Outward orientation and exchange rate policy in developing countries : the Turkish experience

World Bank Reprint Series: Number 266 Bela Balassa Outward Orientation and Exchange Rate Policy in Developinlg Countries The Turkish Experience Reprinted with permission from Thle Middle East Journal (Summer 1983), pp. 429447.  World Bank Reprints No. 239. J. Michael Finger, "Trade and the Structure of American Industry," Annals of the American Academy of Political and Social Science No. 240. David M.G. Newbery and Joseph E. Stiglitz, "Optimal Commodity Stock-piling Rules," Oxford Economic Papers No. 241. Bela Balassa, "Disequilibrium Analysis in Developing Economies: An Overview," World Development No. 242. T.N. Srinivasan, "General Equilibrium Theory, Project Evaluation, and Economic Development," The Theory and Experience of Economic Development No. 243. Emmanuel Jimenez, "The Value of Squatter Dwellings in Developing Countries," Economic Development and Cultural Change No. 244. 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Kemal Dervis, Jaime de Melo, and Sherman Robinson, "A General Equilibrium Analysis of Foreign Exchange Shortages in a Developing Economy," The Economic Journal No. 249. Kyu Sik Lee, "A Model of Intraurban Employment Location: An Application to Bogota, Colombia," Journal of Urban Economics No. 250. J. B. Knight and R. H. Sabot, "From Migrants to Proletarians: Employment Experience, Mobility, and Wages in Tanzania," Oxford Bulletin of Economics and Statistics No. 251. M. Louise Fox, "Income Distribution in Post-1964 Brazil: New Results," Journal of Economic History No. 252. Nizar Jetha, "The Welfare Cost of Taxation: Its Meaning and Measure- ment," Bulletin for International Fiscal Documentation No. 253. Larry E. Westphal, "Fostering Technological Mastery by Means of Selective Infant-Industry Protection," Trade, Stability, Technology, and Equity in Latin America No. 254. Gershon Feder, "On Exports and Economic Growth," Journal of Development Economics No. 255. Mohan Munasinghe, "Third World Energy Policies; Demand Manage- ment and Conservation," Energy Policy No. 256. Keith Marsden and Alan Roe, "The Political Economy of Foreign Aid: A World Bank Perspective," Labour and Society  OUTWARD ORIENTATION AND EXCHANGE RATE POLICY IN DEVELOPING COUNTRIES: THE TURKISH EXPERIENCE Bela Balassa This paper places the economic policies applied in Turkey in an international context, with a view to furthering our understanding of the changes that have occurred since January 1980. The paper will also consider possible future reform measures in Turkey, with attention given to short-term as well as to long-term objectives. The first section of the paper will examine the principal characteristics of inward-oriented policies and their economic effects; it will describe the policy content of reform efforts made by developing countries; and it will indicate the impact of outward-oriented policies on exports and economic growth. The second section will review the Turkish experience with inward orientation; it will briefly describe the 1980-81 reforms; and it will anatyze the economic effects of these reforms. In the third part, possible future reform measures for pursuing short-term and long-term objectives will be briefly discussed. Bela Balassa is Professor of Political Economy at the Johns Hopkins University and Consultant to the World Bank. He prepared this paper in a private capacity for the Third Conference on The Role of Exchange Rate Policy in Achieving the Outward Orientation of the Economy, organized by Meban Securities and held in Istanbul on August 6-7, 1982. The paper expresses the author's views alone and should not be interpreted to reflect the opinions of the World Bank. 429  POLICY REFORM IN DEVELOPING COUNTRIES' Policies of Inward-Orientation With the exception of Britain at the time of the Industrial Revolution and, more recently, Hong Kong, all present-day industrial and developing countries protected their incipient manufacturing industries producing for domestic market. This first stage of import substitution involved replacing the imports of ni ,n- durable consumer goods, such as clothing and shoes, and their inputs, stuch as textile fabrics and leather, by domestic production. It has also been called ;he "easy" stage of import substitution in view of the fact that the commodities in question suit the conditions existing in developing countries. Their manufacture involves largely the use of unskilled labor; the efficient scale of output is relatively low and costs do not rise substantially at lower output levels; production does not involve the use of sophisticated technology; and efficient operatiorns do not require the availability of a network of suppliers of parts, components, and accessories. In the course of first stage import substitution, the domestic production of industrial goods rises more rapidly than domestic demand, since it not only provides for increases in consumption but also replaces imports. The rate of growth of output declines to that of consumption, however, once the process of import substitution has been completed. Maintaining high industrial grow th rates upon the completion of the first stage of import substitution, then, necessitates moving to the second stage of import substitution, or embarking on the exportation of manufactured goods. The first of these alternatives was chosen in the postwar period in several Latin American and South Asian countries, with Turkey providing the principal example of such an inward-oriented development strategy in Southern Europe. Second stage import substitution involves the replacement of the imports of intermediate goods and producer and consumer durables by domestic production. These commodities have rather different characteristics from those replaced at the first stage. Intermediate goods, such as petrochemicals and steel, tend to be highly capital-intensive. They are also subject to important economies of scale, with efficient plant size being large compared to the domestic needs of most developing countries and costs rising rapidly at lower output levels. Moreover, the margin of 1. This section of the paper draws on the author's Graham Lecture, "The Process of Industrial Development and Alternative Development Strategies," published as Essay No. 141 in Essays in International Finance, International Finance Section, Department of Economics, Princeton Universi- ty, Princeton, N.J., December 1981 and as Essay 1 in Bela Balassa, The Newly-Industrializing Countries in the World Economy (New York: Pergamon Press, 1981). 430  processing is relatively snmall and organizational and technical inefficiencies may contribute to high costs. Producer durables, such as machinery and equipment, and consumer dura- bles, such as automobiles and refrigerators, are also subject to economies of scale. But in these industries economies of scale relate not so much to plant size as to horizontal specialization, involving reductions in product variety, and to vertical specialization through the manufacture of parts, components, and accessories on an efficient scale in separate plants. At the same time, the production of parts, components, and accessories has to be done to precision for consumer durables and, in particular, for machinery. This, in turn, requires the availability of skilled and technical labor and, to a greater or lesser extent, the application of sophisticated technology. Given the relative scarcity of physical and human capital in developing countries which completed the first stage of import substitution, they are at a disadvantage in the manufacture of highly physical, capital-intensive, intermedi- ate goods and skill-intensive producer and consumer durables. In limiting the scope for the exploitation of economies of scale, the relatively small size of their national markets also contributes to high domestic costs in these countries. Correspondingly, the establishment of these industries to serve na,-row domestic markets is predicated on high protection. In fact, rates of protection need to be raised as countries "travel up the staircase," represented by ratios of domestic to foreign costs, in embarking on the production of commodities that less and less conform to their comparative advantage. This will occur as goods produced at earlier stages have come to saturate domestic markets. High protection, in turn, limits domestic competition and discriminates against manufactured as well as primary exports and against primary activities in general. But, there is also discrimination within the manufacturing sector as protection rates tend to vary to a considerable extent in countries that embarked on second stage import substitution. High protection is generally associated with overvalued exchange rates, and there is a tendency in countries pursuing an inward-oriented development strategy to undertake devaluations only intermittently. With continuing inflation accompa- nied by periodic devaluations, then, real exchange rates (nominal exchange rates adjusted for changes in relative prices at home and abroad) fluctuate over time. Unforeseen changes in the domestic currency equivalent of foreign exchange receipts, in turn, create uncertainty for the exporter. Protection and fluctuations in real exchange rates are often associated with price control, aimed to keep the prices of consumer goods low and to limit variations in these prices. Price control of staple foodstuffs, however, engenders increases in the consumption of these commodities and discourages their produc- tion. In turn, price control of capital-intensive public utilities increases the 431  demand for capital, which is a scarce factor in developing countries, while adding to the deficit of the public sector. Countries engaged in second stage import substitution also tend to keep nominal interest rates below the rate of inflation. The resulting negative real interest rates contribute to the adoption of capital-intensive techniques and the establishment of capital-intensive industries; discourage domestic savings; lead to capital outflow; and necessitate the rationing of credit. Credit rationing, in turn, is often accompanied by the application of credit preferences that favor particular users at the expense of others. Second stage import substitution thus generally involves overvalued ex- change rates, with the extent of overvaluation varying over time; an anti-export bias; high and variable rates of industrial protection; price control of staple foodstuffs and public utilities; and negative real interest rates, accompanied by credit rationing and credit preferences. Apart from distorting the system of incentives, the measures applied have limited the role of market forces in countries pursuing such an inward-oriented development strategy. Historically, after initially favoring industrial expansion, the described char- acteristics of second stage import substitution have adversely affected exports and economic growth. Primary as well as manufactured exports have suffered as a result of the combination of high industrial protection, overvalued exchange rates, and variations in real exchange rates. In the primary sector, increases in domestic consumption at low prices have aggravated the impact of the reduced profitability of domestic production. With the ensuing decrease in the exportable surplus, developing countries engaging in second stage import substitution lost export market shares to developed countries, in particular the United States, Canada, and Australia, in products such as cereals, meat, oilseeds, and nonferrous metals. At the same time, the policies applied discouraged the development of manufac- tured exports. The balance-of-payments effects of reductions in export market shares were aggravated by the decline in net import savings, due to the increased need for imported materials, machinery, and technological know-how at the second stage of import substitution. Correspondingly, economic growth in countries pursuing an inward-oriented strategy was increasingly constrained by the limited availabil- ity of foreign exchange, and intermittent foreign exchange crises ensued as attempts were made to expand the economy at a rate exceeding that permitted by the growth of export earnings. Also, the savings constraint became increasingly binding as high cost, capital- intensive production at the second stage of import substitution raised capital- output ratios, requiring ever increasing savings ratios to maintain rates of economic growth at earlier levels. At the same time, negative real interest rates reduced the volume of available savings while credit preferences led to inefficien- cies in the allocation of capital. 432  The Turn Towards Outward Orientation The slowdown of economic growth that eventually resulted from the pursuit of an inward-oriented development strategy led to policy reform in several countries that had undertaken such a strategy. Policy reforms were carried out in the mid-1960s in Argentin-t, Brazil, and Colombia, around 1970 in Mexico, in the mid-1970s in Chile and Uruguay, and in 1980 in Turkey. The reforms generally involved establishing realistic exchange rates and subsequently maintaining real exchange rates constant, lessening the bias against exports, reducing the level and the variability of industrial protection, the liberalization of prices as well as increasing real interest rates and limiting the scope of credit preferences. Apart from reducing distortions in the system of incentives, these measures also gave greater scope for the operation of market forces. In the course of the reforms, the first step usually was to devalue the exchange rate to a considerable extent and to establish exchange rate flexibility. This took the form of a step-wise devaluation, followed by mini-devaluations based on changes in relative prices at home and abroad. The devaluation was accompanied by export subsidies to manufactured goods and, in some instances, to nontraditional primary exports that lessened the bias against such exports. Subsequently, imports were liberalized, entailing the gradual replacement of quantitative import restrictions by tariffs as well as the lowering of tariffs. In the process of import liberalization, the variability of rates of industrial protection was also reduced. Finally, the scope of price and interest rate controls was reduced, letting market equilibriumn be increasingly determined by demand and supply. Interest rate reform, in turn, obviated the need for credit rationing and the scope of credit preferences generally decreased. Measures of a similar character were taken earlier by countries that em- barked on an outward-oriented strategy once the first stage of import substitution had been completed. The countries in question include Denmark and Norway in the years immediately following the Second World War, Greece, Portugal, Spain and, with certain lImitations, Japan, in the mid-1950s, and Korea, Singapore and Taiwan in the early 1960s. In fact, outward-oriented economies have gone further in rationalizing their system of incentives and in providing scope to market foi ces than countries which undertook reforms only after having moved to the second stage of import substitution. Thus, in the three Far Eastern count:ies, a free trade regime has been applied to exports. Exporters are free to choose between domestic and imported inputs, they are exempted from indirect taxes on their output and inputs, and they pay no duty on imported inputs. The same privileges have been extended to the producers of domestic inputs used in export production. 433  The application of the described rules provides equal treatment to all exports. And while some additional export incentives have been granted in the three Far Eastern countries, these have not introduced much differentiation among their individual exports. At the same time, the incentives have ensured that, on the average, exports receive treatment similar to that of import substitution in the manufacturing sector. Furthermore, there is little discrimination against primary exports and against primary activities in general; incentives are on the whole provided automatically and the incentive system has undergone few modifications over time. By contrast, countries that earlier moved to the second stage of import substitution do not provide exporters with a free choice between domestic and imported inputs. REn2her, in order to safeguard existing industries, exporters are required to use domestic inputs produced under protection. In order to compen- sate exporters for the resulting excess cost, the countries in question have granted explicit export subsidies. These subsidies do not suffice, however, to provide producers with export incentives comparable to the protection of domestic markets. Thus, there continues to be a bias in ravor of import substitution and against exports, albeit at a reduced rate. The extent of discrimination is especially pronounced against traditional primary exports that do not receive export subsidies and, in some instances, continue to be subject to export taxes. Furthermore, with the share of value added in export value and the Protection of inputs used in export industries varying among industries, there is considerable variation in the ratio of export subsidies to value added in the countries in question. Despite the improvements made, rates of protection on sales in domestic markets also continue to vary. At the same time, rather than being automatic the incentives are often subject to discretionary decision-making. Finally, the three Far Eastern countries have gone further in ensuring realistic exchange rates and in establishing positive real interest rates than countries that earlier followed an inward-oriented development strategy. And, through the liberalization of prices, they have given greater scope to the operation of market forces. The Economic Effects of Alternative Development Strategies The economic effects of alternative development strategies are apparent in the periods preceding and following the quadrupling of oil prices. Countries applying outward-oriented development strategies had a superior record in terms of exports and economic growth; policy reforms aimed at greater outward orientation brought improvements in the economic performance of countries that had earlier applied inward-oriented policies, while countries that maintained an inward-oriented stance exhibited poor performance. 434  In the 1960-73 period, increases in manufactured exports were the most rapid in the three Far Eastern countries. As a result, the share of exports in manufac- tured output rose from I per cent in 1960 to 14 per cent in 1966 and to 42 per cent in 1973 in Korea; from 11 per cent to 20 per cent and, again, to 43 per cent in Singapore; and from 9 per cent to 19 per cent and, finally, to 50 per cent in Taiwan. Notwithstanding their poor natural resource endowment, the three Far Eastern countries also had the highest growth rates of primary exports, and hence of total exports, among countries at similar levels of development. In turn, following poor performance between 1960 and 1966, the growth of manufactured exports accelerated in the four Latin American countries that reformed their system of incentives in the mid-^960s. Thus, the share of exports in manufactured output rose from 1 per cent in 1966 to 4 per cent in 1973 in Argentina and in Brazil, with increases experienced also in Colombia and Mexico. Neverthe- less, this share remained much lower than in the Far East, and the countries in question experienced a continued erosioi in the world market shares of their traditional primary exports, although they made gains in nontraditional primary exports which received subsidies. Finally, India, Chile, and Uruguay, which continued with an inward-looking development strategy during the period, did poorly in primary as well as in manufactured exports and showed a decline in the share of exports in manufac- tured output between 1960 and 1973. India lost ground in textiles, its traditional export, and was slow to develop new manufactured exports. As a result, its share in the combined exports of manufactured goods of the ten countries under consideration declined from 69 per cent in 1960 to 12 per cent in 1973. In the same period, Chile's share fell from 4 per cent to 1 per cent, while in Uruguay it never reached one-fifth of one per cent of the total. Exporting involves resource allocation according to the comparative advan- tage; it permits the exploitation of economies of scale; it leads to increased capacity utilization; while exposure to foreign competition provides stimulus for improved operations as well as for technical change. Correspondingly, income increments were achieved at a lower cost in terms of investment in countries that consistently followed an outward-oriented strategy., In the 1960-73 period, incremental capital-output ratios were 1.8 in Singa- pore, 2.1 in Korea, and 2.4 in Taiwan. At the other extreme, these ratios were 5.5 in Chile, 5.7 in India, and 9.1 in Uruguay. The four Latin American countries that undertook policy reforms represent an intermediate group, with incremental capital-output ratios declining after the institution of policy reforms. In Brazil, where the rate of capacity utilization increased to a considerable extent, the ratio fell from 3.8 in 1960-66 to 2.1 in 1966-73. Outward orientation also appears to have been associated with higher domestic savings ratios. Lower capital-output ratios and higher savings ratios, in turn, ease the savings constraint to economic growth in developing countries. 435  Export expansion also eases the foreign exchange constraint, thereby permitting increased imports of materials and machinery. A case in point is Brazil where the ratio of imports to the gross national product rose from 6.1 per cent in 1966 to 1 1.1 per cent in 1973. The operation of these factors gave rise to a positive correlation between exports and economic growth in the 1960-73 period. The three Far Eastern countries had the highest GNP growth rates throughout the period; the four Latin American countries that undertook policy reforms improved their growth per- formance to a considerable extent after the reforms were instituted; while India, Chile, and Uruguay remained at the bottom of the growth league. Some observers suggested, however, that the high share of exports in the gross national product associated with outward orientation increases the vulnera- bility of countries applying such a strategy to external shocks. Thus, predictions were made that countries following an outward-oriented strategy would fare poorly in the event that the world economic environment deteriorated. The experience of the period following the quadrupling of oil prices in 1973- 74 and the world recession in 1974-75 does not support this proposition. While the balance-of-payments effects of external shocks represented a larger proportion of GNP in countries following outward-oriented, than in those pursuing inward- oriented, policies, the superior growth performance of outward-oriented econo- mies compensated for this loss several times over. Apart from differences in the efficiency of resource allocation, the differential performance of countries applying alternative strategies in the period of external shocks may be explained by differences in the "compressibility" of imports and in the flexibility of their national economies. While outward orientation is associated with high export and import shares that permit reductions in nonessential imports without serious adverse effects on the functioning of the economy, continued inward orientation often involves limiting imports to an unavoidable minimum, so that any further reduction will have a considerable cost in terms of economic growth. Also, the greater flexibility of the national economies of countries pursuing an outward-oriented strategy, where firms learn to live with foreign competition, makes it possible to change the product composition of exports in response to changes in world market conditions whereas inward orientation entails establishing a more rigid economic structure. In addition to the three Far Eastern economies that continued to pursue an outward-oriented strategy, these conclusions apply to Chile and Uruguay, which responded to the deterioration of their terms of trade and the slowdown in the growth of foreign demand for their export products by reforming the system of incentives. The reforms involved adopting realistic exchange rates, reducing the bias against exports, eliminating quantitative import restrictions, abolishing price control, and adopting positive real interest rates. In Uruguay, which had a stagnant economy in the previous decade, the policy 436  reforms led to rapid increases in exports and in the gross national product, with per capita GNP rising by 3.1 per cent a year between 1973 and 1976 and by 4.3 per cent a year between 1976 and 1979. Following a period of dislocation due to the application of a severe deflationary policy aggravated by rapid reductions in tariffs, the growth of exports and GNP accelerated also in Chile. By contrast, several countries, including Brazil, increased the inwardc orientation of their economies, with adverse effects on exports and on economic growth. Thus, while growth rates of per capita GDP increased from 5.3 per cent in 1963-73 to 6.6 per cent in 1973-79 in outward-oriented economies, a decline from 4.9 per cent to 2.3 per cent occurred in inward-oriented economies. The data refer to the group of newly-industrialized countries to which Turk- y belongs. THE TURKISH EXPERIENCE WITH ALTERNATIVE DEVELOPMENT STRA TEGIES2 The Period of Inward Orientation Several reform efforts notwithstanding, Turkey maintained an inward-orient- ed stance during the 1960-1973 period. While this policy permitted attaining relatively high rates of economic growth for a time, increases in per capita incomes were substantially lower than in the other Southern European countries (3.9 per cent a year, compared to 6.8 per cent in Greece and Portugal and 5.7 per cent in Spain, between 1960 and 1973'. The differences are even larger if adjustment is made for the overestimation of the rate of economic growth associated with high protection in Turkey. Turkey continued with inward orientation following the external shocks of the quadrupling of oil prices and the world recession while attempting to maintain its rate of economic growth. This proved temporary, however, as the policies applied aggravated the adverse balance-of-payments effects of external shocks by giving rise to reductions in export market shares and increases in import shares. Under the policies applied, the deterioration of Turkish economic perform- ance continued after 1973. This is indicated by increases in incremental capital- output ratios (ICOR) that reflect the efficiency of using additional resources. With the rising cost of import substitution, the economy-wide ICOR estimated from official data increased from 2.3 in 1963-67 to 2.6 in 1968-72 and, again, to 3.8 in 1973-77. The increase was larger in the manufacturing sector, where inefficient 2. The Turkish experience with inward orientation was examined in Bela Balassa, "Growth Policies and the Exchange Rate in Turkey," in Thie Role of Exchange Rate Policy in Achieving the Outward Orientation of the Turkish Economy, Proceedings of a Conference held in Istanbul in July 1979 and in "The Policy Experience of Newly Industrializing Economies After 1973 and the Case of Turkey" presented at the Second Conference on the same subject, held in Istanbul in July 1981. The latter paper also considered the preliminary results of the 1980-81 reforms. 437  import substitution was concentrated, from 1.6 in 1963-67 to 2.4 in 1968-72 and, finally to 4.7 in 1973-77. Nevertheless, for a time, Turkey was able to avoid a decline in the rate of economic growth by raising the share of gross fixed investment in GDP. This share increased from 16.0 per cent in 1963-76 to 18.0 per cent in 1968-72 and, again, to 22.9 per cent in 1973-77. The rise in investment, in turn, was made possible in large part by the inflow of funds from abroad, first in the form of workers' remittances and, subsequently, through foreign loans. Workers' remittances increased from negligible amounts in 1966 to 5.6 per cent of GNP in 1973, and recorded and unrecorded remittances combined may have reached 6 per cent of GNP in 1977. In turn, the ratio of the net capital inflow to GNP, that was -2.8 per cent in 1973, approached 7 per cent in 1977. In the latter year, workers' remittances and the capital inflow combined were more than double the value of merchandise exports in Turkey. As a result of increased foreign borrowing, the ratio of debt service (amortization and interest charges) to merchandise exports rose from 13 per cent in 1973 to 33 per cent in 1977. At the same time, with the decline in export shares and increases in import shares, the Turkish economy did not generate the foreign exchange earnings (savings) that would have permitted it to reduce foreign indebtedness. By 1978, Turkey's borrowing possibilities were virtually exhausted and it became increasingly difficult to obtain the foreign exchange necessary to purchase the imports needed for the normal functioning of its industry. The situation deteriorated further in 1979, when the acceleration of inflation was only partially offset by increases in nominal interest rates, leading to an outflow of funds and reductions in workers' remittances. With increasing foreign exchange stringency, there were considerable shortages of energy, raw materials. and spare parts in Turkey. As a result, industrial production fell by 5.6 per cent in 1979 and the gross national product also declined. The 1980-81 Reforms It appears then that, rather than adjusting to the external shocks, the policies applied in Turkey after 1973 aggravated the situation. Employing the panoply of measures characteristic of inward-oriented economies, the policies applied includ- ed the overvaluation of the exchange rate, discrimination against exports, high and variable industrial protection, price control, as well as negative real interest rates. Taking as the base year 1973, before the effects of the oil price increase materialized and the world recession occurred, by the end of 1978 the Turkish lira appreciated in real terms by 22 per cent vis-a-vis the US dollar and by 13 per cent vis-a-vis the currencies of Turkey's major trading partners (measured as the 438  average of the results obtained by alternative wholesale price indices for Turkey). The appreciation of the real exchange rate reflected the fact that rapid inflation in Turkey was only partially offset by changes in the nominal exchange rate. Yet, the lira should have been devalued in real terms in order to compensate for the effects of the deterioration of the Turkish balance of payments resulting from external shocks. A substantial devaluation occurred in June 1979, but this was more than offset through rapid inflation in the remainder of the year. In the fourth quarter of 1979, the extent of appreciation of the real exchange rate was 30 per cent vis-a-vis the US dollar and 22 per cent vis-a-vis the currencies of Turkey's major trading partners, compared to its 1973 level. And while differential rates (47 instead of 35 lira to the US dollar) applied to manufactured exports, indirect tax rebate rates on these exports W'ere simultaneously reduced by 5 to 8 percentage points. In fact, the bias of the incentive system against manufactured exports increased in this period. With the same exchange rate applying to manufactured exports and imports, this occurred as export rebate rates were lowered while import protection was increased through the tightening of quantitative restrictions in response to intensified foreign exchange stringency. Industrial protection had been traditionally high in Turkey, with tariffs on manufactured goods in the 30-60 percent range, to which customs surcharges (15 per cent of customs duty), stamp duties (9-9.5 per cent of CIF import value) and pier duties (5 per cent of the CIF value of imports, customs duty and surcharges, and clearance expenses combined) were added. Furthermore, effective rates of protection on value added in the production process were often substantially higher than nominal rates as a number of imported inputs entered duty free. Finally, there were considerable variations in effective rates among industries and products. There was an even greater bias against primary exports. While manufactured exports benefited from indirect tax rebates that exceeded the taxes actually paid until June 1979, primary exports did not receive rebates. And after June 1979, the exchange rate applicable to primary exports was much lower than that for manufactured exports. . Turkish agriculture also suffered the disadvantages of price control, aimed at keeping consumer prices low, that was offset only in part by the low price of fertilizer. Price control extended to most products of the State Economic Enterprises (SEE's) resulting in considerable losses for those enterprises that were financed from the government budget. At the same time, the artificially low prices of energy added to Turkey's balance-of-payments difficulties by keeping demand for energy high. Also, with the acceleration of inflation, real interest rates became increasing- ly negative. In 1979, pre-tax interest rates were 15 per cent on one-year savings deposits while interest charges were 24 per cent on one-year nonpreferential 439  loans. With a rate of inflation of about 70 per cent, real interest rates were -32 per cent in the first case and -27 per cent in the second. The January 1980 policy changes aimed at redressing the situation and changing the development strategy Turkey followed in the previous decades. They combined stabilization measures, with the twin objectives of reducing the rate of inflation and improving the balance of payments, as well as reform measures, with a view to turning the Turkish economy in an outward direction and to giving an increased role to market forces. Stabilization objectives were pursued by reducing the rate of money creation. Both stabilization and reform objectives were served by a substantial devaluation, with the exchange rate set at 70 lira to the US dollar, that aimed at reducing the balance-of-payments 4ficit as well as improving the system of incentives. With subsequent changes in the exchange rate, by the third quarter of 1980 the lira depreciated in real terms by 5 per cent against the US dollar and by 15 per cent on the. average agains' the currencies of Turkey's major trading partners, compared to its 1973 level. The lira depreciated further vis-a-Vis the US dollar in subsequent months. However, with the rise of the US dcllar, it appreciated vis-a- vis the currencies of Turkey's major trading partners, with the real exchange rate approximately returning to its 1973 level in June 1981. The situation was subsequently remedied through the devaluation of the lira vis-a-vis European currencies and by reducing the excessive weight of the US dollar in the currency basket used in setting the exchange rates. Compared to its 1973 level, by May 1982 the Turkish lira depreciated in real terms by 27 per cent against the US dollar and by 13 per cent against the currencies of Turkey's major trading partners. Also, fluctuations in real exchange rates have been reduced. Furthermore, the bias against exports has been considerably reduced. In January 1980, the administrative procedures used in providing export incentives were streamlined and recipients of export licenses were given the right to import materials and intermediate products duty free; in July 1980, the preferential margin on interest rates charged on loans to exporters was increased; in January 1981, income tax exemptions were granted on new exports and on increases in exports, and export-oriented investments were given additional benefits; finally, in May 1981, indirect tax rebate rates were raised by five percentage points across-the-board and firms (mostly trading companies) whose exports exceeded $15 million a year received additional rebates. Import regulations were also streamlined in January 1980, reducing the waiting period for licenses and providing foreign exchange allocation automatical- ly once the licenses were granted. In January 1981, imports were liberalized to a considerable extent, involving the elimination of quotas as well as transfers from the restricted list to the free list. Subsequent measures of import liberalization, taken in January 1982, were of limited importance, however, and practically no change occurred in the system of tariffs. 440  Industrial prices were also liberalized in January 1980, with increases ranging up to 300 per cent for paper and 400 per cent for fertilizer, thereby reducing the deficit of the SEEs to a considerable extent. With few exceptions, the freedom of industrial prices has subsequently been maintained. The scope of central price determination has also been reduced in agriculture, and the prices of the remaining products subject to control have been annually adjusted. Interest rates were freed in July 1980. While a gentlemen's agreement among banks initially limited increases in the rates, over a twelve month period interest rates increased from 15 per cent to 50 per cent on one-year savings deposits and from 31 per cent to 49 per cent on one-year nonpreferential loans. However, the scope of preferential lending has undergone little change. The Economic Effects of the Policies Applied after January 1980 The reform measures thus included a substantial devaluation in real terms, reductions in the bias of the incentive system against exports, the (partial) liberalization of imports, the elimination of much of industrial price control, and the freeing of interest rates. These measures represent important steps towards outward orientation and increased scope for the operation of market forces in Turkey. In evaluating the economic effects of the policy measures applied, emphasis should be given to the simultaneous pursuit of stabilization and reform objectives in a situation characterized by economic disruptions and considerable distortions. This meant that the reforms had to be carried out in a deflationary environment and that reducing the existing large distortions necessarily involved dislocation. Also, political uncertainty and disruptions in production associated with declining labor discipline and increasing strike activity, retarded the economic effects of the reiorm measures until after the military takeover of September 1980. Thus, rarticular interest attaches to the results for the years 1981 and 1982. The dollar value of Turkish merchandise exports rose by 62 per cent in 1981, following a 1 per cent decline in 1979 and a 29 per cent increase in 1980, much of which occurred in the last months of the year. Increases were even larger for industrial exports, 119 per cent in 1981, raising their share in Turkey's merchan- dise exports from 36 per cent in 1980 to 49 per cent in 1981. Available data for the first four months of 1982 show continued rapid expansion in exports. Compared to the corresponding period in 1981, the dollar value of merchandise exports rose by 28 per cent and that of industrial exports by 67 per cent, with the share of the latter category reaching 53 per cent of the total. The rapid expansion of Turkish exports occurred in an inhospitable world environment. Part of the explanation for this favorable performance lies in the fact that Turkey increasingly exploited the market possibilities available in the Middle 441  East and North Africa. As a result, exports to this area reached 42 per cent of Turkish merchandise exports in 1981 compared to 22 per cent in 1980. But, Turkish exports to the OECD countries also rose to a considerable extent, with an increase of 35 per cent in 1981, following a 4 per cent decline in 1979 and a 16 per cent increase in 1980. The increase in 1981 should be set against the 5 per cent decline in the total imports of the OECD countries that occurred in the same year. And while OECD imports are projected to remain flat in 1982, Turkish exports are expected to rise by at least one-foilrth (all figures are in terms of current dollars). The rapid expansion of merchandise exports may be attributed to favorable exchange rates, the availability of export incentives, and the stability of the incentive system, although low capacity utilization associated with the stabiliza- tion policy also played a part. Favorable exchange rates and export incentives were the principal factors behind the rapid rise of construction activity in the Middle East, with the total ,"lue of contracts increasing from less than $3 billion at the end of 1979 to $12 billion two years later. In 1981, workers' remittances and repatriated profits from the Middle East approached $1 billion. The dollar value of merchandise imports rose by 13 per cent in 1981, following a 56 per cent increase in 1980 and virtual stagnation in the previous three years. These changes reversed the decline in the ratio of merchandise imports to the gross national product from 11-13 per cent in the years 1974-1977 to 8-9 per cent in 1978-1979; the ratio rose to 15 per cent in 1980 and to 16 per cent in 1981. In the same period, the ratio of merchandise exports to GNP doubled, reaching 8 per cent in 1981. Even larger increases occurred in the ratio of manufactured exports to manufacturing value added, from 5 per cent in 1979 to 16 per cent in 1981, while the export-import ratio in manufacturing rose from 20 per cent to 53 per cent. With increases in the price of fuels, accounting for one-half of Turkish imports, the volume of merchandising imports rose by 13 per cent in 1980. This increase occurred, notwithstanding the decline of GNP by 1.1 per cent, as stocks were replenished following the foreign exchange shortages of the previous two years. Apart from the stabilization measures applied, political uncertainty and disruptions in production in the first three quarters of the year contributed to the relatively low level of economic activity in 1980. Industrial production was particularly affected, with a fall of 5.9 per cent in industrial value added, following a decline of 5.6 per cent in 1979 that was occasioned by foreign exchange shortages. Led by a 74 per cent rise in the volume of the exports of goods and non-factor services, GNP grew by 4.3 per cent in 1981. In the same year, industrial production (value added) increased by 7.2 per cent. Projections for 1982 call for a 4.4 per cent rise in the gross national product and for a 6.1 per cent increase in 442  industrial production. As a result, industrial production would return to its 1978 level, although production for domestic use would remain below this level, given the increased share of exports in manufacturing output. While limiting the rate of economic expansion, the stabilization measures applied led to a substantial decline in the rate of inflation. According to the wholesale price index of the Ministry of Commerce, the annual rate of inflation peaked at 133 per cent in February 1980, when the liberalization of prices gave rise to a jump of 19 per cent in a single month; it subsequently declined to 35 per cent by the end of 1981 and to 24 per cent by June 1982. The latter figure, however, reportedly underestimates the rate of inflation, and the rise of the GDP deflator for 1982 has been revised from 25 per cent to 33 per cent. The principal instrument of stabilization policy has been the reduction in the rate of growth of the money supply, defined as the sum of banknotes, sight commercial deposits, sight savings deposits, and deposits with the Central Bank, from a peak of 60 per cent in 1980 to 23 per cent in December 1981 on a twelve- month basis. In turn, positive real interest rates on savings, reflecting the joint effects of higher nominal interest rates and lower rates of inflation, contributed to the rapid growth of time savings deposits and deposit certificates. With the consumer price index in Istanbul rising at an annual rate of 34 per cent, the 50 per cent interest rate on one-year savings deposits, adjusted for a 25 per cent withholding tax, represents a real interest rate of 3 per cent compared to the strongly negative real interest rates of earlier years. Correspondingly, time savings deposits and deposit certificates combined doubled between December 1979 and 1980 and tripled in the following twelve months. Including these forms of financial savings in a broader definition of the money supply, the growth rate of this aggregate was 67 per cent and 61 per cent in the two periods, respectively. At the same time, the share of the financing requirements of the public sector in the total declined, although to a lesser extent than projected. The ratio of the budget deficit to the gross national product fell from 4.6 per cent in 1980 to 1.6 per cent in 1981, surpassing the original estimate of 1.0 per cent that is now the target for 1982. And, the ratio of State Economic Enterprise financing requirements to GNP decreased only from 10.3 per cent in 1980 to 9.4 per cent in 1981, compared to a target of 8.1 per cent, with a projected figure of 7.6 per cent in 1982. The public sector thus continues to impinge on private savings, albeit to a lesser extent than beforehand. The investment gap (gross investment less savings) of the sector declined from 10.3 per cent of GNP in 1980 to 6.1 per cent in 1981, compared to the original estimate of 3.3 per cent that is now projected to be reached in 1982. Apart from limitations on the availability of financing, high real interest rates on nonpreferential loans have burdened the private sector. Adjusting for the approximate 30 per cent compensating balance on loans held with commercial banks, the interest cost of nonpreferential credit granted by these banks is 70 per 443  cent in Turkey, representing a real interest rate of 36 per cent at an inflation rate of 25 per cent and a real interest rate of 26 per cent at an inflation rate of 35 per cent. Nonpreferential loans by commercial banks represent a secondary source of credit for firms that have access to preferential loans and finance inventory holdings and wage payments for others. At the same time, private industry has not been allowed to reduce its work force in response to the low level of domestic demand. The financial situation was further aggravated by the failure of the so-called bankers (money lenders) that accepted deposits and provided loans at even higher interest rates to firms which were unable to obtain sufficient funds from commercial banks. As is well-known, the situation culminated in the collapse of Kastelli in June 1982. POLICY PRIORITIES FOR THE FUTURE Short-term Objectives The achievements of the Turkish economy in increasing exports in response to the incentives provided under an outward-oriented strategy have been remark- able, permitting reductions in the current account deficit from $3.7 billion in 1980 to $2.1 billion in 1981, with a deficit of $1.4 billion projected for 1982, the resurgence of imports notwithstanding. It is also remarkable that Turkey has been able to substantially reduce the rate of inflation in a relativ ly short period with only a small decline of its gross national product in 1980, followed by a considerable increase in 1981. Nevertheless, with weak domestic demand, high real interest rates on nonpreferential loans obtained from commercial banks, and even higher interest rates on non-bank credits which represent a marginal source of financing, various segments of private industry have encountered difficulties that are compounded by the inability of the firm to fire labor. At the same time, private investment has remained at low levels and, despite the government's stated desire to reduce the share of the public sector, public investment has gained at the expense of private investment. After declining by 10.5 per cent in 1979 and by 20.0 per cent in 1980, private fixed investment stagnated in 1981 and, even with projected increases of 6.0 per cent in 1982, it would remain considerably below its 1978 level. At the same time, in conjunction with increases in public investment of 7.0 per cent in 1981 and a projected rise of 6.8 per cent in 1982, the share of the private sector in total fixed investment declined from 48 per cent in 1979 to 42 per cent in 1981 and it is estimated at 41 per cent in 1982. The turn towards outward orientation necessarily involves a shift in industrial composition from firms operating under high protection to exporting firms. 444  However, firms oriented towards domestic markets may rationalize their opera- tions and modify their product composition if they can reduce their labor force and have access to financing at reasonable interest rates. In order to facilitate adjustment towards outward orientation, then, policies in regard to employment and credit would need to be reviewed. It has been reported that military commanders in the various districts may now give permission to firms to reduce their labor force. While such action will add to unemployment, it will be necessary in cases when operations are unprofitable. It would be desirable, therefore, to let firms make their own decisions on the size of their labor force. An easing of monetary policy cannot be recommended lest inflation flares up again. This conclusion is of particular importance in view of the acceleration of monetary expansion at the beginning of 1982, associated with increases in reserves due to improvements in the balance of payments and the rise in the reserve money multiplier, as well as in June 1982, in response to the collapse of Kastelli. Measures would need to be taken, however, to increase the availability and to lower cost of nonpreferential credit to the private sector. This would require, first of all, reducing further the financial requirements of the public sector. Apart from economizing with current expenditures of government administration and the State Economic Enterprises, one would need to reduce the public investment program and to raise the low interest rates charged on loans to the SEEs that encouraged stockpiling in 1981, leading to financial requirements much above expectations. In order to put public and private industry on an equal footing, they should be required to pay the same interest rates. More generally, the scope of preferential credits would need to be reduced. The existing system creates inequities, leads to leakages, and gives rise to uncertainty as to the availability of preferential credit. Last but not least, there is need to lower existing charges on bank lending that greatly increase the cost of financial intermediation in Turkey. This objective would be served by eliminating the 15 per cent financial transaction tax. The proposed reform of preferential credit schemes would further permit reducirng the 10 per cent levy accruing to the Differential Interest Rebate Fund that is used to finance such schemes. At the same time, the cost of money to the commercial banks may be lowered by raising interest rates on compulsory deposits held with the Central Bank. Reducing charges on bank lending would permit lowering interest rates on nonpreferential loans without however increasing their volume. Apart from reducing the public sector deficit, the volume of credit to the private sector would be increased by giving greater encouragement to private savings. For this purpose, it would be desirable to eliminate, or at least to reduce, the 25 per cent withholding tax on interest earned by savers. 445  Long-Term Objectives The exchange rate represents a link between policies designed to pursue short-term and long-term objectives. While the depreciation of the real exchange rate has contributed to improvements in Turkey's balance of payments, further changes would be necessary in order to permit liberalizing imports and limiting the extent of export subsidies. Import liberalization is a priority task. For one thing, the eventual pick-up of domestic demand will increase the profitability of production for the highly- protected domestic market at the expense of exports For another thing, present levels of protection are not compatible with outward orientation, and import competition is necessary to promote adjustment in domestic industry. The liberalization of imports would necessitate, first of all, establishing a list of items, the importation of which is effectively prohibited today and eliminating these prohibitions at an early date. Furthermore, annual transfers of restricted items to the free list would need to be made, with priority given to liberalizing the importance of intermediate products and machinery and with a view to abolishing import restrictions by 1987. The liberalization of imports would permit making the lira convertible once an atmosphere of stability is established in the Turkish financial system. In the meantime, existing regulations on international transactions would need to be eased by reforming the Law on the Protection of the Value of the Turkish Lira. Parallel with the abolition of import licensing, existing high tariffs would need to be lowered. This may involve establishing a tariff ceiling, to be reached in annual installments over a transitional period of five years, and reducing interin- dustry differences in tariff rates. The tariff ceiling may be set at 30 per cent, with additional incentives granted to infant industries on a temporary basis. To the extent possible, this should be done in the form of subsidies rather than tariffs in order to avoid the establishment of high-cost industries producing for sheltered domestic markets. Increasing the use of the exchange rate as a policy instrument to promote exports would also permit reducing reliance on export subsidies. At the same time, the remaining subsidies to exports would need to be simplified. Also, they should consistently be granted on a value added basis rather than on export value, so as to discourage import-intensive exports and to provide inducement for increasing the share of domestic value added in exports. The described changes in exchange rate policy, import protection, and export subsidization would ensure continued progress towards outward orientation in the Turkish economy. Together with the proposed reforms in the financial system, they would also increase the scope of operation of market forces. The objectives of the January 1980 reform would further be served by 446  reforming the operation of the state economic enterprises. The implementation of proposals made by the government to increase the decision-making power of managers, and to make them responsible to an independent general assembly, would represent important steps in SEE reform, Additional steps would need to be taken, however, in order to fully integrate the SEEs in the market economy. In this regard, Turkey may follow the example of Hungary in decentralizing decision-making and ensuring competition for public enterprises. This would require breaking up the industry-wide SEEs and giving firm managers the freedom to decide on production, prices, and employment. At the same time, with the elimination of credit and other subsidies and the establishment of an efficient pricing environment, profit maximization by SEE managers would appropriately serve the national interest. In turn, the exploitation of Turkey's agricultural potential would necessitate rationalizing agricultural prices, strengthening research and extension services, and improving transportation facilities. The application of these measures re- quires a coordinated approach, aimed at raising agricultural productivity and at providing inputs for industry, in particular for fruit and vegetable processing. As regards industry, the promotion of research and product development is a priority task. This would permit, in particular, the exploitation of Turkey's long- term comparative advantages in the electrical and nonelectrical machinery, machine tool, and electronics industries. The promotion of R&D could best be accomplished in the framework of a medium-term plan of science and technology that would also provide for the improved training of engineers and technicians. Apart from public programs, incentives for research and training by private industry would be necessary for this purpose. The described policy measures, aimed at furthering the objectives of greater outward orientation and increased reliance on market forces, are interdependent and would need co-ordination. This, in turn, requires establishing a medium-term policy framework and creating an appropriate institutional structure to formulate and to implement policies within this framework. 447  No. 257. James A. Hanson, "Contractionary Devaluation, Substitution in Production and Consumption, and the Role of the Labor Market," Journial of Interntational Economics No. 258. Christiaan Grobtaert, "The Conceptual Basis of Measures of House- hold Welfare and Their Implied Survey Data Requirements," The Revie7lw of Income and Wealth No. 259. Guy Pfeffermann and Richard Webb, "Poverty and Income Distribu- tion in Brazil," The Review) of Income and Wealthl No. 260. Pradeep K. Mitra, "A Theory of Interlinked Rural Transactions," Journal of Public Economics No. 261. David L. Lindauer and Richard H. Sabot, "The Public/Private Wage Differential in a Poor Urban Economy," Journal of Development Eco(olml lics No. 262. J. B. Knight and R. H. Sabot, "Labor Market Discrimination in a Poor Urban Economy," Journal of Development Studies No. 263. Carl Dahlman and Larry Westphal, "Technical Effort in Industrial Development: An Interpretative Survey of Recent Research," The Economics of New Technology in Developing Countries No. 264. Michael Bamberger, "The Role of Self-Help Housing in Low-Cost Shelter Programs for the Third World," Built Environment No. 265. Bela Balassa, "The Adjustment Experience of Developing Economies after 1973," IMF Coniditionality Issues of the World Bank Reprint Series are available free of charge from the address on the bottom of the back cover.  THE WORLD BANK Headquarters: 1818 H Street, N.W., Washington, D.C. 20433, U.S.A. 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