Turkey - External debt, fiscal policy and sustainable growth (Vol. 1 of 2) : Main report

Report No. 7162-TU Turkey External Debt, Fiscal Policy and Sustainable Growth (In Two Volumes) Volume l: The Main Report September 9,1988 Country Department I Europe, Middle East and North Africa FOR OFFICIAL USE ONLY Document of the World Bank This report has a restricted distribution and may be used by recipients only in the performance of their official du' ies. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENT (annual average) 1980 TL 76.04 1981 TL 111.22 1982 TL 162.55 1983 TL 225.46 1984 TL 366.68 1985 TL 521.98 1986 TL 674.50 1987 TL 860.58 FISCAL YEAR March 1 to February 28 - through 1981 March 1 to December 31, 1982 January 1 to December 31 - from 1983 ABBREVIATIONS CPI - Consumer Price Index EBF - Extra-Budgetary Fund FX - Foreign Exchange Deposit MHF - Mass Housing Fund SEE - State Economic Enterprise SIS - State Institute of Statistics SPO - State Planning Organisation WPI Wholesale Price Index  FOR OMCIAL USE ONLY This report is based on the findings of a Worid Bank mission that visited Turkey in October-November 1987. The missfbn consisted of Ritu Anand, mission leader (EKlCO), John Brondolo (CECEM), Ajay Chhibber (CECEN), David Robinson (IMF). Roberto Rocha (ENTTF). Sweder van Wijnbergen (EMTTF) developed the models used and took part ln the preparation of the report. This document has a restricted distribution and may be used by recipients only in the performence of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  TURKEY: EXTERNAL DEBT, FISCAL POLICY AND SUSTAINABLE GROWTH Table of Contents VOLUME I: THE MATN REPORT Page No. BASIC INDICATORS EXECUTIVE SUMMARY (i)-(xiii) Chapter I: INTRODUCTION 1 Chapter II: EXTERNAL ADJUSTMENT, EXCHANGE RATE POLICY AND OUTPUT GROWTH 4 A. Introduction 4 B. Framework 7 C. External Debt, Exchange Rates and Output Growth 10 C.1 Cross-Currency Exchange Rate Fluctuations and the Value of External Debt 11 C.2 External Debt and the Real Exchange Rate 14 C.3 Output Growth, Real Interest Rates and the Current Account: the Dynamics of External Debt 18 D. Internal Adjustment: Means of Financing the External Transfer 24 Chapter III: INTERNAL ADJUSTMENT: THE SIZE AND FINANCING OF THE FISCAL DEFICIT 30 A. Introduction 30 B. Analysis of Sources of Financing 30 B.1 Concept and Measurement Issues 30 B.2 Overall Trends in the Size and Financing of Real Deficits since 1980 32 C. Foreign Exchange Financing of Public Sector Deficits 34 C.1 The Effects of Exchange Rate Changes on the Foreign Exchange Liabilities of the Public Sector 34 C.2 Sources of Growth of Foreign Exchange Liabilities 39 C.3 The Cost of Foreign Exchange Finance 41 D. Analysis of Money Financing and Financial Sector Reform 42 D.1 An Overview of Money Finance from 1979 to 1987 43 D.2 The Reserve Requirement Regime and the Demand for Real Base Money 47 D.3 Financial Innovations and Seignorage 54  - ii - Page No. D.4 Currency Substitution and Seignorage 57 D.5 Revenue from Money Creation and the Financing of Public Sector Deficits 61 E. Analysis of Domestic Debt Finance 62 E.1 An Overview of Domestic Debt Finance from 1980 to 1987 62 E.2 The High Cost of Domestic Debt 66 F. Implications of Current Trends in Domestic and External Debt Finance 76 G. Macroeconomic Consistency, Financial Sector Reform, and the Financing of Government Deficits 78 G.1 Consistency of Fiscal Policy 78 G.2 Fiscal Implications of Financial Sector Policies 82 B. Summary and Concluding Comments 84 Chapter IV: INTERNAL ADJUSTMENT: FISCAL POLICY, PRIVATE SAVINGS AND INVESTMENT, AND OUTPUT GROWTH 86 A. Introduction 86 B. Real Interest Rates, and Private Savings and Investment Behavior: the Role of Fiscal Deficits 90 C. Private Sector Response to Fiscal Policy 96 C.1 Fiscal Policy and Capital Accumulation: Crowding-Out or Crowding-In? 96 C.2 Real Interest Rates, Income Growth and Private Savings 101 D. Fiscal Deficits, Interest Rates and Growth 104 E. Composition of Investment: a Warning Sign? 107 Chapter V: OUTPUT GROWTH AND EXTERNAL BALANCE: CAN THEY BE RECONCILED? .09 A. Introduction 109 B. Expcrts, Output Growth and External Borrowing 110 B.1 Solvency, Creditworthiness and Foreign Debt 110 B.2 Sustainable Current Account Deficits 113 C. Macroeconomic Consistency, Foreign Borrowing and the Public Sector Deficit 115 C.1 Fiscal Implications of Debt Management 116 C.2 Fiscal Consequences of Exchange Rate Policy 117 C.3 Fiscal Implications of Variations in Output Growth 119 D. Fiscal Adjustment, Output Growth and External Debt 120 D.1 Output Growth and External Balance: The Base Case 121 D.2 External Adjustment with Fiscal Restraint 123 D.3 Externil Adjustment without Fiscal Restraint 123  List of Text Tables and Figurs VOLUME I: THE MAIN REPORT Table/Figure No. Page No. Chapter II: EXTERNAL ADJUSTMENT, EXCHANGE RATE POLICY AND OUTPUT GROWTH Table 2.1 Measures of the Overall Debt Burden 5 2.2 Debt Adjusted for Exchange Rate Effects 17 2.3 Contribution to Increase in Debt-Output Ratio 22 2.4 Net Resource Transfers Abroad by the Public and Private Sectors 25 2.5 Domestic Financing of External Transfer 28 Fig. 2.la Weighted Cross-Currency Exchange Rate 13 2.1b Cross-Currency Effect on Foreign Debt 13 2.2 The Real Exchange Rate 15 2.3 Real Interest Rate on FLreign Debt 20 2.4 Real Output Growth 20 2.5 Debt Dynamics: Interest Rates & Output Growth 23 2.6 Means of External Adjustment 27 Chapter III: INTERNAL ADJUSTMENT: THE SIZE AND FINANCING THE FISCAL DEFICIT Table 3.1 Real Public Sector Deficits and Sources of Finance, 1980-1987 33 3.2 Net Foreign Exchange Liabilities of the Public Sector, 1979-1987 35 3.3 Foreign Exchange Financing of Public Sector Deficits, 1980-1986 37 3.4 Currency Composition of Net Foreign Liabilities of the Public Sector 38 3.5 Sources of Growth of the Net Foreign Liabilities of the Public Sector, 1980-86 40 3.6 Interest Expenses on Foreign Exchange Liabilities 42 3.7 Money Financing of Public Sector Deficits, 1979-1987 44 3.8 Reserve Requirements, Liquidity Requirements and Interest Paid on Reserves, 1979-1987 48 3.9 Average Monetary Aggregates, 1979-1987 52 3.10 Stock of Foreign Exchange Deposits in the Turkish Financial System, 1983-87 58 3.11 Domestic Debt Finance of Public Sector Deficits, 1980-1987 64 3.12 Average Real Interest Rates on Government Securities, 1985-1987 67 3.13 Average Maturity of Government Securities 70  - ii - Table/Figure No. Paee No. Table 3.14 Stock of Bonds and Bills Outstanding at End-Year, 1979-1987 72 3.15 Average Cost of Loanable Funds, Lending Interest Rates and Interest Rates and Interest Rates on Government Securities at End-Year, 1983-86 75 3.16 Interest Expenses on Total Public Sector Debt, 1980-1987 77 3.17 Inflation Tax and Seignorage at Various Inflation Rates 80 3.18 Financial Deficit at Various Inflation Targets 82 Fig. 3.1 Statutory and Effective Reserve Requirement Ratios 49 3.2 Base Money Multipliers, 1983-1986 50 3.3 Real Interest Rates on 6-Month Time Deposits 53 3.4 Real Sight Deposits, 1977-1986 55 3.5 Firms' Demand for Sight Deposits, Actual and Predicted 56 3.6 Individuals' Demand for Sight Deposits, Actual and Predicted 60 3.7 Real Interest Rates on 6 Month T-Bills 68 3.8 Real Interest Rates on 1 Year T-Bills 69 3.9 Interest Rates on T-Bills and Deposits 74 Chapter IV: INTERNAL ADJUSTMENT: FISCAL POLICY, PRIVATE SAVINGS AND INVESTMENT Table 4.1 Key Macroeconomic Indicators 87 4.2 Capacity Utilization in Private Sector Manufacturing Industry, 1977-87 100 Fig. 4.1 Public Savings Rate: 1967-87 , 88 4.2a Domestic/Foreign Interest Rates on 6-Month Deposits 92 4.2b Domestic/Foreign Lending Rates 92 4.3 Fiscal Deficits and Real Interest Rates for Given Current Account Targets 94 4.4 Fiscal Deficits and the Current Account, 1980-87 95 4.5a Sectoral Public Investment 97 4.5b Sectoral Private Investment 97 4.6 Real Interest Rate for Lending 98 4.7 Interest Rates and Private Investment 98 4.8 Effect of Public Policy on Private Investment 102 4.9 Public and Private Savings 103 4.10 Real Interest Rate on 1 Year Time Deposit, 1981-87 103 4.11 The Effect of Changes in Fiscal Deficit on Interest Rates and Output Growth 106 4.11a Entire Fiscal Cut from Government Consumption 106 4.11a 60 Percent of Fiscal Cut from Public Sector Investment 106  - iil. - Table/Figure No. -ame No. Chapter V: OUTPUT GROWTH AND EXTERNAL BALANCE: CAN THEY BE RECONCILED? Table 5.1 Measures of C:eAitworthiness 112 5.2 Allowable Foreign Borrowing: Current Account Deficits as Share of GV'P 114 5.3 Real Exchange Rate Depreciation, Fiscal Adjustment and Feasible External Borrowing 118 5.4 Fiscal Implications of Output Growth 120  TURKEY: BASIC INDICATORS 1980 1981 1982 1993 1984 1985 1986 1987 Est. Macro balances: (share of GNP) Total Consumption 84.1 82.0 81.8 83.7 83.3 80.9 77.7 76.5 Private 71.9 71.3 71.1 73.5 74.5 72.5 6A.9 67.0 Government 12.3 10.7 10.8 10.2 8.8 8.4 8.8 9.5 Fixed Investmwnt 19.5 18.9 18.9 18.8 18.0 20.1 23.6 24.9 Public 10.9 11.7 11.5 10.6 9.9 11.7 14.0 13.6 Private 8.5 7.2 7.3 8.2 8.2 8.4 9.6 11.3 Stock Changes 1.9 2.6 1.5 1.1 1.4 0.9 1.4 0.1 Public 0.5 -.S 0.5 -0.4 0.0 -0.2 0.1 -0.1 Private 1.4 1.1 1.0 1.5 1.4 1.0 1.3 0.2 Current Account -5.5 -3.5 -2.2 -3.5 -2.8 -1.9 -2.6 -1.5 Imports of goods & NFS 15.0 16.5 17.9 19.6 23.1 23.5 20.7 n.a Exports of goods & NFS 7.2 10.9 14.5 15.7 19.5 20.7 18.0 n.a GNP (Omillion) 58327 58925 53737 51237 50111 53238 58082 64790 GNP growth -1.1 4.1 4.5 3.3 5.9 5.1 8.0 6.8 Gross External Debt ($ billion) 16.3 16.9 17.6 18.2 20.8 25.5 32.5 37.3 Medium/long term 13.8 14.7 15.9 16.0 17.6 20.8 25.6 28.8 Short term 2.5 2.2 1.8 2.3 3.2 4.8 6.9 8.5 Debt/GNP 28.0 28.6 32.8 35.6 41.5 47.9 55.9 57.6 Debt/exports,' 284.1 198.3 175.0 192.9 180.5 194.5 260.5 227.2 Real Exchange Ratek,: Average 100.0 98.4 107.7 107.4 111.3 110.0 131.9 141.8 End of Period 100.0 106.3 110.00 109.4 103.0 114.1 135.4 143.7 Nominal Exchange Rate (TL$) Average 76.0 111.2 162.6 225.5 366.7 522.0 674.5 860.6 End of Period 90.2 133.6 186.8 282.8 444.7 576.9 757.8 1020.9 Monetary Aggregates: (percent of GNP) Base Money 8.1 8.5 9.7 10.2 9.1 8.7 8.2 7.2 M2 14.9 17.4 22.1 23.0 21.7 23.2 23.5 21.4,.. M2X - - - 23.0 22.8 26.0 28.4 28.3k, Inflation Rate: CPI (year average) 110.9 36.8 23.1 31.4 48.4 44.0 34.6 38.8 CPI (year end) 89.6 28.3 26.2 37.1 49.7 44.2 30.7 55.1 &, Exports of goods, services and workers' remittances ,. 1980 export weights SL' June 1987  i EXECUTIVE SUMMARY A. INTRODUCTION 1. This report documerti how Turkey has managed to maintain high output growth without jeopardizing creditworthiness after rescheduling its debt: an achievement few countries who recently rescheduled debt have been able to match. The country has achieved and maintained high levels of capacity utilization, with exports by far the fastest growing component of aggregate demand. The increase in the debt-output ratio that did take place is to a large extent the counterpart of this successful export drive; the latter was made possible by a continued real depreciation of the Turkish ltra, which in turn is responsible for more than half of the increase in the debt- output ratio between 1980 and 1986. The large capital losses on external debt due to this real depreciation have not jeopardized Turkey's creditworthiness: in commercial assessments of major debtor countries, Turkey's creditworthiness ranks amongst the highest. One reason why creditworthiness did not suffer is that the high export growth rate improved the debt-export ratio substantially since 1980. 2. The report develops a framework to analyze how output growth can be maintained within the limits set by creditworthiness. It focuses on what constitutes sustainable external debt accumulation, and how fiscal policy can play a role in reconciling such external targets with internal balance as well as the need to maintain output growth. This framework is then used to analyze Turkey's performance and the extent to which external factors and internal policies have helped to bring this about. It is also used to assess whether the same growth- oriented debt strategy can be pursued in the future, what the risks are, and what policy adjustments are necessary for its continued success. 3. The report argues that severe external restraint is both unnecessary and highly damaging to Turkey's growth prospects and internal balance. The report demonstrates the need for additional foreign financing, but stresses the necessity of fiscal policy adjustments to restore consistency with a growth-oriented debt strategy at acceptable inflation rates. The urgency of fiscal adjustment is highlighted by the significant deterioration in the fiscal deficit during 1987 and the accompanying acceleration in inflation. B. THE STRATEGY SO FAR: ACHIEVEMENTS AND CONCERNS B.1 External Adjustment: the Role of Exchange Rate Policy. External Debt and Outp;t Growth 4. Turkey's net external dXbt increased substantially between  ii 1980 and 1986, from 21 percent of GNP to 51 percent of GNP 1/, but in a manner very different from most other debtor countries. Three striking features highlighlt Turkey's external debt strategy and explain why Turkey is in a much better position than most other debtor countries. First, the ratio of external debt to exports, in marked contrast to developments in countries with recent debt-servicing problems, fell on average by a third since 1980. A major reason for the improvement in the debt-export ratio is the sustained real depreciation of the Turkish lira against the currencies of Turkey's trading partners. The depreciation improved the competitiveness of Turkish goods abr2ad arid led to a spectacular surge of Turkish exports. The counterpart of this real depreciation, however, has been a substantial capital loss on Turkey's external debt. This was a major contributing factor to the increase in the debt-output ratio; it accounts for more than half of the increase in the debt-output ratio between 1980 and 1986. Empirical results presented in the report show, however, that the debt-export ratio will in fact improve after a real devaluation: exports will increase enough in volume terms to offset the lower price. A real devaluation causes a capital loss on foreign debt and thus a reduction in national wealth. Higher exports cannot undo this, but increased export orientation eases access to foreign capital markets. 5. Secoad, Turkey continued to have access to foreign capital after it rescheduled its debt in the late 1970s. One factor explaining this was a set of measures that raised the attractiveness for Turkish workers abroad to repatriate their savings back to Turkey. Anc2her was continued support by multilateral institutions. As a consequence, Turkey could and did run a much lower non-interest current account surplus 2/ than, for example, the group of countries with recent debt- service difficulties 3/ did on average after their respective debt crises; -0.25 percent of GNP over 1980-86 for Turkey versus 2.6 percent over 1982-86 for the "high-debt" countries. Turkey therefore did not have to cut back expenditure as dramatically as most high debt countries had to after 1982. 1 Net external debt equals gross debt minus foreign assets of the banking system, including the Central Bank. 2 The non-interest current account deficit equals the increase in net foreign debt (funds received from foreigners) minus interest payments made to foreigners. It thus equals the net resource transfer received from the rest of the world and is therefore a more fundamental measure of external (im)balance than the current account. 3 This country classification is taken from the IMF's World Economic Outlook. For brevity, the group is referred to as "high-debt" countries in this report. Note that k%is group is not the same as the group labeled "15 heavily indebted" countries in the IHF's World Economic Outlook. However, in the latter group, debt accumulation and current account deficits have also followed similar patterns.  iii 6. This has enabled Turkey to maintain a high rate of output growth, the third major difference between Turkey and the "high-debt" countries. Turkey's growth rate after 1980 was on average 4 percentage points higher per year than the average growth rate in the "high-debt" countries. A short period of recession after its debt crisis was followed by seven years of high output growth, on average more than 5 percent in real terms since 1981. This explains why, although Turkey's external debt increased relatively more than it did in other countries, its debt-output ratio did not: output grew so much faster than in the other countries. 7. The high real growth rate implied that the economy grew faster thaa interest payments rose on existing debt, especially since in the early 1980s, real interest rates were low.l/ At that time a large part of Turkey's debt was still at concessional terms. As a consequence of these lower debt-service costs there was more room for continued borrowing. 8. Real interesc rate developments turned unfavorable in the mid-1980s as non-concessional multilateral loans and high-cost deposits by Turkish workers abroad became more important as sources of foreign financing. But, at the same time Turkey improved its non-interest current account. In fact, Turkey has run a surplus on the non-interest current account since 1984 (and, in fact, also in 1982), after some substantial deficits in the preceding years. 9. Thus, while much of the increase in Turkey's external debt to GNP ratio was due to capital losses caused by exchange rate developments, more fundamental factors have also contributed: 45 percent of the increase in the debt-output ratio can be traced to the cumulative effect of non-interest current account deficits and rising interest payments. A striking feature of the pattern of external adjustment has been a shift in the relative contribution of these two factors. Interfist payments have gone up not only because debt has increased but also because real interest rates have risen; they now exceed the real growth rate of the economy. As the burden of interest payments increased, the non-interest current account deficit fell. High real interest rates have now reduced the leeway Turkey has to engage in foreign borrowing without jeopardizing creditworthiness; borrowing at the scale of the early 1980s is no longer sustainable. 10. The rise in interest rates on its external debt over the last few years marks a fundamental difference w,Lth the situation in the early 1980s. The increase in the cost of Turkey's foreign debt greatly reduced the leeway for external deficits. It also accentuates the need for Turkey to maintain a high growth rate of its GNP, to avoid rapid 1 As long as the real growth rate of the economy exceeds the real interest paid on external debt, real interest payments tend to rise at a lower pace than GNP for a given non-interest current account. This is explained more fully in Chapter 2, Section C.3.  iv acceleration of debt-service costs as a share of GNP. Turkey has beer successful on both counts in the past few years. 11. In short, Turkey has been successful in striking a balance between external restraint and continued output growth. But the internal policies that have formed the counterpart of this external transfer give some reason for concern. The public sector has been making a net external resource transfer since 1981: its interest payments on foreign debt exceeded additional foreign borrowing. Initially, the transfer was effected through a substantial improvement in the non-interest fiscal surplus. But from 1982 onwards, the government has been financing its contribution to the external transfer through increasing reliance on monetization and the issue of high-cost debt. Monetization at current rates is incompatible with reducing inflation; continued debt issue at real rates much above the real growth rate of the economy threatens future fiscal balance and hence achievement of inflation targets in the future. B.2 Internal Adjustment: Fiscal Policy. Real Interest Rates and Investment Expenditure 12. Turkey has adopted a growth-oriented strategy rather than rc.ly on sustained high surpluses on the non-interest current account to keep the debt-output ratio in check. While Turkey has been transferring resources to its creditors in almost every year since 1982, the size of the transfer (as a share of GNP) was much less than in the "high-debt" countries. Nevertheless Turkey's debt-output ratio did not rise much more than in these countries, because Turkey sustained a much higher output growth rate. In such a strategy, the Government needs to make sure that the extra expenditure the lower trade surplus allows is indeed channeled into investment, and not into consumption. If consumption increases, either output growth or external balance will be sacrificed. The high growth rate of the past seven years suggests that the adlitional borrowing has indeed been used to finance investment. 13. In fact, Turkey has not only restrained total consumption, but reduced it as a proportion of GNP. Government consumption (net of interest expenses and other transfers) was reduced substantially, from 12.3 percent of GNP in 1980 to 8.8 percent in 1986. A major part of the budgetary resources freed by this cut in consumption was used to finance increased public sector investment. Public investment increased by 3 percentage points of GNP since 1980, to reach almost 14 percent of GNP in 1987. The sustained public sector investment program has been an important factor, together with tne strong shift towards export incentives, behind the high output growth rates in Turkey since 1980. 14. However, because of the rise in public sector investment, the cut in government consumption did not translate into decreases in public sector deficits. This in spite of an accompanying rise in tax revenues as a share of GNP since the introduction of the VAT in 1985  v (however, some of the increase in tax revenues was offset by rising non-interest transfer payments). In fact, after the initial decrease in the non-interest deficit of the public sector in 1981, no major further improvement took place. Thus increasingly high real interest rates were necessary to reconcile persistent fiscal deficits with external balance targets. The high real interest rates induced the private sector to run a matching surplus of savings over investment; this enabled Turkey to sustain these fiscal deficits without endangering the current account. 15. As a consequence, private consumption, after rising between 1980 and 1984 from 72 percent of GNP to 74.5 percent, subsequently fell to 69 percent of GNP. The econometric work presented here shows that the rising real interest rates on bank deposits have been a major contributing factor to the resulting increase in private savings. The after-tax real interest rate on time deposits has risen from -3.5 percent in 1980 to almost 6 percent in 1984, and close to 13 percent in 1987. Econometric analysis presented in the report suggests that the private savings rate would have been lower by two percentage points of GNP in 1987 if real time deposit rates had not increased from their level in 1984. Higher real interest rates cannot, however, explain the entire increase in private savings. The analysis also suggests that a substantial part of the increase is due to the above-average growth rates achieved in 1986 and 1987.1/ The economy grew by 8 percent in 1986, and by almost 7 percent in 1987. Private saving is expected to decline once growth rates fall to a more sustainable 5 or 6 percent a year. This is a reason for concern: it implies that unless interest rates rise further or substantial fiscal cutbacks are made, the fall in private savings will cause the current account to deteriorate in the years to come. 16. The high real rates on time deposits have also triggered high real lending rates, as banks attempted to maintain their profit margins. However, this has not l.d to a decline in private investment, as might have been expected: while private investment is certainly not booming, it has recovered from its low point in 1981 to levels similar to those reached in the early 1970s. The composition of private sector expenditure has thus, like public expenditure, shifted away from consumption towards investment. 17. Government policies have played an important role here too. First, the Government has provided generous investment incentives over the period. In addition, tax deductibility of nominal interest payments has cushioned the impact of high real interest rates, and the more so as inflation rose. Second, the growth rate of credit available to the private sector has consistently exceeded the growth rate of the economy. Third, the growth-oriented fiscal policy stance and the strong export drive have contributed to sustained improvements in 1 In addition, the operations of the Mass Housing Fund since late 1984 may also have contributed to an increase in private savings.  vi capacity utilization, an important determinant of private investment behavior. Finally, the composition of public investment has shifted away from sectors where it competes with private investment towards areas where the two are in fact complementary. Public sector investment in manufacturing was cut back and public investment in transport, communications, power, health and education increased rapidly. As a consequence, the share of infrastructure investment in the public sector investment program rose from below 50 percent in 1980 to around 70 percent in 1986. Econometric results confirm that these factors more than offset the negazive impact of high real interest rates on private investment performance. Of course, if high real interest rates make it necessary to increase Investment incentives, the negative impact on the budget is reinforced: the cost of public sector debt increases and the cost of providing investment incentives goes up. 18. Moreover, there is another reason for concern. The adverse effect of high interest rates has mostly fallen on investment in manwufacturing; investment in housing, in particular, was largely shielded from the effects of high real rates through more liberal access to preferential credit, administered by the Mass Housing Fund, than was available for manufacturing investment. As a consequence, private investment seems to have shifted away from the main export sectors, agriculture and manufacturing. The share of each sector in aggregate private investment has fallen by 5 percentage points between 1981 and 1987. 19. The combined effect of these private and public sector developments has been a substantial decline of the share of total investment going towards the main export sectors. This may have a bearing on the link between export growth, the real exchange rate and the cost of external debt discussed in Sections A and B.1. With less capital in the tradable sectors, a larger shift in the real exchange rate is necessary to achieve a given export target. This in turn increases the capital losses Turkey will sustain on its external debt. A reallocation of investment incentives cowards the traded goods sectors and lower real interest rates would increase capacity in traded goods production. This in turn would allow the export drive to continue with less need for continued real depreciation and hence less of an increase in the debt-output ratio. B.3 Is the Current Fiscal Policy Stance Sustainable? 20. Since 1980, Government consumption has fallen more than public investment has increased, and government revenue has increased as a share of GNP. Yet fiscal deficits have risen substantially. To a large extent the worsening of the fiscal situation reflects the burden of higher interest payments on both foreign and domestic debt. The higher interest cost of foreign debt reflects the increasing share of non-concessional loans and high cost Dresdner deposits. But interest expenses on the domestic debt have also gone up: for the Central Government alone from less than 1 percent of GNP before 1984 to an estimated 2.5 percent of GNP in 1987. This increase in interest  vii expenses exceeds the rate of increase in the debt itself by a wide margin, reflecting the rapid rise in the cost of domestic debt. 21. Real interest rates on auctioned Government securities have been high since the start of the auctionirg system in 1985. Despite a decline in early 1987, the average real rate for the year was still around 10 percent. These high rates have been rapidly translated into a high average cost of debt as the maturity of Government domestic debt has shortened. Moreover, the net cost of debt is even higher than the high real rate on Treasury bills suggests. This is because the Governman