18,879 27,069 28,378 Total external debt (US$ bn) 102.2 118.3 115.1 131.6 141.3 Debt-service ratio, paid (%) 35.4 35.4 40.0 38.4b 26.5 Exchange rate (av) TL:US$ 418,782.9 625,218.5 1,225,587.0 1,507,226.7 1,516,184.7 a Actual. b Economist Intelligence Unit estimates.

Origins of gross domestic product 2002 % of total Components of gross domestic product 2002a % of total Agriculture, forestry & fishing 11.9 Private consumption 66.7 Industry (excl construction) 25.4 Government consumption 14 Construction 4.2 Gross fixed investment 16.7 Services 58.5 Stockbuilding 4.7 Statistical discrepancy -2.7 Exports of goods & services 28.8 Imports of goods & services -30.5

Principal exports 2001b US$ m Principal imports 2001b US$ m Textiles & clothing 10,344 Chemicals & products 6,770 Metals 2,921 Crude oil & gas 6,076 Motor vehicles & parts 2,659 Machinery & equipment 5,140 Agricultural products 2,225 Metals 3,612 Food & beverages 1,789 Motor vehicles & parts 2,213

Main destinations of exports 2002b % of total Main origins of imports 2002b % of total Germany 16.6 Germany 13.7 US 9.2 Italy 8.1 Italy 6.4 Russia 7.6 UK 8.5 US 6 France 6.0 France 5.9 Russia 3.3 UK 4.8 EU 51.5 EU 45.5 a Including statistical discrepancy. b Excluding “suitcase” trade.

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Quarterly indicators 2001 2002 2003 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr Consolidated central government finance (TL trn)a Revenue & grants 36,373 51,813 15,028 35,821 55,404 76,401 20,364 44,689 Expenditure 54,807 80,379 27,663 53,696 79,982 115,486 31,253 69,448 Balance -18,434 -28,567 -12,636 -17,875 -24,579 -39,085 -10,889 -24,759 Output GDP at constant 1987 buyers' prices (TL bn) 35,187 26,512 23,226 27,711 37,975 29,528 25,100 28,790 GDP at constant 1987 buyers' prices (% change, year on year) -7.5 -10.3 2.1 8.9 7.9 11.4 8.1 3.9 Industrial production index (1995=100)b 110.5 108.7 118.6 121.4 120.7 121.5 128.4 129.5 Industrial production index (% change, year on year) -9.8 -12.7 4.4 11.0 9.2 11.8 8.3 6.7 Manufacturing production index (1995=100)b 107.0 106.5 117.7 120.1 120.0 120.6 129.5 129.1 Mining production index (1995=100) 103 90 87 85 92 84 76 n/a Employment, wages & prices Employment, manufacturing (‘000) 737.5 717.8 760.9 799.9 819.4 819.1 807.9 n/a Employment, manufacturing (% change, year on year) -6.6 -6.8 0.6 7.8 11.1 14.1 6.2 n/a Unemployment rate (% of the labour force) 7.8 10.4 11.5 9.3 9.6 11.0 12.3 10.0 Hourly earnings, manufacturing (1995=100)c 2,486 2,656 2,897 2,946 3,198 3,362 3,079 n/a Consumer prices (1994=100) 4,812 5,561 6,158 6,407 6,710 7,319 7,858 8,329 Consumer prices (% change, year on year) 58.6 67.5 70.3 47.0 39.5 31.6 27.6 30.0 Wholesale prices (1994=100) 4,086 4,758 5,278 5,522 5,863 6,335 7,059 7,332 Wholesale prices (% change, year on year) 70.0 84.9 86.7 51.2 43.5 33.2 33.7 32.8 Financial indicators Exchange rate TL'000:US$ (av) 1,398 1,524 1,358 1,412 1,666 1,614 1,649 1,425 Exchange rate TL'000:US$ (end-period) 1,552 1,450 1,341 1,573 1,662 1,644 1,704 1,415 Deposit rate (av; %) 67.8 62.6 57.4 48.7 49.5 46.4 45.9 42.1 Interbank money market rate (av; %) 62.3 59.0 57.3 49.1 46.7 44.8 44.0 40.9 M1 (end-period; TL trn) 10,105.8 10,839.6 10,552.1 12,135.4 12,988.5 14,814.3 13,888.6 n/a M1 (% change, year on year) 65 46.3 35 30.8 28.5 36.7 31.6 n/a M2 (end-period; TL trn) 102,604 107,296 109,318 124,264 131,947 138,543 138,931 n/a M2 (% change, year on year) 92.5 86.2 49.5 45 28.6 29.1 27.1 n/a Stockmarket index (end-period; 1986=1)d 7,626 13,782 11,809 9,380 8,842 10,370 9,475 10,884 Stockmarket index (% change, year on year) -32.8 46.0 45.6 -16.3 15.9 -24.8 -19.8 16.0 Sectoral trends Crude steel production ('000 tonnes) 3,829 3,670 3,582 4,087 4,381 4,423 4,496 4,471 Cement production ('000 tonnes) 8,854 6,046 5,436 9,922 9,814 7,405 4,901 n/a Car production (‘000) 54.3 48.3 56.1 68.1 58.8 76.8 69.3 n/a Foreign trade (US$ m) Exports fob 7,663 8,176 7,913 8,511 9,166 9,687 10,271 11,160 Imports cif -10,086 -10,103 -10,359 -12,437 -13,480 -14,756 -14,146 -16,280 Trade balance -2,423 -1,926 -2,446 -3,926 -4,314 -5,070 -3,874 -5,118 Balance of payments (US$ m) Merchandise trade balance fob-fobe -1,310 -641 -905 -2,245 -2,295 -2,867 -2,301 -3,225 Services & income balanceef 2,415 354 -523 682 2,498 678 -708 537 Net transfer paymentse 863 927 846 772 864 1,014 777 840 Current-account balancee 1,968 640 -582 -791 1,067 -1,175 -2,232 -1,848 Reserves excl gold (end-period) 18,987 18,879 20,496 22,426 25,195 27,069 26,935 28,890 a Cumulative from the beginning of year. b Seasonally adjusted. c Gross earnings per production worker. d ISE National-100. e Central Bank of Turkey. f Including other goods. Sources: Central Bank of Turkey; State Institute of Statistics; OECD, Main Economic Indicators; IMF, International Financial Statistics; Standard & Poor’s, Emerging Stock Markets Review.

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Outlook for 2004-05

Political outlook

Domestic politics Thanks to its parliamentary majority of two-thirds of the total number of seats, the present Justice and Development Party (AKP) government under Recep Tayyip Erdogan appears likely to stay in power beyond the outlook period. In the medium term the most serious threat to its popularity is the lingering risk of another financial crisis. The risk of a debt default in 2004 appears to have diminished thanks to IMF agreement to postpone some repayments scheduled for 2004 and US agreement to provide loans worth US$8.5bn. However, the burgeoning current-account deficit fuelled by recovering domestic demand and real exchange rate appreciation makes a sharp depreciation of the lira a likely cause of financial instability in the short term. In recent months the main opposition to government policies has come from the president, Ahmet Necdet Sezer, who has returned several bills to parliament, including changes to a constitutional amendment that would have allowed the state to sell off degraded “forest” land (see The political scene). This may well be put to a referendum, but it does not seem to be treated by the government as a make-or-break issue. Hence, if a referendum is held and the government loses the vote, it will almost certainly survive with no more than a tarnished image. The other main challenge to the government has come from the military chiefs, as the ardent guardians of Kemalist secularism. Nonetheless, recent changes to the powers and composition of the military-dominated National Security Council (MGK), as well as changes in personnel at the top of the armed forces, seem to have reduced the risk of a clash between the government and the military (see The political scene). So far, the government has avoided policies seen as flagrantly pro-Islamist and seems likely to continue this, although government plans to reform Turkey’s inadequate education system could be a source of contention. In mid-August Mr Sezer returned a law to parliament for reconsideration on the grounds that the approved amendments to the education law allowing up to 10,000 pupils from poorer families to attend private schools at state expense might undermine the democratic and secular nature of the state. The AKP also favours lifting the ban on female students wearing Islamic headscarves, arguing that it is a human right. The military and secularists strongly oppose this, deeming it to be part of an Islamist political agenda.

Election watch Local elections, to be held by May 2004 (the exact date has yet to be set), could well see the AKP’s share of the vote rise above the 35% it scored in the general election of November 2002. The government benefits from the fact that the Republican People’s Party (CHP), the sole opposition party effectively represented in parliament, is failing to capture more public support. A challenge to the government could also come from the maverick Youth Party (GP) and its leader, the controversial media magnate, Cem Uzan, but the collapse of the Uzan family’s Imar Bank and the indictment of leading members of the family have greatly reduced this threat. There remains the slight chance that the

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decision at the end of September of Turkeyrs highest court of appeal to uphold charges of fraud against the pro-Kurdish Democratic Peoplers Party (Dehap) at the November 2002 general election could lead to an election rerun or an early election called by the government. However, the Economist Intelligence Unit believes that this is unlikely because of the authorities’ concerns that political instability could trigger financial turmoil. Even in the unlikely event that the Supreme Electoral Board (YSK) should decide to declare the November 2002 election result invalid, it is however probable that the AKP would win a decisive victory in the election rerun.

International relations The government faces major foreign policy challenges during the outlook period. The most immediate is repairing Turkey’s damaged relations with the US following the parliament’s decision, by the narrowest of margins, on March 1st not to allow US forces on Turkish soil during the Iraq war (April 2003, pages 15- 16). Efforts have been made by both sides to heal the rift, but the risk of further tensions will remain high as long as Iraq is unstable and Turkey is concerned about the possibility of an independent Kurdistan emerging in northern Iraq and fuelling separatist sentiment among Turkey’s Kurds in the south-east. Turkey is currently under pressure from the US to contribute troops to an international “stabilisation force” in Iraq. The government appears ready to accept the idea in principle, since it is anxious to restore its strategic partnership with the US, and wants to have some influence over the future shape of Iraq. There is, however, opposition to this among the public and a group of AKP deputies will almost certainly oppose the proposal when it is put to parliament, probably in October. Nevertheless, it appears that they will not be numerous enough to vote it down. It is therefore possible that around 10,000 Turkish troops will be sent to Iraq before the end of 2003. However, the Turkish government insists that the US must first eliminate the remaining elements of the militant Kurdish organisation, the Kurdistan Workers’ Party (PKK, now renamed the Kurdistan Freedom and Democracy CongressKADEK) from Iraqi territory, and the US now seems prepared to conduct a joint operation to achieve this. Much will also depend on reactions from within Iraq. These are uncertain, given the deep divisions in Iraqi society and the lack of a credible national government. Recent constitutional and legal changes, which the government claims have brought Turkey into line with the EU’s Copenhagen criteria of democratic norms, have been welcomed by representatives of the European Commission and the governments of leading EU countries. However, they have made it clear that they must be assured that these reforms are actually being implemented, especially in areas such as the elimination of torture by the police and allowing the use of the Kurdish language in broadcasting and education. Without this, they will be reluctant to allow accession negotiations with Turkey to begin by the provisionally established date of December 2004, or soon thereafter. We believe that the government will have done enough for the EU to agree to start negotiations in early 2005. However, a further delay cannot be completely ruled out given the persistence of conservative attitudes in parts of the judiciary and state bureaucracy, the lack of effective control over the police in many instances, and the re-emergence of tensions between the state and pro- Kurdish groups.

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Currently, the Cyprus problem persists as the main political sticking point between Turkey and the EU, with the Turkish Cypriot leader, Rauf Denktash, firmly opposing settlement proposals put forward by the UN Secretary-General, Kofi Annan. However, the three opposition parties in the self-proclaimed Turkish Republic of Northern Cyprus (TRNC) have strongly favoured starting negotiations with the Greek Cypriot government, on the basis of the Annan plan, and have formed an alliance to achieve this. According to opinion polls, they are likely to win a majority in the parliamentary elections to be held in the TRNC on December 14th 2003. This would force Mr Denktash to appoint an agreed substitute to serve as negotiator with the Greek Cypriots. Although statements by Mr Erdogan and his minister of foreign affairs, Abdullah Gul, have been cautious ahead of the election in northern Cyprus, we believe that they would fully support a resumption of negotiations on the basis of the Annan plan in the event of a victory for the opposition parties in the TRNC. We continue to believe that there is a better than 50% chance of a settlement being reached on the island by end-2004.

Economic policy outlook

Policy trends After a series of delays and slippages on IMF-agreed targets and reforms in the second quarter of the year, the government has taken positive steps to put the economic stabilisation programme back on track. These measures, combined with some fortuitously benign factors such as exceptionally low short-term international interest rates, have helped to improve Turkey’s short-term economic outlook. In addition, at the request of the government the IMF has agreed to ease Turkeyrs repayment schedule in 2004 by moving some of the repurchases from 2004-05 to 2005-06. In addition, in late September Turkey successfully concluded negotiations with the US regarding loans worth US$8.5bn that the US promised in April in return for partial Turkish support in the war against Iraq. As result, concerns about the government’s ability to meet its financing requirements next year have eased. However, because of the burgeoning current-account deficit fuelled by continued real appreciation of the lira and recovering domestic demand growth, a substantial correction of the lira-dollar exchange rate is likely in the short term.

In focus

The risk of a debt crisis remains high in the medium term The sheer size of Turkey’s public debt (about 85% of GDP at end-2002), an overvalued lira and a widening current-account deficit leave Turkey vulnerable to sudden shifts in investor sentiment, keeping the risk of a financial crisis high during the outlook period. Although the Economist Intelligence Unit’s assessment of the risk of a government debt default in 2004 is now below 50%, Turkey will remain vulnerable to a default in the medium term because we believe that without continued external support the fiscal retrenchment required to reduce Turkey’s government debt burden to a more sustainable level in the next few years will be politically unacceptable (regardless of the government in power). With the stand-by loan agreed with the IMF in February 2003 already 17 times Turkey’s quota in the

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Fund (compared with five times for Argentina and six times for Brazil), it will be extremely difficult for the IMF to lend Turkey additional funds. Apart from the US$8.5bn loan already agreed by the US in connection with the Iraq war, we believe that the US administration is unlikely to act as “lender of last resort”, in part because of the recent deterioration in relations with Turkey, but also because a crisis in Turkey would be unlikely to trigger wider turmoil in international financial markets.

The assumptions required to conclude that the public debt burden will stabilise over the next five to ten years are still, in our opinion, overoptimistic. These include steady annual GDP growth of around 4-5%, stable real interest rates substantially below the current level of about 20% on domestic debt, only modest depreciation of the real exchange rate, and unprecedented, large primary budget surpluses. Even the IMF has admitted that a combination of poor fiscal performance, low growth, high interest rates and a weaker exchange rateall assumptions that are at least as plausible, if not more so, than the baseline assumptionswould produce an unsustainable path for public debt over the medium term. Turkey is also vulnerable to external shocks, given its large (and growing) external financing requirement.

The exact timing and extent of a crisis are extremely difficult to predict. We have tentatively pinpointed 2004 as the year in which we think a crisis will occur. Towards the end of 2003 we believe that it will become apparent that this year’s fiscal targets are unlikely to be achieved and that the government will be unable to tighten fiscal policy sufficiently ahead of the 2004 local elections. This could result in a decline in investor confidence, making it more difficult for the government to roll over its domestic debt, most of which is short-term.

Apart from the IMF’s continued support, its agreement to reschedule some of Turkey’s repayments, and the loans worth US$8.5bn agreed by the US, several factors are currently acting to reduce the risk of a crisis in the short term. In particular, the bulk of Turkish government debt is held by Turkish investors, with the public sector, mainly state-owned banks, accounting for 30% of the total. These investors appear for the moment willing to give the government the benefit of the doubt, but this could change quite quickly if the government becomes over-complacent, as it has sometimes appeared to be. Also, the lira has remained strong against the US dollar, reducing the cost of servicing the government’s dollar-denominated domestic debt (just over 25% of total domestic debt in July). However, with the lira widely considered to be overvalued, a sharp correction in the exchange rate could soon reverse this trend. International short-term interest rates also remain exceptionally low, which has driven a search for higher yields and helped Turkey to tap the international capital markets. However, once rates start to rise again, this may not be quite so easy.

Fiscal policy The fiscal targets that the government has agreed with the IMFparticularly the public-sector primary surplus (the public-sector balance less interest payments on government debt) of 6.5% of GNP a year in 2003-04are highly ambitious and unlikely to be achieved in full. Nevertheless, we are still forecasting quite a substantial primary surplus in 2003, helped by the additional measures already taken since the introduction of the 2003 budget and a supplementary budget to be introduced in October. The consolidated central government primary

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surplus is expected to be about 4.5% of GDP in 2003 (5.7% of GNP is the government’s IMF-agreed target for this part of the public-sector primary balance, which is to be supplemented by a surplus on off-budget parts of the public sector, particularly state enterprises, in order to achieve the broader public-sector primary surplus of 6.5% of GNP). A further improvement is also expected in the overall consolidated central government budget deficit/GDP ratio, compared with 19.6% of GDP in 2001 and 14.2% in 2002. However, in 2003 the deficit will remain high at about 13.5% as a result of the high cost of servicing Turkey’s burgeoning debt stock. Interest payments, estimated to amount to almost 19% of GDP in 2002, are forecast to be around 18% of GDP in 2003. The government’s ambitious target for privatisationdeals worth US$4bn in 2003 and receipts of just over US$2bnis also unlikely to be achieved as a result of repeated delays of the tenders for the state refiner, Tupras, and the alcohol and tobacco company, Tekel. Privatisation receipts are earmarked for debt reduction, but indirectly this would reduce interest payments. In 2004 we expect the deficit to remain more or less stable, benefiting from lower interest rates in 2003. However, another rise in interest rates in 2004 will prevent an improvement in the budget balance in 2005.

Monetary policy The Central Bank of Turkey is likely to continue its generally cautious monetary policy stance in 2003. However, pressure to adopt a more accommodating stance is likely to continue from various sources, including exporters hurt by the current strength of the lira and members of the government who want interest rates on Treasury bills to fall to reduce government borrowing costs. So far the Central Bank appears to have resisted pressure, and rate reductions (the latest, on September 18th, brought the Bank’s overnight borrowing rate down to 29%) have followed improvements in Turkey’s inflation outlook and other positive developments. Failure to maintain this stance would seriously damage the credibility of the Central Bank’s recently established independence and contribute to an erosion of investor confidence. The Central Bank still plans to move from “implicit inflation targeting” to a fully-fledged policy of inflation targeting. This was initially scheduled to start at the beginning of 2003, but has been delayed and is now unlikely to be introduced this year.

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Economic forecast International assumptions International assumptions summary (% unless otherwise indicated) 2002 2003 2004 2005 Real GDP growth World 2.9 3.3 3.9 4.1 OECD 1.8 1.9 2.4 2.6 EU 1.0 0.6 1.9 2.3 Exchange rates ¥100:US$ 1.25 1.18 1.17 1.16 US$:€ 0.945 1.115 1.165 1.135 SDR:€ 0.729 0.804 0.823 0.810 Financial indicators € 3-month interbank rate 3.33 2.27 2.25 3.83 US$ 3-month Libor 1.80 1.17 1.47 3.66 Commodity prices Oil (Brent; US$/b) 25.0 27.6 19.6 18.9 Gold (US$/troy oz) 310.3 343.3 317.5 307.5 Food, feedstuffs & beverages (% change in US$ terms) 12.7 5.6 1.7 5.8 Industrial raw materials (% change in US$ terms) 2.2 8.0 3.5 6.0 Note. Regional GDP growth rates weighted using purchasing power parity exchange rates. The performance of the global economy has begun to improve, suggesting that a recovery is under way, although there are still massive downside risks. US GDP growth in mid-2003 is strengthening, primarily boosted by tax cuts feeding through to consumer demand. Although the impact will fade quickly, a further strengthening is expected for 2004. A recovery in the EU, Turkey’s main export market, driven by improving business and consumer confidence and the rising need for replacement investment, is also expected in 2004, although with GDP growth forecast at 1.9%, it is expected to be moderate, reflecting fiscal constraints, a renewed appreciation of the euro, and continued concerns about global economic instability. Although the downside risks to the global economy have been reduced, they are still significant, especially taking the year 2005, which now comes into our forecast horizon together with 2004. The main concern continues to stem from the huge imbalances in the US economy, specifically the large current-account deficit (more than 5% of GDP) and high levels of private-sector debt. The financing of the current-account deficit would then become problematic, which could lead to a depreciation of the dollar to US$1.30:æ1 or beyond. Since Asian currencies tend to move more with the dollar than the euro, the consequences for euro area exports, and consequently euro area growth prospects, would be serious. We put the chances of a sharp fall in US business and consumer confidence, together with a sharp dollar depreciation, at 15% in 2004 and again at 15% in 2005, given a cumulative risk over the two-year forecast period of about 30%.

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Economic growth Gross domestic product by expenditure (TL bn at constant 1987 prices; % change year on year in brackets unless otherwise indicated) 2002a 2003b 2004c 2005c Private consumption 74,847.0 77,300.4 74,200.0 76,925.3 (2.0) (3.3) (-4.0) (3.7) Public consumption 9,940.0 9,890.3 9,791.4 10,085.1 (5.4) (-0.5) (-1.0) (3.0) Gross fixed investment 22,612.0 23,854.6 19,920.8 19,132.2 (-0.8) (5.5) (-16.5) (-4.0) Final domestic demand 107,399.0 111,045.3 103,912.2 106,142.7 (1.7) (3.4) (-6.4) (2.1) Stockbuilding 6,008.0 9,650.0 -500.0 1,025.0 (7.0)d (3.1)d (-8.2)d (1.3)d Total domestic demand 113,407.0 120,695.3 103,412.2 107,167.7 (9.2) (6.4) (-14.3) (3.6) Exports of goods & services 46,723.0 51,630.1 57,555.9 61,742.8 (11.0) (10.5) (11.5) (7.3) Imports of goods & services 41,313.0 48,091.4 41,795.9 44,673.8 (15.7) (16.4) (-13.1) (6.9) Foreign balance 5,410.0 3,538.7 15,760.0 17,069.0 (-0.9)d (-1.6)d (9.9)d (1.1)d GDPe 118,440.0 123,834.0 118,822.2 124,136.7 (7.8) (4.6) (-4.0) (4.5) a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts. d Contribution to real GDP growth. e The total includes a statistical discrepancy. Annual GDP growth is expected to slow from 7.8% in 2002 to about 4.5% in 2003. In the second quarter of 2003 the GDP growth rate was already down sharply to 3.9% from 8.1% in the first quarter, although this can be explained in part by the negative impact of the Iraq war, the rapid conclusion of which may have a positive effect on growth in the second half of the year. However, the continued strength of the Turkish lira since April, the effect of which, although not evident in trade data available for the first seven months of 2003, will be to damage the competitiveness of Turkey’s exports and boost imports, having a dampening effect on growth in the second half of 2003 and going into 2004. Over the outlook period as a whole the need to keep fiscal policy tight, high unemployment, limited foreign investment and the ongoing impact of unwinding problems related to banking and corporate debt will check economic expansion. In 2004 a sharp fall in the value of the lira and a rise in inflation is expected to trigger another recession. We forecast that GDP will contract by about 4%, with all components of domestic demand likely to record sharp declines. However, the resulting steep fall in imports of goods and services, and a surge in exports driven by an expected devaluation of the Turkish lira, should reduce the size of the fall in overall GDP. In 2005 economic growth is forecast to rebound, lifted by the boost to exports from a weaker exchange rate and the base effect.

Inflation Following month-on-month falls in the index in June-July, the year-on-year rate of inflation declined to 24.9% in August, from 30.7% in May, mainly reflecting the strength of the lira since April and lower international oil prices during most of the second quarter. We now expect the year-end rate to be close to the

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IMF-agreed target of 20% for 2003, down from about 30% at end-2002. However, further major reductions in inflation will be hard to achieve during the outlook period. With the current-account deficit widening sharply and the lira appreciating in real terms, a correction is expected which, combined with seasonal price rises at the end of the year and higher oil prices since May, is likely to push up prices. The government is also in a dispute with public-sector and civil service trade unions over the long-overdue wage agreement for 2003-04. The government is seeking to tailor its incomes policy to its inflation targets, but we expect the authorities to make some concessions, given that local elections are scheduled to take place in May 2004. Based on our prediction that the fall in the value of the lira will be of the order of 15-20% in real terms, we expect a surge in inflation to a year-end rate of about 60% in 2004, driven higher mainly by the inflationary effect of a much weaker lira on import prices. In 2005 we expect consumer prices to stabilise, but the year-end rate of inflation is still forecast to be over 40%.

Exchange rates Exchange rate volatility, which has been a major source of instability since the devaluation of the Turkish lira in February 2001, is expected to continue during the outlook period. Following a sharp appreciation to about TL1,400,000:US$1 since mid-July and a marked deterioration of the current-account balance, we expect a correction in the exchange rate, pushed down mainly by concerns about the current-account deficit, recent interest rate cuts and a recovery in US economic growth. The timing of the correction is highly uncertain, however, given that Central Bank’s intervention in the foreign-exchange markets, a 600 basis point reduction in Central Bank interest rates, and the widespread belief that the lira is overvalued have so far failed to prompt a switch out of lira-denominated assets. In 2004 the lira is forecast to depreciate in real terms by 15-20% from an average of TL1,500,000 in 2003 to TL2,400,000:US$1 in 2004. In 2005 we expect the lira to stabilise in real terms, falling to about TL3,700,000:US$1.

External sector Turkey’s current-account deficit is expected to widen from about 1% of GDP in 2002 to about 3% in 2003, causing some concern about Turkey’s ability to meet its external financing requirements (the current-account balance plus principal repayments on Turkey’s external debt). Imports have risen sharply as a result of the recovery of domestic demand, higher non-oil commodity prices and a strengthening lira against the dollar. At the same time, we expect export revenue growth to be checked by the appreciation of the lira in the first half of 2003 and the continued weakness of demand in the US and the euro area, Turkey’s main export markets. In 2004 the current account will return to surplus, reflecting a marked improvement in the merchandise trade balance as a result of our forecast that next year the Turkish lira will fall sharply in real terms and domestic demand will collapse again, thereby boosting export earnings and reducing the import bill. In 2005 the current-account surplus is expected to decline slightly as the lira stabilises and domestic demand growth recovers again.

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Forecast summary (% unless otherwise indicated) 2002a 2003b 2004c 2005c Real GDP growth 7.8 4.6 -4.0 4.5 Industrial production growth 9.0b 6.7 -5.5 6.0 Gross fixed investment growth -0.8 5.5 -16.5 -4.0 Unemployment rate (av)d 10.7 11.3 13.8 15.7 Consumer price inflation (av) 45.0 26.0 39.4 55.0 Consumer price inflation (year-end) 29.7 22.3 60.5 42.8 Short-term interbank rate 49.5 40.0 65.0 66.0 Government balance (% of GDP) -14.2e -13.6 -13.2 -13.0 Exports of goods fob (US$ bn) 39.8 45.2 50.6 54.5 Imports of goods fob (US$ bn) 48.2 64.4 58.9 63.8 Current-account balance (US$ bn) -1.5 -7.4 2.0 1.6 Current-account balance (% of GDP) -0.8 -3.1 0.9 0.7 External debt (year-end; US$ bn) 131.6 141.3 141.5 137.6 Exchange rate TL '000:US$ (av) 1,507.2 1,516.2 2,420.9 3,688.3 Exchange rate TL '000:¥100 (av) 1,202.4 1,283.8 2,073.6 3,179.6 Exchange rate TL '000:€ (av) 1,424.2 1,690.9 2,820.4 4,186.2 Exchange rate TL '000:SDR (year-end) 2,234.6 2,237.7 4,593.2 5,459.4 a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts. d Break in the series from 2000. e Derived from official government figures.

The political scene

Turkey-US ties improve after The US decision to go to war with Saddam Hussein has strained Turkey’s Suleimaniyah incident in July traditionally good relations with the US. In particular, the Turkish authorities fear that regime change in Iraq might lead to the creation of an independent Kurdistan in northern Iraq, which, in turn, might revive calls for greater autonomy from the Kurds in south-east Turkey. Since the vote in the Turkish parliament on March 1st, when Turkish deputies rejected a US plan under which US forces would have used Turkish territory to invade Iraq from the north, with Turkish troops also being sent into Iraq, there have been efforts on both sides to improve relations (April 2003, pages 14-16).

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However, a new low point in the relations between the two countries was reached on July 4th, when US forces arrested 11 soldiers of the Turkish special forces who were stationed in Suleimaniyah, in Iraqi Kurdistan, originally to monitor the ceasefire between the Iraqi Kurdish parties, the Patriotic Union of Kurdistan (PUK) and the Kurdistan Democratic Party (KDP), and held them for three days, on suspicion of having been involved in “disturbing activities” (in the words of the US State Department), and even of having been involved in a plot to murder the Governor of Kirkuk (according to Jelal Talabani, the leader of the PUK). These accusations were hotly denied in Ankara, and the US Secretary of Defence, Donald Rumsfeld, later expressed his “regret” over the affair. Nevertheless, it increased anti-US sentiment in Turkey, just as the US was attempting to persuade the Turkish government to take on a bigger post-war role in Iraq.

The US requests Turkish troops A crucial question facing the Turkish government has been whether to accept to help in Iraq new US proposals for Turkish participation in a widened international “stabilisation force” in Iraq. The US’s request came amid increasing difficulties that US and British forces have been facing in restoring law and order in Iraq. The US proposals began before more recent moves by the US government to secure a UN mandate for its occupation of Iraq, and were independent of them. On July 20th the Turkish prime minister, Recep Tayyip Erdogan, announced that the US had made such a request, and this was confirmed by the US Secretary of State, Colin Powell, on July 24th, during a visit to Washington by the minister of foreign affairs, Abdullah Gul. Discussions between the two sides established the likely size of the force at around 10,000 troops, although this could be increased if needed. In response, government leaders emphasised that, under Article 92 of the Turkish constitution, this step would have to be supported by an overall majority in the Turkish parliament, as in the case of the earlier plan. However, subsequent statements by government leaders have suggested that they regard it favourably, provided certain conditions can be met. Their motives are first, to reassure the US of the value of its strategic partnership with Turkey, and second, to exercise some leverage over future developments in Iraq (in particular, by preventing the formation of an independent Kurdish state). The Turkish president, Ahmet Necdet Sezer, was viewed as the main opponent to the proposal, since it was expected that he would insist that any Turkish military presence in Iraq must have authority from the UN. Following a meeting with Mr Erdogan, Mr Gul, and the Chief of the General Staff, General Hilmi Ozkok, on August 12th, the president appeared to have dropped this objection, maintaining simply that the proposal must have the approval of parliament. However, as Mr Erdogan remarked on September 6th, approval by the UN would certainly “make it easier for us”, and support for the move from within Iraq might also depend on this factor. Reactions from the military were also more positive than in March, probably facilitated by recent changes in personnel at the top of the armed forces (see below). As a sign of this, General Ozkok was reported to be of the view that the risks of not sending troops to Iraq were greater than those of accepting the US request.

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In mid-September Mr Gul indicated that a decision on sending Turkish troops to Iraq would not be taken until mid-October. Once parliament reassembles on October 1st, the government will take a decision and a motion will then be put to the parliament. The Turkish government is apparently postponing a decision to make sure the US agrees to a plan eliminating the surviving elements of the Kurdistan Workers’ Party (PKK)now officially renamed the Kurdistan Freedom and Democracy Congress, or KADEKwho are currently holed up in north- eastern Iraq, and who carried out a costly campaign of violence in Turkey between 1984 and 1999 (see below, and April 2003, page 19). The government is also awaiting developments in the UN Security Council, although Mr Gul confirmed that Turkish participation in the stabilisation force would not be dependent on a decision by the UN. The National Security Council (MGK), which brings together the president, prime minister, government ministers, and the military chiefs, met on September 19th, and considered the situation in detail, but made no recommendation. Mr Erdogan later claimed that there had been no disagreement in the MGK, but the ball is clearly now in the government’s court. Mr Gul said there would not be another meeting of the MGK meeting before the government took a decision, but that Mr Sezer would attend meeting as Chair (which constitutionally he is allowed to do).

The government lays down While keen to improve relations with the US and have some influence over fairly tight conditions developments in Iraq, the Turkish government is also wary of the risk of getting bogged down in a lengthy conflict in Iraq, and anxious to avoid a second defeat in parliament. Hence, it has apparently laid down the following conditions. • To avoid conflict with the Iraqi population, any Turkish force must be able to differentiate itself from the US presence. Hence, the Turkish contingent must be under separate Turkish command (although in co-ordination with the US) and assigned its own discreet geographical area. It is accepted that this must be outside the Kurdish region of northern Iraq, thanks to fierce opposition from the Iraqi Kurdish leaders. However, the security of its supply lines from Turkey through northern Iraq must be assured (possibly through joint Turkish-US patrols). • As a quid pro quo, the US must agree to eliminate the surviving elements the PKK/KADEK. • Turkish troops would emphasise an humanitarian role, concentrating on the reconstruction of schools, hospitals, public buildings, mosques, and water and electricity supplies. To this end, plans have been prepared for the construction of a Turkish hospital in Baghdad, and the establishment of field hospitals in the designated area, with patients requiring urgent treatment being transferred to hospitals in Turkey (a process that has already started). • Any Turkish deployment should be in agreement with the Iraqis (although whom this refers to is unclear). Turkey needs US financial support in its efforts to avoid another financial crisis, but the US has stated in an agreement with the Turkish government that the disbursement of loans worth some US$8.5bn will not depend on Turkey

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agreeing to send troops to Iraq (see Economic policy). Instead, Turkey will be required to implement strong economic policies and co-operate with the US in Iraq by providing supplies to US forces, which the Turkish government has never put in question.

The proposal faces obstacles The first risk facing the government, of which it is evidently well aware, is that parliament might vote down the proposal, leaving Turkish-US relations in serious disarray, and Turkey without any leverage over the future of Iraq. Understandably, Turkish public opinion is less opposed to a peacekeeping and humanitarian role in Iraq than to full support for the US-led invasion, which was the plan proposed before the Iraq war. It was predicted that around 50 AKP backbenchers could vote against the motion to send troops to Iraq, but this would be far less than the 100-odd who voted against the government motion on March 1st. Hence, given the government’s current majority of 367 of the 550 parliamentary seats, a second motion should be successful. Assessing Iraqi reactions is far more difficult because of the deep divisions within Iraqi society and the lack of a proper national government. Predictably, the Iraqi Kurdish leaders have strongly criticised the idea, and it was immediately opposed by the PUK leader, Mr Talabani. On August 25th a “Mission of Scholars” sent by the Sunni Muslim community in Iraq to Istanbul, opposed the proposal, as did Muqtada al-Sadr, one of the several Shi’i leaders in southern Iraq. On the other hand, the idea was strongly supported by the leaders of the Ubeidi tribe, the main Sunni Arab tribe in Kirkuk, and by a delegation of the Iraqi Tribal Confederation, said to represent around 2,000 tribes in Iraq, both of whom visited Turkey. An official Turkish delegation, which included two AKP deputies, visited Iraq in the last week of August and claimed that “the people of Iraq” favoured a Turkish presence, provided it were independent of the US. The Turkish government had evidently been hoping that the provisional Governing Council, set up by the US authorities in Baghdad in July, would issue an official invitation, but the Council is badly divided, and lacks national authority since it is purely nominated by US officials. On September 4th Hoshiyar Zebari, a former spokesman for the KDP, who is foreign minister in the Council of Ministers nominated by the Governing Council, stated that no troops from Turkey or any other neighbouring country should be sent to Iraq. The US State Department promptly denied that Mr Zebari’s views were those of the Governing Council as a whole. On September 9th Ahmad Chalabi, the rotating chairman of the Governing Council, stated that Turkish troops would be welcome to take part in the stabilisation force, provided it had UN backing, but he later contradicted himself, saying that the Council did not want any more foreign forces. Mr Chalabi visited Ankara at the head of a delegation from the Governing Council on September 11th. He admitted that the Council was not in a position to invite Turkey to send troops to Iraq as “this is a job for the UN”, and more frankly, that the US was actually the ruling power in Iraq. Reports suggest that the US military is wary of engaging in detailed bargaining over a possible Turkish military presence in Iraq, prior to the acceptance of the idea in principle by the Turkish parliament. It does not want to repeat its experiences of April-March, when detailed plans for a joint invasion of Iraq

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were put in place after much hard bargaining, and then narrowly defeated in the Turkish parliament. Nonetheless, on September 6th Mr Gul stated that that it was agreed with the US that Turkish forces would have a separate command and a designated area of operations, for which they could express their own preference (probably, this would be in the Sunni Arab area north of Baghdad). The Turkish authorities have estimated that stationing 10,000 Turkish troops in Iraq will cost around US$20m per month. For the first six to nine months Turkey would meet this cost, but after that would wish to discuss the issue with the US government.

New law fails to persuade PKK One of Turkey’s conditions for participating in an international stabilisation militants to give themselves up force in Iraq is that the US should eliminate the remaining presence of PKK/KADEK militants in the north-east of the country, in territory nominally controlled by the KDP or PUK, who are believed to number around 5,000. In principle the US seems prepared to take action against them, since it classifies KADEK as a terrorist organisation. However, the US pressed Turkey to offer some kind of amnesty to the militants. Accordingly, on July 29th parliament passed a “Return to Society Law” under which those who had been members of the PKK or assisted it, but had not participated in violence, would be pardoned, while others, except for the top leaders of the organisation, would benefit from reduced sentences if they turned themselves in. The deal was abruptly rejected by KADEK leaders, who demanded a full amnesty. Instead, on September 1st they announced that the unilateral ceasefire that they had declared in 1999 was officially at an end (sporadic attacks on Turkish security forces in south-east Turkey have recently been attributed to the PKK). The announcement is unlikely to have much effect, unless the situation in Iraqi Kurdistan deteriorates badly for Turkey, since KADEK now has little strength on the ground in Turkish territory. However, the attempt to persuade the militants in Iraq to give themselves up has had little effect so far. By the start of September around 2,000 people had applied to benefit from the new law, but almost 90% of these were already in prison in Turkey. Only a handful had actually come in from Iraq, where the KADEK leadership evidently still exercises tight control over its followers.

Parliament enacts another Since coming to power, the AKP has injected a real sense of urgency into political reform package Turkey’s efforts to bring its laws into line with the democratic standards demanded by the EU. On July 19th the “Sixth Harmonisation Package”, which was passed by parliament on June 19th, came into effect (July 2003, page 16). Parliament followed this up on July 30th by passing a “Seventh Harmonisation Package”. The most crucial amendments were those affecting the MGK. The MGK has been strongly criticised for giving the military wide political power, affecting issues other than national security (July 2003, pages 14-15). The main provisions of the reform package were as follows. • The laws governing the powers and functions of the MGK and its Secretariat Council were amended to restrict the decisions that the Council could take to those regarding the “national security policy of the state”, and stated that these decisions could only be “advisory” for the government. The frequency of regular meetings of the MGK was reduced from once a month to

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once every two months. The secretary-general of the MGK, who plays a pivotal role, would be appointed by the president on the recommendation of the prime minister, and could be a civilian, rather than a military officer, as previously provided. • Article 159 of the Penal Code, which governs supposed “insults” to state authorities, was amended to provide that those who “express ideas purely for the purposes of criticism, without indulging in insult, derision or vituperation” would not be punished. • An article was added to the Law on Criminal Procedures, to provide that complaints of torture or malpractice by the police must be followed up by judicial hearings within 30 days.

The reforms are generally Soon after the Seventh Harmonisation Package was passed by parliament, welcomed by EU leaders Günter Verheugen, the EU Commissioner in charge of enlargement, called Mr Gul personally with his congratulations, while reminding him that the EU would need to see that the reforms are properly implemented before deciding whether accession negotiations could begin in December 2004 (July 2003, pages 19-20). Praise for the reforms also came from Greece, Britain and Italy, which holds the six-month rotating presidency of the EU until December 2003. A crucial encounter for Mr Erdogan was his visit to Berlin on September 3rd, when the German chancellor, Gerhard Schroeder, characterised the reforms as “a very important contribution on the road to the EU”, and expressed full support for Turkey’s bid for EU membership. A very different note was, however, struck by Angela Merkel, the leader of the opposition Christian Democratic Union/Christian Social Union group in parliament, which has opposed Turkish accession to the EU, on the grounds that a Muslim country cannot be classified as “European”. On this occasion, Ms Merkel claimed that the reason for this attitude was actually the economic costs to the EU of accepting Turkish accession. Meanwhile, the government has set up a special Reform Monitoring Group, composed of the ministers of foreign affairs, justice and the interior, to ensure the implementation of the new legislation, with Mr Gul claiming that Turkey will have met the EU’s Copenhagen criteria by the end of 2004, and aims for accession by 2010.

Important changes are made at The apparent reduction of the political power of the military was a crucial the top of the armed forces (and, for some, contentious) issue since many senior commanders have been suspicious of the AKP government, which they see as opposed to secularist and modernist principles (July 2003, pages 14-15). On August 4th a meeting was held of the High Military Council, which in August of each year makes new appointments at the top of the armed forces to replace those retiring. The government made one concession to the military viewpoint, when it forewent its power to appoint a civilian as secretary-general of the MGK, by nominating General Sukru Sariisik to the post for one year, in place of General Tuncer Kilinc, with effect from August 30th. Simultaneously, General Cetin Dogan was replaced as Commander of the 1st Army by General Yasar Buyukanit. The changes were significant, since General Kilinc had strongly criticised political liberalisation reforms, especially on the Kurdish issue (July 2003, page 16) and

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used the final days of his period in office to attack the reduction of the powers of the MGK contained in the latest Harmonisation Package. General Dogan also seized the chance of his imminent departure to denounce the idea of sending Turkish troops to Iraq. It thus appeared that two powerful military opponents of government policies had been removed. Evidently, General Ozkok, as the top commander, approved of the change: as he put it on August 28th, “we should get rid of those who merely copy the past, and march on the spot”.

Mr Sezer vetoes constitutional On July 24th parliament passed amendments to the constitution, reducing the change to sell state land minimum age at which candidates could be elected to parliament from 30 to 25, and allowing the government to sell off land officially classified as forest (all of which is counted as belonging to the state), but which is actually deforested or unproductive scrub. The government claimed that it could realise as much as US$25bn for the state coffers from such sales, although critics put the likely returns as much less than this. The proposal was strongly attacked by environmentalists and the opposition Republican People’s Party (CHP), and returned to parliament by Mr Sezer. Following some changes, the amendments were again passed by parliament on July 29th, this time by 368 votes, or just over the two-thirds majority by which they could take effect without resort to a referendum. However, on August 15th, after parliament had dispersed for its summer break, the Mr Sezer again exercised his right to return the amendment to parliament, on the grounds that it would “encourage the total annihilation of forests”. The government immediately promised to re-submit the amendment to parliament unchanged, after it re-assembles on 1st October. Under Article 175 of the constitution, the president can return a constitutional amendment passed by parliament for reconsideration. If it is passed again in exactly the same form by more than two-thirds of the total number of deputies (that is, 367 or more votes) he can either promulgate it, or call a referendum on the issue. Although no president has done this since the present constitution came into force in 1982, it is thought likely that if parliament re-passes the amendment with a two-thirds majority, then Mr Sezer will break with precedent by demanding a referendum. The outcome is hard to predict. An opinion poll carried out by the AKP in August found that 54% of the public approved of the president’s stand, but this proportion could alter once a referendum campaign (if there is one) builds up.

Mr Sezer also objects to Another dispute between the president and the government has emerged over changes to the education law education policy. Education is an important and contentious issue for the government, partly because Turkey lags well behind other OECD countries in educational expenditure and the proportion of pupils staying on to high school, and partly because the AKP would like to boost Islamic education. It also favours allowing female students to wear Islamic headscarves in class. The latter is hotly opposed by the military and secularist opinion in general, but can be viewed as a human right rather than just as part of the Islamist political agenda. Disputes over education came to a head on August 14th when Mr Sezer returned to parliament a bill that would allow up to 10,000 pupils from poor families to attend private schools at state expense. His reasons were that there is no provision in the constitution to allow this, that it was the duty of the state to

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provide good education for all pupils in state schools, and that it would increase a “mentality that will not be in line with the characteristics of a secular and democratic Turkish Republic”. On the last score, it was claimed that most of the schools that would benefit would be those run by private Islamic foundations. Parliament can be expected to reconsider the bill after it reassembles on October 1st, and the AKP may use its huge majority to approve it again unchanged. In this case, the president could still submit it for adjudication by the constitutional court. However, the issue is less problematic than the proposed sale of forest land in the sense that it involves an ordinary statute rather than a change to the constitution. Hence, it cannot be submitted to a referendum.

Dehap ruling increases At the end of September Turkeyrs highest court of appeal upheld charges of uncertainty electoral fraud against the Democratic Peoplers Party (Dehap). The ruling implies that Dehap, which is dominated by Kurdish interests, contested last Novemberrs general election illegally, and that its votes should instead have gone to other parties. Dehap attracted more than 2m votes, equivalent to 6.23% of the total. However, it was revealed before voting began that the party had used fake documents to meet electoral requirements, and last June a local court handed down jail sentences to four Dehap officials over the affair. The appeals court upheld that ruling, effectively confirming that Dehap was not eligible to contest the election. Although Dehap failed to reach the 10% share of the votes required to gain parliamentary seats, its participation in the election had a significant impact on the outcome. Most significantly, it is highly likely that the centre-right True Path Party (DYP), which polled 9.5% of the vote in November, would have surpassed the 10% threshold. Judging by its showing in November, the DYP would have secured between 40 and 50 seats in the 550-seat parliament had Dehap not taken part, reducing the share of seats of the only two parties to enter parliament, the CHP in opposition and the ruling AKP. Now if either a political party or a citizen entitled to vote appeals to the Supreme Electoral Board (YSK) to ask that the election results be cancelled, the YSK may decide on one of four courses of action. • Reject the application altogether, in which case nothing changes. • Leave it to the parliament to decide whether or not to re-run the elections, which it would almost certainly decide not to do. • Cancel the votes obtained by Dehap. In this case the remaining votes would be redistributed: DYP would gain 40-50 seats at the expense of both the AKP and the CHP. If this happened, then the AKP might well decide to call early elections anyway (they would merely have to pass a bill through parliament to achieve this). • Cancel the election results as a whole, in which case new elections would be inevitable (they could be timed for the same day as the local elections next March/April). The AKP and CHP want to avoid this, although the AKP would probably increase majority.

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The YSK has in the past ordered the re-run of an election in a single province, but not the whole election, so it is hard to know what it will decide. The most likely outcome seems to be either the first or second option, but until a decision is reached the uncertainty surrounding the case will hang over the government.

Economic policy

The IMF releases credit in The IMF Executive Board completed the “fifth review” of the February 2002 August, after a delay standby accord on August 1st, when it approved the release of a US$476m credit tranche. The completion of the fifth review had been delayed by several weeks and came only after a late-July rush on the part of the government to meet IMF preconditions. In an attempt to allay concerns over the prospects for meeting the central IMF-agreed fiscal target of a public-sector primary budget surplus of 6.5% of GNP, the government agreed to introduce additional fiscal measures, including continued blocking of certain budget allocations and price increases for the products of the public tobacco and alcoholic drinks enterprise, Tekel. In addition, parliament approved reform laws concerning bankruptcy procedures and the management of the social security administrations. The social security laws contain clauses that offer employers and self-employed people in arrears with premium payments a fresh opportunity to pay. However, unlike the earlier “tax peace” scheme, this does not amount to an amnesty, as penalties and a rate of interest linked to Treasury borrowing costs will be payable. The government has now promised the IMF that it will offer no amnesties for any kind of public receivables. The government has pledged to the IMF that in October it will introduce separate legislation regarding “pre-packaged bankruptcy”, which was excluded from the new bankruptcy code. In the meantime, the IMF has appeared upbeat about Turkey’s economic performance and the government’s progress with reforms under the agreement.

Future IMF reviews and policy As a result of the delay in the fifth review, a new timetable has been set for actions are rescheduled subsequent reviews and hence for the release of the remaining credit instalments under the three-year standby accord. The “sixth review”, which was due to be completed in August, is now scheduled for October. In parallel with this, the government has been allowed extra time in which to fulfil various pledges. Passage of the long-awaited Public Financial Management and Control law, which has been approved by the Council of Ministers, is due in October. Further direct tax reform, expected to address incentives and exemptions, is to be prepared in October and approved by parliament in November. Passage of legislation on state enterprise governance is now scheduled for December. The government also expects the process of reducing staff numbers at state enterprises with the help of voluntary retirement to accelerate. As of the end of June, the cumulative figure for staff reductions since the end of January was some 2,500 lower than the target of 9,900. By the end of the year, the figure is to reach 25,000.

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Revised schedule for IMF reviews Amount of credit Earliest possible release Review no. (SDRs) Previous New 6 340.2 Aug 15th 2003 Oct 20th 2003 7 340.2 Nov 5th 2003 Jan 15th 2004 8 340.2 Feb 5th 2004 Apr 15th 2004 9 340.2 May 5th 2004 Jul 15th 2004 10 340.2 Aug 5th 2004 Oct 15th 2004 11 340.2 Nov 5th 2004 Dec 15th 2004

Source: Adapted from Letter of Intent from the Turkish government to the IMF, dated July 25th,2003.

A new timetable is agreed for Along with the completion of the fifth review and the release of the credit repayments of IMF credit tranche, the IMF granted, at Turkey’s request, what effectively amounts to a one-year extension to some of Turkey’s IMF debt repayments in 2004 by moving part of the repurchases due under the expectations basis schedule from 2004-05 to 2005-06. The rephasing spreads the bulk of Turkey’s repayments to the IMF more evenly over three years (2004-06) than was envisaged under either of the existing IMF schedules (see table), thereby easing concerns about the government’s ability to meet its financing requirements in 2004 and 2005. However, IMF debt repayments are still high in 2006, at US$10.7bn. According to the Treasury the 2006 situation is not as bad as it appears, because it can request that repurchases due in 2006 under the earlier “expectations” schedule be made under the “obligations” schedule, effectively pushing them back a year. The same applies to the repayments due in 2007-08. Making these adjustments in the final part of the schedule would result in the repayment plan given in the final line of the table.

Turkey’s repayment schedules US$ bn 2003 2004 2005 2006 2007 2008 2009 Expectations basis a 2.6 9.7 10.1 3.6 1.8 0.8 0.0 Obligations basis b 1.6 2.7 9.2 10.0 3.6 1.8 0.8 New “hybrid” schedule approved by IMF board on August 1st 2.6 5.2 7.8 10.7 1.8 0.8 0.0 Alternative future repayment plan 2.6 5.2 7.8 7.3 3.6 1.8 0.8 a This schedule presents all scheduled payments to the IMF, including repayment expectations and repayment obligations. The IMF Executive Board can extend repayment expectations (within predetermined limits) upon request by the debtor country if its external payments position is not strong enough to meet the expectations without undue hardship or risk. b The obligations basis schedule presents all payments to the IMF under the assumption that repayment expectations would be extended to their respective obligation dates by the IMF Executive Board upon request of the debtor country. Source: Under-secretariat of the Treasury; IMF.

Agreement on US loan On September 22nd Turkey and the US finally reached agreement on loans is reached worth US$8.5bn, following protracted negotiations. The US originally offered Turkey the aid shortly after the start of the Iraq war in March as compensation for the negative impact of the conflict on the Turkish economy. The loans, which the Turkish government has committed itself to use to service Turkey’s external and domestic debts (and not to finance additional government spending) are expected to contribute to a much-needed reduction in Turkey’s borrowing costsreal interest rates on domestic Turkish lira government

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securities are still over 20% and interest payments in January-August were the equivalent of almost 70% of total revenue in that period. The agreement states that the loans will have a ten-year maturity with a four-year grace period for repayment of principal and will be disbursed in four equal tranches over a period of about 18 months. The agreement specifies that disbursement of the loans, the timing of which will be decided by the Turkish Treasury depending on its financing needs, will be decided on two conditions: first, implementation by the Turkish government of “strong economic policies”; and second, continued Turkish co-operation with the US in Iraq. By this, the agreement explicitly states that the contribution of troops for peacekeeping and stability operations in Iraq is not a condition.

Consolidated central government budget (TL trn) 2001 % of 2002 % of 2003 % of 2002 2003 Outturn GNP Outturn GNP Target GNP Jan-Aug Jan-Aug Total revenue 51,543 29.2 75,592 27.6 100,782 28.4 48,749 63,648 Tax revenue 39,736 22.5 59,632 21.8 85,955 24.2 36,481 53,292 Direct taxes 16,081 9.1 20,077 7.3 28,444 8.0 12,695 17,998 Indirect taxes 23,655 13.4 39,554 14.5 57,511 16.2 23,785 35,294 Other revenue 11,807 6.7 15,960 5.8 14,827 4.2 12,268 10,356 Income from state property 4,491 2.5 3,514 1.3 5,085 1.4 2,258 2,904 Funds 2,933 1.7 1,961 0.7 3,557 1.0 1,103 1,537 Total expenditure 80,579 45.7 115,682 42.3 145,949 41.2 70,392 92,091 Interest payments 41,062 23.3 51,871 19.0 65,450 18.5 34,559 43,968 On domestic borrowing 37,494 21.2 46,807 17.1 58,050 16.4 31,439 39,772 On foreign borrowing 3,568 2.0 5,064 1.9 7,400 2.1 3,120 4,196 Non-interest expenditure 39,517 22.4 63,812 23.3 80,499 22.7 35,833 48,123 Personnel 15,212 8.6 23,089 8.4 28,036 7.9 14,474 19,443 Other current expenditure 5,236 3.0 8,019 2.9 9,280 2.6 3,348 3,485 Investment 4,150 2.4 6,892 2.5 7,999 2.3 2,870 2,598 Tax rebates 2,918 1.7 5,666 2.1 6,762 1.9 3,301 5,529 Social security 5,112 2.9 11,205 4.1 14,923 4.2 7,225 10,986 Agricultural support 1,033 0.6 1,868 0.7 2,545 0.7 1,104 1,918 Funds 1,480 0.8 234 0.1 200 0.1 70 155 Primary budget balance 12,026 6.8 11,781 4.3 20,283 5.7 12,916 15,525 Budget balance -29,036 -16.5 -40,090 -14.7 -45,167 -12.7 -21,643 -28,443 Memorandum item GNP 176,484 100.0 273,463 100.0 354,575 100.0

Source: Ministry of Finance, General Directorate of Public Accounts.

Further action may be needed The consolidated budget, which covers most public-sector revenue and to achieve 2003 fiscal target expenditure, produced a primary surplus (net of interest payments) of TL15,525trn (about US$11bn) in the first eight months of 2003, compared with a government target of TL20,283trn (or 5.7% of projected GNP) for the year as a whole. Total revenue amounted to TL63,648trn (about 63% of the target for the year) and non-interest expenditure TL48,123trn (almost 60% of the full-year target). However, since expenditure tends to increase faster than revenue towards the end of the year, additional corrective measures are deemed necessary. Accordingly, the IMF is expected to call for additional measures (over and above those already taken in July) during the next review of the standby accord in October. In September the minister of finance indicated that a

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supplementary budget would be introduced in October when parliament reconvenes after the summer recess. Meanwhile, preparations have also begun for the 2004 budget, which is due to be presented to parliament on October 17th.

So far in 2003 tax revenue has been relatively robust, aided by the economic recovery and by revenue of TL1,400trn from the first three instalments of the “tax peace” scheme (July 2003, page 25). Consequently, uncertainty regarding the government’s ability to meet its year-end targets stems mainly from higher than expected expenditure in some areas. Personnel costs (see also Employment, wages and prices) rose by 34.3% year on year in the first eight months of 2003, compared with an average increase in consumer price inflation of about 28%. Social security transfers, tax rebates (consisting mainly of value-added tax rebates to exporters) and agricultural support payments rose by 52%, 67% and 74% respectively in the same period. The government has admitted that while its tax amnesty has raised somewhat more revenue than the IMF expected, it has also had the effect of increasing applications for tax rebates. Investment spending and “other current expenditure” (which mainly relates to the armed forces) continued to be kept to a minimum in the middle months of the year, but it is unclear how long these cuts (or delays) can be sustained. Interest payments amounted to TL43,968trn in January-August27.2% higher than in the same period of 2002, and roughly in line with the target. As a result, the overall budget deficit (including interest payments) was TL28,443trn, compared with a year-end target of TL45,167trn, or 12.7% of projected GNP. The key fiscal target under the standby accord with the IMF is a primary budget surplus for the broader public sector of 6.5% of GNP with a surplus of 0.8% of GNP expected to come from extra-budgetary institutionsprimarily state enterprises. Although only limited information is available, these institutions appear to be on course to generate more than the required surplus.

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The Imar Bank liquidation At the beginning of July, just as it appeared that the banking regulator, the may prove costly Banking Regulation and Supervision Agency (BRSA), had identified all of Turkey’s weak private-sector banks and placed them under the management of the Savings Deposit Insurance Fund (SDIF), the BRSA ordered the takeover of Imar Bank. Imar Bank, owned by the controversial Uzan family, had reportedly faced a loss of deposits in the wake of the governmentrs decision to revoke the operating licences of the two electricity companies of the Uzan group in June. Unlike all the other troubled banks seized from their owners in recent years, the BRSA decided to liquidate Imar Bank straight away. Bona fide deposit and repo account holders are to be reimbursed in full under the state deposit insurance guarantee scheme, although interest will be calculated at typical market rates, and not at the notoriously high rates offered by Imar Bank. Other savers and creditors may have to await the liquidation process before they will know how much, if any, of their money they will recover. The reimbursement of Imar Bankrs customers has been delayed because, the authorities say, the bankrs records are incomplete. The net liabilities of Imar Bank are reportedly far higher than initially expected, and may be in the vicinity of TL9,000 trn. This amount would easily exceed the resources of the SDIF, which is expected to seek support from the government. Only a part of the reimbursements is likely to be made in cash, with the remainder taking the form of bonds or time deposits. With the help of a special legal amendment, the authorities are pursuing the Uzans and other bank directors and officials vigorously. The BRSA, which was established in 2000 as part of the overhaul of Turkey’s banking sector, faces criticism for not taking action earlier.

Tenders for sale of major state After stalling in 2002 as a result of poor market conditions and political enterprises are delayed instability that led to the November general election, privatisation has made slow progress in 2003. Although in recent months there has been an improvement in market conditions and the government appears to have adopted a more determined approach because of the need to reduce the burgeoning public debt burden, major obstacles remain. Tenders are due to be held in the concluding months of this year for four major state enterprises with dominant market positions. However, in late September the government announced that the closing date for bids for the oil refiner, Tupras, was to be pushed back, for a second time, from October 2nd to October 24th. The previous closing date was September 18th. The reason given for the latest delay was to allow parliament time to pass a new petrol market law, which would allow Tupras to enter the retail fuel market, thereby boosting its value to potential buyers. The closing date for bids for the Tekel alcohol and cigarette businesses has also been postponed, from September 26th until October 24th. According to the minister of finance, Kemal Unakitan, the delay will allow the large number of interested parties, including major multinationals, more time to complete their evaluations. A fresh tender has been announced for the petrochemicals plant, Petkim, with bids due on November 18th. An earlier tender for Petkim was won by a company belonging to the Uzan group with a bid of US$605m in June. However, the tender was cancelled when the winning bidder was unable to pay. The government and IMF are targeting cash proceeds of US$2.1bn by the end of the year. This target is unlikely to be reached.

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Preparations are also continuing for possible privatisations in other sectors in 2004. The government failed to adopt a satisfactory privatisation plan for Turk Telekom by the end of June, but has promised the IMF that it will do so by the end of October. This plan is expected to clarify responsibility for decisions on timing and method. Legislation approved by parliament in June provides for the issue of a convertible bond as part of the Turk Telekom privatisation process. The same legislation makes various other arrangements to facilitate privatisation, and provides for the privatisation of the national lottery. Meanwhile, the government formally included a large number of electricity distribution and generation assets in the privatisation portfolio, and an advisor is reportedly to be appointed by the end of the year to privatise the regional distribution networks. In June the government belatedly kept a pledge to the IMF by adopting a privatisation plan for the sugar refineries, which are to be sold off in groups. In July a law was approved to facilitate Treasury land sales. Plans to privatise the third-largest state bank, Vakifbank, are being reconsidered following successive failures. Consultants have been appointed for the privatisation of Halkbank, the second largest of the three main state banks. Separately, the banking authorities received two bids for Pamukbank on July 31st. Pamukbank was seized from its private-sector owner in mid-2002 when it became insolvent and has since been run by the Deposit Insurance Guarantee Fund (TMSF).

The public procurements law Parliament approved amendments to the Public Tenders Act at the end of July. is amended Many features of the system of public procurements that was established in 2002 with the support of the international financial institutions in order to ensure transparency and fair play have been retained, while clauses discriminating in favour of local companies have been softened. At the same time, however, other restrictions have been eased and a range of exemptions have been made. Ministers and bureaucrats had frequently complained that the new procedures, which came into force at the beginning of this year, were excessively stringent and cumbersome. Julyrs amendments also reduce the income of the independent supervisory body, the Public Tenders Authority. State enterprises in the energy, water, transport and telecommunications sectors have been excluded from the scope of the law altogether, but this provision will only take effect once new alternative legislation has been adopted.

Rising domestic debt pushes The central government debt stock, which accounts for almost all of Turkey’s up government debt stock public-sector debt (the rest amounted to about 2% of GNP at end 2002), has continued to rise since 2001 when it surged mainly as a result of the bail-out of the banking sector. At the end of July 2003 central government debt was equivalent to US$185.4bn at the end of July, compared with US$148.5bn at the end of 2002 and US$123.6bn at the end of 2001, although as a percentage of GDP it declined sharply in 2002 to 85% from about 100% as nominal GDP growth outpaced the increase in the debt stock. The sharp rise in the central government debt stock in dollar terms is mainly the result of an increase in domestic debt, since external government debt (see Foreign trade and payments) has remained more or less stable, despite IMF credit more than doubling since the end of 2001. Since last year, the Treasury has generally been

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in a position to borrow smaller amounts from the domestic debt market each month than it is due to repay in principal and interest. This situation, which facilitates the roll-over of the debt and relieves pressure for higher yields, is the result of the primary budget surplus and of net foreign borrowing. Nevertheless, in view of the high cost of interest, the domestic debt stock continues to increase. As of the end of July, the domestic debt stock stood at TL179,230trn, compared with TL162,558trn at the end of March.

Central government debt (US$ bn; year-end unless otherwise indicated) 2001 2002 2003 Year 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr Jul Debt by lender: Domestic market 28.8 34.8 35.4 38.1 43.3 46.4 62.6 65.4 Public sector 46.4 49.4 40.6 41.2 42.5 43.0 54.1 54.1 Foreign market 26.0 26.8 28.0 27.9 29.4 29.8 31.6 31.0 Bond issues 20.1 20.9 22.0 21.8 23.1 23.7 25.7 25.1 Other 5.8 5.8 5.9 6.1 6.3 6.1 5.9 5.9 International institutions 12.3 12.1 12.8 13.2 13.4 13.4 13.4 13.4 IMF credit 10.0 15.3 16.2 19.4 19.9 19.7 21.6 21.5 Total central government debt 123.6 138.3 133.0 139.8 148.5 152.3 183.3 185.4 Domestic debt n/a n/a n/a n/a 91.7 95.2 123.3 126.1 External debt n/a n/a n/a n/a 56.8 57.1 60.0 59.3 Debt by currency: US$ n/a n/a n/a n/a 22.8 23.7 24.7 24.6 ¥ n/a n/a n/a n/a 4.4 4.1 3.8 3.8 € n/a n/a n/a n/a 14.9 14.7 15.8 15.2 SDR n/a n/a n/a n/a 13.9 14.0 15.0 14.9 Other n/a n/a n/a n/a 0.7 0.7 0.7 0.7

Source: Turkish Treasury.

As of the end of July, 67% of the domestic debt was in the form of cash debt that is, securities issued in the market in return for cash lending. The remainder of the debt was non-cash debt, mainly issued by the Treasury in the past to support troubled state and private banks. The share of non-cash debt in the total is gradually declining as no new non-cash debt is being issued. Partly related to this, the share of public-sector lenders in the domestic debt is also falling. The share of these lenders in the total domestic debt stock fell below 50% in May and reached 48% as of the end of July. Public-sector lenders include the Central Bank of Turkey, state banks, the Savings Deposit Insurance Fund (which is responsible for troubled banks) and other state enterprises. Some of these organisations hold normal tradeable Treasury securities purchased at auctions as well as non-cash debt. Private lenders are primarily banks. However, according to Central Bank data, which is based on market value, non- bank lenders have come to hold over TL60,000trn worth of government securities in recent months, compared with under TL40,000trn at the end of last year. Individuals account for over half of this amount, institutions for close to 30%, investment funds for about 15% and non-residents for under 5%. Since most fresh borrowing has been conducted through the issue of fixed-rate lira- denominated securities, the share of such instruments in the total domestic debt stock has increased from about one-quarter to over one-third since the

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beginning of the year. Over 65% of total domestic debt, including all of the non- cash debt, still takes the form of foreign currency-denominated/indexed debt, which has eased debt servicing costs while the lira has been strong, but increases vulnerability to a sharp exchange-rate correction.

Domestic debt (TL trn unless otherwise indicated) 2000 2001 2002 2003 Year Year Year 1 Qtr 2 Qtr Jul Borrowing 32,469 209,613 125,303 33,461 49,571 13,281 Debt service 37,577 164,361 141,059 34,774 54,438 13,792 Principal 18,968 123,877 97,591 20,973 26,859 9,322 Interest 18,609 40,484 43,469 14,001 17,579 4,471 Total domestic debt stock (end-period) 36,421 122,157 149,870 162,558 175,270 179,230 Average no. of months to maturity 15.5 38.9 32.1 29.0 28.0 27.1 Cash debt 29,423 58,354 89,271 101,450 116,664 120,540 Average no. of months to maturity 9.4 20.2 12.8 11.5 13.3 12.9 Non-cash debt 6,998 63,804 60,599 61,107 58,606 58,690 Average no. of months to maturity 41.4 55.9 60.4 58.0 57.3 56.2 By lender (end-period) Public sectora n/a 80,574 79,107 83,262 86,249 86,284 Markets n/a 41,584 70,763 79,296 89,021 92,946 By instrument (end-period) Fixed-rate TL n/a 17,745 37,576 44,723 57,265 61,112 Floating-rate TL n/a 60,938 64,118 67,940 71,190 71,362 Foreign exchange-denominated/indexed n/a 43,474 48,176 49,894 46,814 46,756 a Central bank, state banks, Savings Deposit Insurance Fund (SDIF) and other public institutions. Source: Under-secretariat of the Treasury.

The average maturity of the domestic debt stock has been declining slightly as a result of the increasing weight of cash debt, particularly Turkish lira- denominated instruments, which typically have relatively short maturities. As of the end of July, the average outstanding maturity of the domestic debt was 27.1 months, compared with 32.1 months at the end of 2002. For cash debt alone, the average maturity was 12.9 months, little changed from the end of 2002. The Treasury provisionally estimated the average real interest rate on the total domestic debt stock at 12.87% as of the end of July, up from 10.97% at the end of April, but down from 13.12% at the end of June. In addition to domestic borrowing and IMF credits, the Treasury has raised about US$4bn through the issue of bonds on international capital markets so far this year. The most recent issue, on June 18th, was a US$750m augmentation of a bond first issued in March 2002 with a maturity of six years. Boosted by these bond issues, the central government foreign debt stock reached US$60.24bn by the end of May, compared with US$56.8bn as of the end of 2002. However, the stock declined slightly to US$59.34bn by the end of July. This decline in June and July may reflect cross-rate effects (a stronger dollar against the euro since end-May reduces the dollar value of euro-denominated debt) as well as high debt repayments.

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Central Bank cuts interest rates The Central Bank has cut interest rates six times so far this year, and four times four times in July-September since the beginning of June. The latest interest rate move came on September 18th when the Central Bank reduced its overnight borrowing rate to 29%, compared with 44% at the beginning of 2003. The standard overnight lending rate came down to 35%, compared with 51% at the beginning of this year. Justifying the cuts, the Bank has pointed to improving inflation expectations as measured by its own surveys, the beneficial impact of the strong lira on cost inflation and to a “controlled” rise in domestic demand, which in its view does not appear to pose a major threat to inflation targets. In September the Bank added that it would continue to monitor demand pressures carefully. It repeatedly emphasised the importance of adherence to the IMF-agreed economic programme. No date has yet been fixed for the anticipated switch to a fully fledged system of inflation targeting. Most recently, the monetary authorities described a track record of fiscal discipline and an incomes policy directed towards meeting inflation objectives as “preconditions” for the switch. Meanwhile, IMF-agreed nominal monetary targets were met as of the end of June. Net international reserves of the Central Bank and the Treasury were -US$3.9bn, well above the agreed floor of -US$7bn. Base money was US$13bn, only just below the ceiling of US$13.2bn. Mr Unakitan stated on September 9th that the government and Central Bank were planning to renew the lira at the end of 2004. One new lira would be worth one million old liras.

Domestic borrowing rates Typical secondary market Treasury bond yields have fallen steadily in 2003. In tumble August they dipped to under 40%, the lowest level since November 2000. For most of June and July, yields had fluctuated between 47% and 50%, although they had backed up to 55% in early July amid heightened concern over relations with the IMF and the US. The decline in yields in August reflected the IMF credit release and the cuts in Central Bank rates as well as falling inflation. In accordance with these trends, the average cost of fresh lira-denominated borrowing fell from 46-47% in June and July to about 39% in August.

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As usual, most Treasury domestic borrowing in June, July and August took the form of Turkish lira-denominated discount bills. About TL700trn was also raised through a floating rate note issue in June. The average maturity of lira- denominated borrowing was put at 300 days in June, 262 days in July and 284 days in Augustlittle different from the preceding months. A small proportion of the Treasury borrowing in each month took the form of US dollar and (in August) euro-denominated issues. On July 8th the Treasury sold US$1.4bn worth of 15-month dollar paper at an annual yield of 6.2%, and on August 19th it sold about US$1bn worth of 18-month dollar paper at just 5%.

Yields on Treasury bills and government bonds at auction (%) 2001 2002 2003 Dec Nov Dec Jan Feb Mar Apr May Jun Jul Aug 6-month bill ratea 73.6 56.5 49.0 57.0 53.3 55.4 57.0 49.2 46.0 44.5 41.6 3-month bill rate 71.0 48.2 45.5 50.4 47.0 58.3 46.4 42.0 39.5 36.1 34.3 a Or nearest maturity, excluding three-month. Source: Under-secretariat of the Treasury.

The domestic economy

Output and demand

Gross domestic product (% real change, year on year; 1987 prices) 2000 2001 2002 2003 4 Qtr Year 4 Qtr Year 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year 1 Qtr 2 Qtr Jan-Jun Private consumption 5.6 6.2 -11.3 -9.2 -1.8 3.2 2.5 4.2 2.0 6.5 2.5 4.5 Public consumption 5.8 7.1 -8.9 -8.5 2.2 2.6 12.0 4.5 5.4 -3.0 -2.9 -2.9 Gross fixed investment 17.6 16.9 -38.6 -31.5 -28.8 -2.3 5.9 22.2 -0.8 9.3 5.5 7.1 Public sector 19.9 19.6 -18.8 -22.0 -18.1 3.0 29.8 22.7 14.5 -37.8 -11.3 -19.8 Machinery & equipment 18.6 20.3 -32.4 -39.0 -19.3 10.8 71.2 52.8 29.3 -42.3 22.8 -7.8 Building construction 55.4 31.6 -27.3 -20.0 -17.8 27.1 34.1 25.2 23.9 -38.0 -46.3 -44.5 Other construction -2.0 12.2 -0.8 -10.3 -16.8 -13.0 12.7 6.5 1.1 -31.9 -3.5 -11.3 Private sector 16.4 16.0 -50.0 -34.9 -30.9 -4.2 -3.7 21.8 -7.2 20.4 11.9 15.5 Machinery & equipment 33.0 37.2 -69.0 -49.6 -40.8 6.8 15.2 71.0 1.4 53.0 29.9 39.1 Buildings -8.6 -9.7 -8.5 -8.0 -15.1 -16.7 -16.3 -14.7 -15.8 -15.5 -14.4 -14.9 Exports of goods & services 13.7 19.2 6.4 7.4 10.4 5.0 15.8 12.3 11.0 14.5 12.5 13.4 Imports of goods & services 19.6 25.4 -26.0 -24.8 2.1 20.3 19.3 22.1 15.7 23.9 20.2 21.9 GDP by expenditurea 8.4 7.3 -10.3 -7.5 2.1 8.9 7.9 11.4 7.8 8.1 3.9 5.8 GNPb 7.8 6.3 -12.3 -9.5 0.4 10.4 7.9 11.5 7.8 8.1 3.9 5.4 a Including change in stocks and excluding statistical discrepancy. b Including net factor income from abroad. Source: State Institute of Statistics.

GDP rises by 5.8% in the first The recovery in economic activity that began in 2002 continued in the first half of half of 2003 2003. However, real GDP growth slowed from 8.1% year on year in the first quarter of the year to 3.9% in the second quarter, making for total year-on-year growth of 5.8% in the January-June period. Mainly to a baseline effect, last year, economic activity was noticeably stronger in the second quarter than in the first quarter. In addition, investment and consumer demand may have been restrained

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to some extent in the second quarter by the impact of the Iraq situation on investor and consumer confidence. There was a dip in tourist numbers in these months and agricultural output also contracted (see Sectoral trends). In the first half of 2003 stockbuilding has continued to play a major role, accounting for 11.1% of total expenditure in the first half of 2003. Compared with the same period of 2002, there were also significant real increases in private investment, which rose by 15.5%, including an increase of 39.1% in purchases of machinery and equipment, and private consumption, which increased by 4.5%, including a 15.8% increase in spending on durable goods and an 8.2% increase in spending on services. However, government consumption and investment spending declined by 2.9% and 19.8% respectively in real terms in the first six months of the year compared with the same period of 2002, under the impact of tight fiscal policy.

A strong lira and falling interest rates (See Financial indicators) may have boosted domestic demand in the third quarter of the year. The government is targeting 5% GNP growth for the year as a whole (this would imply a slightly higher rate of GDP growth). However, this will be difficult to achieve, especially if the stock-building cycle flattens.

Sectoral trends

National accounts by sector (% real change, year on year; 1987 prices) 2000 2001 2002 2003 4 Qtr Year 4 Qtr Year 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year 1 Qtr 2 Qtr Jan-Jun Agriculture 12.2 3.9 -13.2 -6.5 0.1 2.7 6.1 15.3 7.1 7.0 -2.8 0.6 Industry 5.5 6.0 -10.7 -7.5 2.8 12.6 10.5 11.4 9.4 7.8 4.4 6.0 Construction 5.9 4.4 -3.3 -5.5 -11.8 -9.6 -3.3 2.7 -4.9 -17.0 -14.5 -15.6 Tradea 12.0 12.0 -14.4 -9.4 4.3 11.7 10.1 16.1 10.7 10.8 6.0 8.1 Transport & communications 6.8 5.5 -4.1 -5.3 2.1 8.3 5.4 5.6 5.4 13.7 5.8 9.6 a Consists of wholesale and retail trade, and hotels and catering. Source: State Institute of Statistics.

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Industry and services have The breakdown of national accounts data by sector shows that output was grown rapidly strongest in industry and services in the first half of 2003, while agricultural output contracted and the construction sector continued its long-term decline. Industrial output increased by 6% year on year in real terms in the January-June period. For manufacturing industry, the growth rate reached 7% (9.2% in the first quarter followed by 5.1% in the second). Trade, made up of wholesale and retail trade and hotel and catering services, grew by 8.1% year on year in the same period. In the case of wholesale and retail trade, including trade in export products and imports, the growth rate was 9.7% (11.5% in the first quarter followed by 8.3% in the second). However, hotel and catering services shrank by 1.1% compared with the first six months of 2002. This was the result of a 6.2% decline in the second quarter, reflecting in part the dip in foreign visitors between March and May (see below).

Industrial output is up by 4.9% More details of the performance of industry are revealed by the quarterly in January-June industrial production index published by the State Institute of Statistics. The index rose by 6.8% year on year in the first half of 2003, but slowed in the second quarter compared with the first. For manufacturing industry, which is the main component of the index, the rise was 7.7%. Among the sub-sectors of manufacturing industry, output was particularly strong in the automotive industry (+40.3% year on year in the first half), in sectors producing industrial inputs such as miscellaneous machinery and equipment (+19.1%), main metals primarily iron and steel (+15.6%), and plastic and rubber goods (+18.1%), and in the food industry (+12.4%). The output of the clothing industry, fell by 5.5% year on year, possibly reflecting de-stocking and strong international competition. The monthly industrial production index, also published by the State Institute of Statistics, suggests that industrial production continued to rise in July. The monthly index, which is less comprehensive than the quarterly index, showed a year-on-year increase of 11.9% in July. Manufacturing output was up by 12.8%, utility output rose by 6.4%, and even the long-declining mining sector managed a year-on-year output increase of 4.7%. Among the major manufacturing sub- sectors, automotive output rose by 56.6% year on year, miscellaneous machinery output by 45% and food output by 34.5%, according to the index. However, textiles production was only 3.4% higher than in the same month of last year, and clothing output was down by 1.2%.

Industrial production, quarterly index (1997=100; % change year on year in brackets) 2001 2002 2003 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr Total 90.9 93.8 98.2 94.8 93.8 105.0 107.8 106.8 102.2 110.1 (-0.9) (-11.1) (-9.7) (-11.9) (3.2) (11.9) (9.8) (12.7) (9.0) (4.9) Manufacturing 88.5 92.4 96.0 92.7 91.5 105.1 107.1 106.3 100.9 110.8 (-0.4) (-12.4) (-10.6) (-12.9) (3.4) (13.7) (11.6) (14.7) (10.3) (5.4) Mining 83.6 91.8 97.8 85.0 82.4 80.4 86.7 79.1 71.6 68.3 (-2.0) (-3.4) (-8.8) (-16.7) (-1.4) (-12.4) (-11.3) (-6.9) (-13.1) (-15.0) Utilities 120.7 109.6 121.8 123.7 125.0 118.7 128.4 129.5 135 127.3 (-3.4) (-22.) (-1.7) (0.0) (3.6) (8.3) (5.4) (4.7) (8.0) (7.2)

Source: State Institute of Statistics.

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The automotive industry leads Output in the automotive sector has recorded a surge compared with 2002, the way partly because of the continuing recovery of the domestic market, which shrank dramatically following the financial crises of 2001-2002, and partly on account of strong export growth. Turkish plants, which include subsidiaries and joint ventures of Renault, Ford and Fiat, exported approximately 117,000 cars, 79,000 commercial road vehicles and 7,000 tractors in the first seven months of 2003. These figures represent increases of 22%, 87% and 184% respectively compared with the same period of 2002. In January-July total domestic sales of cars and commercial vehicles almost doubled year on year to 152,000. Road vehicle sales this year are clearly set to outstrip the figures recorded in 2001 and 2002 (just under 200,000). However, they will remain modest compared with the 1997-2000 period when the number of vehicles sold was more than 500,000 in 1997, more than 400,000 in each of 1998 and 1999, and nearly 660,000 in 2000. Moreover, imports accounted for 53% of total domestic vehicle sales in the January-July period, compared with 45% in the corresponding months of 2002. The stronger exchange rate may be partly responsible for the higher share of imports, which was as high as 66% in the case of cars.

The construction sector According to national accounts data, output in the construction sector fell by remains depressed 15.6% year on year in real terms in the first six months of 2003. The sector has been lagging the rest of the economy for many years, taking more time to recover from each crisis than other sectors. However, it recorded a rare positive year-on-year growth figure of 2.7% in the final quarter of 2002. The renewed deterioration so far this year is partly the result of further cuts in public investment spending. In addition, although private investment increased, investments were made in machinery rather than buildings. Confidence in future economic and political stability does not appear to have been strong enough to encourage long-term investments, with the Iraq crisis possibly playing a part in this. Construction statistics compiled by the State Institute of Statistics from local authority records indicate that the total volume of buildings completed in the first half of 2003 was 6.9% lower than in the same period of 2002, despite a 5.6% increase in housing completions. The total volume of planned new buildings for which construction licences were issued in this period rose, but only by 0.3%.

Estimates signal a relatively A strong harvest and a low baseline lifted often-sluggish annual agricultural poor year for agriculture output growth to 7% in 2002. However, agricultural output is expected to act as a brake on growth this year. According to the national income figures, agricultural output fell by 2.8% year on year in the second quarter after rising by 7% in the first. The first official crop estimates for 2003 were announced in the third week of August. The wheat crop is estimated at 19,000 tonnesthe same as in 2001 and 2.6% lower than in 2002. Estimated output of many other crops including barley, chickpeas, lentils, tobacco, sugar beet, cotton and sunflower seeds is also lower than last year, albeit higher than in 2001. A poor hazelnut crop is anticipated, and olive production, which follows a two-year cycle, is thought to be half last yearrs level. Three successive estimates are made each year for the output of most major crops, and the third estimate is taken as the

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final output figure. Agriculture accounts for about 12% of annual GDP, but its contribution rises to over 20% in the third quarter of the year when most crops are harvested.

Tourist arrivals rise in June- The number of foreign visitors arriving in Turkey in June, July and August 2003 August, after fall in March-May was higher than in the same months of 2002. At over 2.1 million, the number of visitors in July was the highest in any single month on record. In August, foreign visitor arrivals soared further to almost 2.3 milliona year-on-year increase of 19.1%. The strong performance in the summer months more than offset the 19% year-on-year decline in visitor numbers in the March-May period, when bookings were low because of security concerns over the war in Iraq, on Turkey’s south-eastern border. In the first eight months of this year cumulative tourist arrivals were 2.3% higher than last year. While almost 60% of Turkeyrs foreign visitors continue to come from the wealthier European countries, the number of visitors from the former Soviet countriespredominantly Russians has been growing. In July and August, Russia was Turkeyrs second-largest market, accounting for 450,000 visitors, or 10% of the total, compared with 22% for Germany, 9% for the UK and 7% for the Netherlands. Tourist numbers for the year as a whole are likely to be similar to the record 13.2m recorded in 2002. Concern persists, however, about the low level of spending per tourist.

Tourist arrivals (% of total in brackets) 2001 2002 2002 2003 Year Year %change Jan-Aug Jan-Aug % change OECD countries (Europe) 6,854,504 7,947,397 15.9 5,296,261 5,188,441 -2.0 (59.0) (60.0) (59.9) (57.4) OECD countries (non-Europe) 646,143 443,107 -31.4 276,626 262,006 -5.3 (5.6) (3.3) (3.1) (3.9) Other European countries 1,353,101 1,756,168 29.8 1,155,589 1,168,626 1.1 (11.6) (13.3) (13.1) (12.9) Commonwealth of Independent States (CIS) 1,431,190 1,661,767 16.1 1,147,803 1,392,837 21.3 (12.3) (12.5) (13.0) (15.4) Asia 1,074,877 1,203,394 12.0 803,749 879,438 9.4 (9.3) (9.1) (9.1) (9.7) Total incl others 11,619,909 2,123,678 14.0 8,837,011 9,036,597 2.3

Source: State Institute of Statistics.

Employment, wages and prices

Economic recovery fails to The number of people in employment rose in all sectors in the second quarter boost employment of 2003 compared with the first quarter of the year, according to the household labour survey conducted by the State Institute of Statistics. However, this mainly reflects a seasonal increase in jobs in agriculture and construction as the employment data are not adjusted for seasonal factors. Compared with the second quarter of 2002, the number in employment was estimated to have fallen by about 280,000, or 1.3%. The year-on-year decline in employment was 2.9% in agriculture, 4.5% in industry and 0.2% in construction, but employment in services rose by 1.5%.

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The overall year-on-year decline in employment was primarily the result of a sharp decline of about 500,000 in unpaid family labour between the second quarter of 2002 and the second quarter of 2003. As a result, the proportion of unpaid family workers to the total number of employed fell from 20.2% to 22.2%. Public-sector employmentwhich accounts for about 15% of total employmentwas estimated to have fallen by about 60,000, or 1.8%, between the first quarter of 2002 and the second quarter of 2003. The decline followed a sharp year-on-year increase in the first three months of this year.

Workforce and unemployment ('000 unless otherwise indicated) 2001 2002 2003 Year 2 Qtr 3 Qtr 4 Qtr Year 1 Qtr 2 Qtr Workforce 23,491 24,233 25,247 24,347 23,818 23,088 24,155 Workforce participation rate (%)a 49.8 50.6 52.4 50.3 49.6 47.5 49.4 Total no. in employmentb 21,524 21,975 22,833 21,658 21,354 20,244 21,696 Agriculture 8,089 7,961 8,709 7,618 7,458 6,639 7,731 Industry 3,774 3,976 3,996 3,953 3,954 3,769 3,798 Construction 1,110 1,008 1,118 913 958 676 1,006 Services 8,551 9,029 9,011 9,173 8,984 9,160 9,162 Unemployment rate (%)c 8.4 9.3 9.6 11.0 10.3 12.3 10.0 Underemployment rate (%)c 6.0 5.8 5.0 5.1 5.4 5.0 4.6 a Percentage of the population aged 15 or over in the workforce. b Including underemployed. c Percentage of workforce. Source: State Institute of Statistics.

The unemployment rate in the second quarter of 2003 was 10%, up from 9.3% in the same period a year earlier. A decline compared with the first quarter of 2003 reflects mainly seasonal factors. Indeed, the year-on-year rise in the second quarter would have been higher but for a decline in the workforce participation rate from 50.6% in the second quarter of 2002 to 49.4% in the same period of this year. Unemployment among women in the second quarter of 2003 was as high as unemployment among men. Urban unemployment was put at 13.2%, non-agricultural unemployment at 14.6% and unemployment among young educated people in urban areas at 28.1%. The share of the services sector in total employment rose to 42.2% in the second quarter of 2003, whereas agriculture and industry fell to 35.6% and 17.5% respectively. Construction was unchanged at 4.6% of total employment. Paid employment accounted for 49.8% of employmentup from 48.5% a year earlierwhile employers and the self-employed accounted for 30%up from 29.5%. The ratio of those considered “underemployed” (because they are not working full hours or do not consider themselves properly employed in their current occupations) to the total workforce declined from 5.8% in the second quarter of 2002 to 4.6% in the same period of 2003, extending a recent trend.

Real incomes get some The three-year decline in the real earnings of the formally employed has protection from low inflation decelerated as inflation has fallen. According to the hourly wages index for production workers in manufacturing, real wages fell by 0.5% year on year in the fourth quarter of 2002 and by 0.9% in the first quarter of 2003. The fall in real hourly wages in the first quarter was due to a 2.6% decline in real hourly wages in the public sector; in the private sector, real hourly wages rose by about

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1% year on year for the second quarter in succession. Nevertheless, earnings per person in the January-March period remained 5.5% lower than a year earlier, indicating that fewer hours are being worked.

Real hourly wages of production workers in manufacturing (% change, year on year) 2000 2001 2002 2003 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr Public sector 12.0 10.2 17.2 4.3 -12.5 -15.2 -21.0 -12.6 5.9 4.1 6.9 -2.6 Private sector -3.0 -3.8 2.1 -5.9 -15.6 -15.9 -20.1 -15.1 -3.3 -1.1 1.1 0.9 Total -0.7 -1.9 4.7 -4.1 -14.6 -15.8 -20.5 -15.9 -4.3 -2.7 -0.5 -0.9

Source: State Institute of Statistics.

Public-sector workers win a Wage moderation is a key element of the IMF-backed disinflation programme, modest rise but the government has been inconsistent in its adherence to it. In July the government and trades union representatives belatedly agreed a two-year pay deal for some 450,000 public-sector employees of worker status. Basic gross wages are to go up by an initial 5.5-9.2%, bringing the pay of the lowest-paid workers up to TL455m (US$325) per month. This is to be followed by pay increases of 9%, 5% and 5% at six-monthly intervals. The pay rises envisaged for the last two six-month periods may be increased if inflation surpasses 5%. Social benefits have also been increased. The pay deal, which was more generous than the IMF would have liked, was due at the beginning of 2003, but actual payment of overdue increments has been put off until 2004.

Public servants await Over two million public servants received a mid-year pay increase averaging arbitration outcome about 9%higher than the 7% previously budgeted for. This follows Januaryrs rise of 5%, which added up to 6.5-13.7% when increases in various allowances are included. In its dealings with both public-sector workers and public servants, the Justice and Development Party government has shown a preference for staggered pay rises, which favour the lowest paid, and for increases in family-related benefits. The right of public-service trade unions to engage in pay bargaining has been recognised, but they do not have the right to strike. However, the first pay negotiations produced no agreement on a pay increase for 2004, or on compensation for real loss of earnings in 2003 so the dispute was put to an arbitration committee. The government has offered a rise of 6% at the beginning of 2004 and a mid-year rise of 6%, in line with the 2004 inflation target of 12%. It has also proposed an initial increment of TL160m per month to make up for real loss of earnings in 2003. The arbitration committee has suggested rises of 10% and 8%, plus TL200m per month. However, its proposals are not binding on the government.

Inflation dips further with the The downward trend in inflation, which was interrupted in the early months help of the strong lira of the year, resumed in the middle of the year, assisted by a strengthening lira and a marked seasonal decline in agricultural prices. The wholesale price index (WPI) recorded four consecutive month-on-month falls in May-August, reflecting the impact of the rising lira on the price of imported goods. In June- July, the consumer price index (CPI) also declined month on month. As a result, in August the year-on-year rate of increase was 22.7% for wholesale prices and 24.9% for consumer prices. These are the lowest levels since 1982.

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The domestic crude oil price declined by 22.4% between April and July before rising by 7.8% in August. Wholesale prices of several other heavily imported or internationally traded commodities such as metals, chemicals and communications equipment also declined in this period. These developments are directly related to the strong currency. In general, however, wholesale prices in private manufacturing industryregarded as “core inflation” because they are the least sensitive to seasonal factors or political decisionscontinued to rise, albeit by well under 1% a month. Wholesale prices in agriculture declined by 14.9% between April and August, but on a year-on-year basis they have risen by a relatively steep 36.8%. Successive price rises, initiated in the public sector, pushed up the price of cigarettes by over 20% over the summer months. The consumer price index was also adversely affected by a summer acceleration of housing rents and by Augustrs school fee increases. Further seasonal price rises for education-related expenditures, clothes and food are likely to lead to higher monthly inflation figures from September onwards. Rising consumer demand may also make inflation more difficult to control. Nevertheless, unless the lira depreciates significantly before November, we expect the rate of consumer price inflation will be close to the IMF-agreed year-end target of 20%.

Inflation: consumer and wholesale prices (% change, year on year; % change month on month in brackets) 2002 2003 Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Consumer prices 37.0 33.4 31.8 29.7 26.4 27.0 29.4 29.5 30.7 29.8 27.3 24.9 (3.5) (3.3) (2.9) (1.6) (2.6) (2.3) (3.1) (2.1) (1.6) (-0.2) (-0.4) (0.2) Wholesale prices 40.9 36.1 32.8 30.8 32.6 33.4 35.2 35.1 33.7 29.6 25.6 22.7 (3.1) (3.1) (1.6) (2.6) (5.6) (3.1) (3.2) (0.8) (-0.6) (-1.9) (-0.5) (-0.2)

Source: State Institute of Statistics. Financial indicators

Better IMF and US ties boost After rallying in the wake of the Iraq war, the main Istanbul Stock Exchange share prices (ISE) index fluctuated between 10,000 and 11,000 points in June and July. The index broke through the 11,000-point mark at the beginning of August in the wake of the release of the IMF credit tranche and the rescheduling of some of Tu rkeyrs repayments to the IMF. The market then traded mainly in the 11,500- 12,000 range, before rising above 12,000 points in the second week of September, as agreement on a US bilateral loan came closer. On September 11th the index recorded its highest close of the year at 12,507 points. The average daily volume of transactions picked up to US$320m in August from the very low level of US$186m recorded in July. Net purchases of shares by foreign institutions and individuals increased noticeably to US$174m in the month of August, according to ISE data. In dollar terms, share prices retreated slightly in June and July after rising sharply in the preceding months, when a stock exchange rally coincided with a marked recovery in the lira. In August, however, the ISE dollar-based index rose again. As of the end of August, share prices were higher in dollar terms than at the end of any month since December 2002and 50% higher than at the end of March.

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Turkish lira strength continues Following the remarkable rally of the Turkish lira in April and May, the currency has remained stable at around TL1,400,00:US$1 as demand for the currency has persisted. The Central Bank of Turkey has continued to hold regular foreign-exchange purchasing auctions and despite the floating exchange rate regime, the Central Bank intervened directly in the currency markets again on July 18th and September 10th, purchasing foreign exchange in order to “curb excess volatility”. In real termsthat is allowing for inflation differentialsthe value of the lira continued to edge upwards in the summer months. In August the Central Bankrs CPI-based real exchange rate index (1995=100) reached 147.1 points. This was its second-highest level ever: in December 2000 and January 2001, the two months before the 2001 devaluation, the index stood at 147.6 and 148.1 points respectively. Despite the current-account deficit (See Foreign trade and payments), the lira is being supported by the decline in inflation, attractive Turkish lira interest rates and low international interest rates. However, concerns persist about a possible sharp correction in the lirars value within the next few months, particularly in the event of any further hesitation in the implementation of IMF-agreed economic policies.

Exchange rates (TL'000 per currency unit unless otherwise indicated; end-period; Central Bank buying rates) 2000 2001 2002 2003 Dec Dec Dec Jan Feb Mar Apr May Jun Jul Aug US$ 671.8 1446.6 1,639.7 1,635.5 1,588.6 1,700.1 1,567.3 1,419.8 1,407.6 1,411.8 1,392.8 € 618.6 1281.3 1,718.9 1,769.6 1,712.2 1,850.4 1,743.4 1,680.6 1,609.5 1,598.6 1,519.5 Real exchange ratea 147.6 116.3 125.4 119.2 122.7 123.5 127.5 135.4 140.6 145.0 147.1 a Trade-weighted; 1995=100; CPI-based. Provisional data for December 2002-January 2003. Source: Central Bank of Turkey.

Credit rises as interest rates fall Interest rates have continued to fall in line with Central Bank interest rate cuts (see Economic policy), the fall in inflation and recent financial market confidence. One-month and one-year Turkish lira interbank (TRLibor) rates, which hovered at just over 40% and around 50% respectively in June and the first half of July, had come down to 33% and 39% by the second week of

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September. Three-month deposit rates offered by major banks ranged between 31% and 35% in early Septemberfive percentage points lower than in June. Banks have also been cutting their consumer credit rates; in some cases these have come down to little over 3% per month. In these circumstances, bank credit has been expanding. Domestic bank loans rose by 22% in the first eight months of 2003, compared with a cumulative rise in consumer price inflation of 11.9% in the same period. Most of the expansion came in the first quarter and in July-August. Consumer credit led the way. The outstanding volume of consumer creditincluding both bank loans and use of credit cardsrose by over 50% in the first eight months of the year to TL10,600trn (about US$7.6bn). The total value of bank deposits in lira terms rose by only about 1% in the first eight months of 2003well below the rate of inflation. This was because foreign-currency deposits remained stagnant, and therefore declined in local currency terms in line with the rising lira. In contrast, there was a 19% increase in lira deposits. As a result, total Turkish lira deposits have exceeded total foreign-currency deposits since July. Meanwhile, other forms of savings have grown. Apart from the rise in share prices, the resident non-banking sector (including investment funds) increased its holdings of government debt instruments by 57% to TL59,000trn at market value, in the year to August.

Selected financial indicators (TL trn unless otherwise indicated; end-period; % change quarter on quarter/month on month in brackets) 2001 2002 2003 1 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr July Aug Money supply M1 (currency & sight deposits) 8,190 11,073 11,486 12,871 13,707 14,259 14,622 16,869 18,472 18379 (-0.2) (5.9) (3.7) (12.1) (6.5) (4.0) (2.5) (15.4) (9.5) (-0.5) Deposits and repos TL bank deposits 36,813 45,035 47,334 49,691 52,166 56,481 58,850 63,309 66,341 67489 (19.1) (14.7) (5.1) (5.0) (5.0) (8.3) (4.2) (7.6) (4.8) (1.7) Foreign-currency bank deposits 34,705 58,732 54,777 65,865 71,823 74,537 71,770 64,742 64,983 64315 (36.8) (-3.4) (-6.7) (20.2) (9.2) (3.8) (-3.7) (-9.8) (0.4) (-1.0) Customer repos (banks & brokers) 3,868 2,798 3,690 3,707 3,391 2,763 3,925 2,440 2,628 2657 (-35.3) (-30.7) (31.9) (0.5) (-8.5) (-18.5) (42.1) (-37.8) (7.7) (1.1) Credits Banking system credit volume 34,351 39,049 37,748 38,391 38,546 39,469 45,949 45,711 46,879 47629 (13.1) (-5.6) (-3.3) (1.7) (0.4) (2.4) (16.4) (-0.5) (2.6) (1.6) Domestic loans of deposit money banksa 28,032 31,249 30,911 30,610 30,318 31,845 36,559 37,077 38,242 38975 (9.1) (-3.3) (-1.1) (-1.0) (-1.0) (5.0) (14.8) (1.4) (3.1) (1.9) Consumer credits & credit cards 5,965 4,768 4,627 5,408 5,992 7,001 7,897 9,237 9,656 10599 (-10.9) (-6.2) (-3.0) (16.9) (10.8) (16.8) (12.8) (17.0) (4.5) (9.8) Past due loans (PDL) 4,037 6,421 6,845 8,204 9,639 10,122 9,393 9,342 9,308 9207 (29.3) (-23.5) (6.6) (19.9) (17.5) (5.0) (-7.2) (-0,5) (-0.4) (-1.1) PDL as % of banking system credit volume 11.8 16.4 18.1 21.3 24.8 25.6 20.4 20.4 19.9 19.3 a Excluding loans to the financial sector. Source: Central Bank of Turkey.

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Foreign trade and payments

Trade deficit widens as import In the first half of 2003 the dollar value of exports rose by 32.1% year on year growth strengthens and imports by 34.4%. Exports totalled US$21.7bn and imports US$30.6bn, resulting in a formal trade deficit of US$8.9bn, some US$2.6bn higher than in the first six months of 2002.

Foreign trade (US$ m unless otherwise indicated; customs basis; excl "suitcase" trade) 2001 2002 2002 2003 Year % change Year % change Jan-Jun Jan-Jun % change Total exports fob 31,334 12.8 35,753 14.1 16,423 21,698 32.1 Capital goods 2,630 22.9 2,723 3.5 1,264 2,034 60.9 Intermediate goods 13,403 15.8 14,478 8.0 6,970 8,954 28.5 Consumption goods 15,253 8.9 18,402 20.6 8,172 10,589 29.6 Total imports cif 41,399 –24.0 51,203 23.7 22,796 30,628 34.4 Capital goods 6,964 –38.6 8,431 21.1 3,498 4,469 27.8 Intermediate goods 29,971 –16.1 37,173 24.0 16,985 22,901 34.8 Consumption goods 4,084 –43.4 4,989 22.2 2,172 3,071 41.4 Trade balance –10,065 –62.3 -15,450 53.5 -6,373 -8,930 40.1

Source: State Institute of Statistics.

From just US$4.4bn in January and US$4.1bn in February the monthly value of imports settled at US$5.3bn-5.7bn in March-June. Imports of consumer goods, including cars, increased by 41.4% year on year in the first half of 2003. Even so, consumer goods imports still accounted for only 10% of imports. 75% of merchandise imports were made up of intermediate goodsmainly inputs for Turkish industryand 15% of capital goods. Lower crude oil price in March- May helped to check the rise in the import bill. However, prices have risen for some non-oil imports, headed by steel, and oil prices have also moved higher since May. Germany, Italy, Russia, France and the US remained Turkeyrs leading suppliers, accounting for 39% of the total value of imports. However, imports from the US rose in value by just 9.7% compared with the first half of 2002. In contrast, imports from the UK increased by 68.5% to take a 5.2% market share, imports from Switzerland rose by 46.8% to take a 4.5% market share and imports from China expanded by 78% to take a 3.4% market share.

Exports continue to rise, but Exports have also continued to rise, increasing from an average value of just lira strength may curb growth under US$3.5bn a month in the first quarter to a monthly average of almost US$3.8bn in the second quarter. There were significant year-on-year increases in exports of a wide range of industrial products, including textiles and clothing, Tu rkeyrs single largest export. However, the most important increases came in automotive vehicles and parts (up by 69% compared with the first half of 2002, to US$2.4bn), iron and steel (up by 61.4% to US$1.6bn) and boilers, machinery and mechanical equipment (up by 40.4% to US$1.3bn). In the first half of 2003 the EU accounted for 52.3% of Turkeyrs exports in dollar terms, compared with 50.6% in the same period of 2003. This increase may reflect the relative strength of the euro (the appreciation of the lira was more

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marked against the dollar than the euro). Within the EU, sales to Spain and Holland rose faster than sales to the traditional, but depressed, markets of G e r ma ny, Ita ly, Fra n ce o r to no n- e u ro B r i ta i n . Tu rkey rs exports to the US increased by only 13.3% year on year in the first half of 2003, while exports to Russia fell by 8.8%. Iranian exports to Turkey rose by 91.9% mainly because of gas sales. Like Spain and Japan, Iran claimed a 2.7% share of the total value of Turkey’s exports. The surge in exports appears to have continued in the summer months. Figures from the Exportersr Assembly (TIM) suggest that exports rose by 34.2% and 29.1% respectively year on year in July and August. There is nevertheless some concern that the strong lira may have begun to hurt exports, at least in some sectors, particularly textiles and clothing.

Current account (US$m) 2000 2001 2002 2003 Year 2 Qtr 3 Qtr 4 Qtr Year 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year 1 Qtr 2 Qtr Total exports of goods 30,721 8,777 8,431 9,101 34,373 8,831 9,444 10,354 11,189 39,818 11,153 12,257 “Suitcase” trade 2,946 714 772 787 3,039 919 933 1,090 1,123 4,065 757 954 Total imports of goods -53,131 -9,303 -9,741 -9,742 -38,916 -9,736 -11,689 -12,649 -14,056 -48,130 -13,418 -15,444 Foreign trade balance -22,410 -526 -1,310 -641 -4,543 -905 -2,245 -2,295 -2,867 -8,132 -2,265 -3,187 Services income: credit 20,364 4,158 5,469 3,130 16,030 2,242 3,746 5,393 3,400 14,781 2,501 3,626 Travel income 7,636 2,365 3,555 1,433 8,090 896 2,087 3,813 1,685 8481 803 1,862 Services income: debit -8,996 -1,807 -2,014 -1,437 -6,900 -1,539 -2,049 -1,820 -1,489 -6,897 -1,699 -1,837 Services balance 11,368 2,351 3,455 1,693 9,130 703 1,697 3,573 1,911 7,884 802 1,789 Investments income: credit 2,836 695 570 639 2,753 610 674 515 690 2,489 600 611 Interest 1,168 321 247 247 1,139 248 186 137 213 784 134 238 Investments income: debit -6,838 -2,125 -1,610 -1,978 -7,753 -1,836 -1,689 -1,590 -1,923 -7,038 -2,112 -1,861 Interest -4,825 -1,473 -1,307 -1,312 -5,497 -1,059 -1,082 -1,116 -1,160 -4,417 -1,172 -1,108 Investments income balance -4,002 -1,430 -1,040 -1,339 -5,000 -1,226 -1,015 -1,075 -1,233 -4,549 -1,512 -1,250 Current transfers 5,225 860 863 927 3,803 846 772 864 1,014 3,496 780 842 Workers' remittances 4,560 612 611 649 2,786 477 505 539 415 1,936 440 537 Current-account balance -9,819 1,255 1,968 640 3,390 -582 -791 1,067 -1,175 -1,481 -2,195 -1,806

Source: Central Bank of Turkey.

The trade gap continues to The current-account deficit amounted to US$4bn in the first half of 2003, weaken the current account compared with under US$1.4bn in the same period of 2002, according to the latest provisional Central Bank of Turkey balance-of-payments data. The deficit was US$2.2bn in the first quarter of 2003which is the low season for tourism creditsand US$1.8bn in the second. The deterioration in the current-account balance is mainly the result of the widening merchandise trade deficit. In addition to the formal trade deficit described above, estimated revenue from the informal “suitcase trade” with the countries of the former Soviet Union were about US$140m, or 8%, lower than in the first half of 2002. However, these exportsconsisting of goods ostensibly carried on the persons of private citizens returning to their countries after visiting Turkeyappeared to be strengthening again in May and June. A second factor negatively affecting the current-account balance in the first half of 2003 was a year-on-year decline of US$320m, or 11%, in tourism credits. Tourism receipts fell by as much as 31%, 27% and 16% year on year respectively

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in March, April and May, as a result of low bookings because of the Iraq war, before increasing by 2% in June (See also Sectoral trends). Tourism spending by Turks travelling abroad was little changed, rising in the first quarter of the year compared with the same period of 2002, but declining in the second. Despite the fall in tourism revenue, the surplus on the services balance improved by 8% on a year-on-year basis in the first half of 2003, amounting to US$2.6bn. Lower expenditure on financial services and increased net revenue from transport serviceswhich was related to the growth of foreign tradewere among the main reasons for this improvement. The deficit on the investment income balance also increased to US$2.8bn in the first six months of 2003, compared with a deficit of US$2.2bn a year earlier. Outflows of earnings from portfolio investments in Turkey, particularly in February and June, were mainly responsible, along with net interest payments on Turkey’s debt. Meanwhile, workersr remittances, which account for the bulk of current transfers credit declined by US$37m year on year in the first quarter, but rose by US$32m in the second. A large trade deficit is also expected in the third quarter of 2003. However, a seasonal increase in tourism revenue is likely to have kept the current-account balance close to balance in this period. The current-account balance is expected to widen again in the final quarter of the year. In July the government further increased its forecast for the 2003 current-account deficit to US$7.4bn.

Capital account (US$ m) 2000 2001 2002 2003 Year Year 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year 1 Qtr 2 Qtr Current-account balance -9,819 3,390 -582 -791 1,067 -1,175 -1,481 -2,195 -1806 Direct investments (net) 112 2,769 95 311 236 220 862 4 22 Portfolio investments (net) 1,022 -4,515 -59 -735 -466 670 -590 -75 1087 Other investments (net) 11,801 -2,667 3,810 1,350 1,486 853 7,499 3,542 -1356 IMF credits 3,351 10,230 2,979 1,092 2,294 0 6,365 -175 483 Reserve assets (- indicates increase) -354 2,694 -1,700 -689 -2,815 -949 -6,153 661 -1194 Reserve position in Fund 0 0 0 0 0 0 0 0 0 Official reserves -354 2,694 -1,700 -689 -2,815 -949 -6,153 661 -1194 Capital & financial account 12,581 -1,719 2,146 237 -1,559 794 1,618 4,132 1441 Net errors & omissions -2,762 -1,671 -1,564 554 492 381 -137 -1,937 3247

Source: Central Bank of Turkey.

Government borrowing helps Net inflows of capital through the banking system played an important part in to fund current-account deficit financing the current-account deficit in the first quarter of 2003 (July, pages 43- 44). According to provisional Central Bank data, however, this trend did not continue in the second quarter. Net short-term credit usage by the banks declined by US$908m year on year in the second quarter after rising by US$855m in the first. Moreover, banks built up their reserves abroad by US$825m after reducing them by US$4bn in the January-March period. Instead, the second-quarter current-account deficit was financed with the help of government borrowing, notably the US$700m IMF credit released in April and a net inflow of US$1.4bn from government bond issues (included under “portfolio investments” in the table below). Direct investment remained

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minimal. These capital-account figures are likely significantly to be revised, given the high positive figure for net errors and omissions, which may be partly related to unrecorded cash transactions, but which also suggests that estimates made for various items may have been too low.

Foreign exchange reserves Official foreign-exchange reserves increased by US$1.2bn in the second quarter exceed US$30bn of 2003 after falling by US$661m in the first quarter. The Central Bank gross foreign-exchange reserves stood at US$28.5bn at the end of June. The Bank is known to have been able to build up its reserves further in the summer months through foreign-exchange buying auctions. The reserves reached almost US$30bn at the end of August and US$31.4bn as of September 12th.

Foreign-exchange and gold reserves (US$ m; end-period) 2000 2001 2002 2003 Dec Dec Dec Feb Mar Apr May Jun Jul Aug Central Bank gold 1,009 1,004 1,032 1,279 1,279 1,279 1,279 1,279 1,279 1,279 Central Bank forex 19,635 18,741 26,725 27,698 26,663 27,011 28,540 28,841 28,891 29,762 Commercial banks' forex 16,717 13,393 11,093 10,505 7,824 8,100 8,995 9,274 10,467 10,932 Total gross reserves 37,361 33,138 38,850 39,482 35,767 36,390 38,815 39,394 40,737 41,974

Source: Central Bank of Turkey.

The foreign debt stock rises The most recent comprehensive foreign-debt figures, including the debts of slightly other public-sector institutions and the private sector, date back to the end of March 2003. They put the total foreign-debt figure at US$133.2bnan increase of US$1.3bn compared with the end of 2002. Besides a rise in government debt stemming from bond issues, there was a notable increase in short-term commercial bank loans, which is consistent with a recovery in economic confidence, activity and trade. However, the greater part of the increase in the foreign debt between December and March was attributable to the weakness of the dollar against other major currencies. This caused an increase in the dollar value of that part of the foreign debtapproximately 53%which is denominated in other currencies. The same factors are likely to have increased Tu rkeyrs total foreign debt in dollar terms in the second quarter of 2003. Upward influences on the debt stock in the third quarter include the syndicated international bank loans totalling over US$1.5bn, which leading Turkish banks and conglomerates secured in July and early August, and the US$476m credit tranche which the government obtained from the IMF at the beginning of August. Increased borrowing is likely to be offset, at least in part, by a revaluation of the debt stock because of the recovery of the dollar against the euro since end-May.

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External debt stock (US$ m; end-period) 1997 1998 1999 2000 2001 2002 2003 Year Year Year Year Year Year 1 Qtr Short-term debt 17,691 20,774 22,921 28,301 16,241 15,192 16,708 Medium- & long-term debt 66,552 75,644 80,059 90,384 97,565 116,215 116,488 Total outstanding debt 84,243 96,418 102,980 118,685 113,806 131,407 133,196 By lender: Short-term debt Commercial banks 8,160 9,935 11,540 17,306 7,775 5,187 6,597 Private creditors 9,531 10,839 11,381 10,995 8,466 10,005 10,111 Medium- & long-term debt Official creditors 17,036 17,651 16,878 20,054 30,616 40,092 39,961 Bilateral lenders 8,995 9,697 9,128 8,669 8,552 9,193 9,084 Multilateral organisations 8,041 7,954 7,750 11,385 22,064 30,899 30,877 Private creditors 49,516 57,993 63,182 70,331 66,949 76,123 76,527 Private lenders 35,785 43,958 46,444 48,197 45,612 52,280 52,071 Bond issues 13,730 14,034 16,738 22,134 21,337 23,843 24,456 By borrower: Short-term debt General government 54 0 0 1,000 0 0 0 Central Bank of Turkey 889 905 686 653 590 451 444 Deposit money banks 8,503 11,159 13,172 16,900 7,997 6,344 7,808 Other sectors 8,245 8,710 9,063 9,748 7,654 8,397 8,456 Medium- & long-term debt Public sector 38,873 39,891 42,381 47,803 46,325 63,877 64,069 General governmenta 34,744 35,673 37,635 42,376 41,173 59,093 59,394 Other governmentb 937 686 863 1,192 1,116 988 949 State-owned enterprises 3,191 3,531 3,883 4,234 4,035 3,797 3,726 Central Bank of Turkey 10,868 12,073 10,312 13,429 23,753 21,544 21,971 Private sector 16,812 23,680 27,367 29,153 27,487 30,794 30,448 Financial institutions 5,535 6,879 7,482 7,581 4,788 4,714 4,617 Non-financial institutions 11,277 16,801 19,885 21,571 22,699 26,080 25,831 a Central and local government, universities and extra-budgetary funds. b Export-import Bank and Turkish Development Bank. Source: Under-secretariat of the Treasury.

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