External balance, fiscal policy, and growth in Turkey

Policy, Planning, and Reserch WORKING PAPERS Public Economic I _ _I__ _ _ _ __ 0 C ' s Country Economics Department The World Bank September 1988 WPS 86 External Balance, Fiscal Policy, and Growth in Turkey Ritu Anand, Ajay Chhibber, and Sweder van Wijnbergen How did Turkey - alone among high-debt countries - sustain high real growth after rescheduling its debt? Can it continue on a high growth path and manage its external debt? Mme Poicy. Planning, and Research Conplex distnbutes PPR Woking Papers to disseinaute the findings of work in progss and to icouoage the exchange of ideas anong Bank suaff and all others interested in developtnent issues These papers carry the namet of the authors. reflect orly their viws, nd should be used and cited accordingly. The findings, intapretations. and conclusions are the authore own. Ihey should not be atuibuted to the World Bank. its Board of Directors. its nmungernet, ora ny of its manberoountries.  Polkyanning, and Rrsoch Public Econornis Since Turkey rescheduled its debt, its real (>>4P Turkey's well-directed public expenditure has grown 5 percent a year - compared with an program supported the private sector through average 1.2 percent for other high-debt coun- key investments in infrastructure, special incen- tries. tives, and credit for export and investment. How did Turkey translate the extra breathing Turkey also inherited substantial excess space it got from foreign financing into sus- capacity from heavy investment made in the tained high real growth? 1970s. This allowed for a quick improvement in output and exports once the exchange rate was Turkey's financing needs for large public aligned. sector deficits generated high medium-term inflation and high real interest rates. But the Extemal debt does not threaten Turkey's thrust of Turkey's program was to keep savings creditworthiness. Internal adjustment is neces- and interest rates up and to improve export per- sary for consistency with inflation targets, but formance. tighter extemal policies are both unnecessary and potentiaUly damaging to Turkey's growth prospects and intemal balance. This paper is a product of the Public Economics Division, Country Economics De- partment. Copies are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Ajay Chhibber, room N1O-055, extension 60102. The PPR Working Paper Series disseminates the findings of work under way in the Bank's Policy, Planning, and Research Complex. An objective of the series is to get these fndings out quickly, even if presentations are less than fully polished. The findings. interpretations, and conclusions in these papers do not necessarily represent official policy of the Bank. Copyright /e 1988 by the International Bank for Reconstruction and Developinenlhe World Bank  TABLE OF CONTENTS I. INTRODUCTION II. EXTERNAL DEBT, INVESTMENT AND THE PUBLIC SECTOR A. Analytical Framework B. Real Interest Rates, Fiscal Policy, Output Growth: the Way the Model Works C. Application to Turkey: Empirical Preliminaries i. Private Consumption ii. Private Investment iii. Investment ar.d Output Growth III. FISCAL POLICY, PRIVATE SAVINGS AND INVESTMENT, AND OUTPUT GROWTH A. The Role of Fiscal Policy: an Outline B. Fiscal Policy and Capital Accumulation: Crowding In or Crowding Out? C. Real Interest Rates, Income Growth and Private Savings D. Fiscal Deficits, Interest Rates and Output Growth IV. OUTPUT GROWTH AND EXTERNAL BALANCE: CAN THEY BE RECONCILED? A. Looking Ahead: External Constraints, Fiscal Consistency and the Prospects for Sustainable Growth B. Exports, Output Growth and External Borrowing i. Solvency, Creditworthiness and Foreign Debt ii. Sustainable Current Account Deficits C. Macroeconomic Consistency, Foreign Borrowing and the Public Sector Deficit i. Fiscal Implications of Debt Management ii. Fiscal Consequences of Different Rates of Output Growth D. External Borrowing and the Potential for Continued Growth i. The Base Case: Creditworthiness and Sustainable Growth ii. What Happens to Growth if Foreign Financing is Cut Back? V. CONCLUSIONS This paper draws on joint work with Roberto Rocha, to whom we are indebted for helpful discussions and to John Brondolo for research assistance. In addition, we would like to thank Rusdu Saracoglu, Teoman Akgur, Hasan Ersel and Haluk Tukel, of the Central Bank, Gazi Ercel of the Treasury and Yavuz Ege of the State Planning Organization in Turkey and Javad Khalilzadeh-Shirazi at the Bank for comments and assistance at various stages of this project.  I. INTRODUCTION Turkey has, alone among the high-debt countries, managed to maintain a high growth rate after rescheduling its debt. Its real GNP grew by 5% on average since 1980. By comparison, countries with recent debt-servicing problems, grew at only 1.2% since 19811 , almost a four percentage point difference on average. At the same time, Turkey's debt-output ratio increased by an amount roughly similar to the increase in the debt-output ratio of the high-debt countries, from 28% at the end of 1980 to 56% at the end of 1986 (see Table 1). in fact, it is surprising that Turkey's debt-output ratio did not increase a great deal more than it did in the higt.-debt countries. As a percentage of GNP, Turkey ran a much lower non-interest current account surplus than the high-debt countries did on average after their debt-crisis: -0.25 percent of GNP for Turkey over the period 1980-1986 versus +2.6 percent over 1982-1986 for the high-debt countries. This apparent inconsistency is explained by th. higher growth rate that Turkey managed to sustain. Turkey's debt-output ratio followed a path similar to that of the high-debt countries, not so much because of large trade surpluses, but because of its high output growth coupled with continued access to foreign financing. This paper discusses two issues this experience raises. One, how did Turkey translate the extra breathing space continued access to foreign financing gave it into sustained high real growth? In particular, what was the 1/ Turkey's rescheduling exercise took place over the period 1978-80, before other debtor countries rescheduled their debt. Hence the shift if comparison period. The data for the high debt countries are taken from the IMF World Economic Outlook, October 1987. The WEO refers to this group as "Countries that experienced recent debt servicing problems". For brevity's sake, we refer to the same group as "high-debt" countries in this paper. ChhibberDisk/chh4hbPr-",trklv Paer/ac:07-2F-88. Ic  -2- Table 1 MEASURES OF THE OVERALL DEBT BURDEN- 1980 1981 1982 1983 1984 1985 1986 1987 Est. Turkey: Debt (US$ 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 Current Account Surplus/GNP -5.0 -2.8 -1.6 -3.4 -2.8 -1 .u -2.6 -1.5 Non-Interest Current Account Surplus/GNP -3.9 -0.8 1.2 -0.4 0.4 1 1 1.0 2.2 Countries with Recent Debt-Servicing Problems: Debt/GDP 32.5 37.6 43.7 47.6 47.6 49.1 51.3 53.9 Debt/exports 151.5 186.1 240.9 254.6 246.3 266.8 309.5 313.4 Current Account Surplus/GDP -3.6 -5.9 -5.5 -2.0 -0.9 -0.5 -1.8 -1.5 Non-Interest Current Account Surplus/GDP -0.5 -1.7 -0.5 2.8 4.1 4.2 2.5 2.6 Notes: For comparability the debt figures reported here for Turkey refer to gross debt. In the rest of the chapter aet debt Ls used. See Page 4, footnote I in the text. The debt-export ratio refers to year-end debt to exports of goods and services (and for Turkey also workers' remittances) during the year. Countries with recent debt-servicing problems are defined as those which incurred external payment arrears in 1985 or rescheduled their debt during the period from end-1983 to ead-1986. Source: Undersecretariat of Treasury and Foreign Trade, Central Bank and World EcoQomic Outlook (IMF), October 1987. 7469e1 p LO  -3- public sector's role in this process? Second, what are the prospects for a repeat performance? Can Turkey, in the years to come, reconcile external balance and sustained output growth? To this end, we develop and apply to Turkey an econometric model designed to shed light on the public sector's role in the internal adjustment to externel transfer targets. The central issue is, how to bring about a private savings over investment surplus that will reconcile external targets and fiscal deficits without jeopardizing output growth. The analysis focuses on two aspects of fiscal policy that can contribute to this goal. First, the impact of aggregate fiscal deficits on external balance, and the way real interest rates can resolve potential conflicts betweer, targets for the two. Second, the impact of the composition of government expenditure on output growth, in investment of course has a direct impact on potential output growth to the extent that it adds to productive capacity. This effect could be negated if public investment, either directly or through the impact of its method of financing, would reduce private investment. This issue is at the core of our empirical analysis. In what follows we first present the analytical structure of the model (Sections II.A and II.B). The results of empirical estimation of the behavioral equations in that model are presented in Section II.C. This Section first deals with the impact of real interest rates on private consumption; a subsequent subsection links private investment to capacity utilization, real interest rates, the volume of credit to the private sector and variables relating to the size and composition of public investment expenditure. Finally, in Subsection lI.C(iii), we establish econometrically the link between private and public investment and the growth rate of real GNP. ChhibberDisk/chhibber-Turkey Peper/ac:O7-28-88: c  -4- This model is then used in Section III to assess the public sector's role in Turkey's macroeconomic achievements since 1980. In Section IV the focus is on the future. We first assess Turkey's leeway on the current account if creditworthiness is to be maintained. We use a pragmatic approach due to Daniel Cohen (1985,1987) to quantify this issue. The model developed in this paper is then used to explore whether sustainability restrictions on fiscal -leficits and the creditworthiness constraints on external borrowing leave enough room for satisfactory output growth. Finally we highlight the importance of continued access to foreign financing by presenting scenarios where such aca.ess is denied. II. EXTERNAL DEBT, INVESTMENT AND THE PUBLIC SECTOR A. Analytical Framework The model presented here has been designed to shed light on the key question raised in this paper: can the objectives of external balance and satisfactory output growth be reconciled? What is the role of fiscal policy in this trade-off? The model is sharply focused on the role of fiscal policy, and hence covers only the essential relations necessary to explore the impact of fiscal policy on private savings and investment behavior, output growth and external balance. It is used in an analysis of the past in Section III, and then in Section IV in an exploration of the trade-offs between output growth, external debt and real interest rates. Several channels are highlighted. First of all, the relation between interest rates, fiscal deficits and external balance. High real interest rates, by depressing private investment and consumption, create more room fc_ fiscal deficits for any given external balance target. At the same time, high real interest rates complicate fiscal management, since they raise the cost of servicing the domest'c public debt. Crucial parameters are the sensitivity of private savings and investment with respect to the real interest rate; these receive detailed econometric attention in Section II.C. ChhibberDisk/chhibber-Turkey Paper/ac:07-28-88:1c  -5- A second channel relies not so much on the interrelation netween aggregate fiscal deficits, real interest rates and the current account, but more on the composition of government expenditure programs. A substantial part of total investment in Turk, s undertaken by the public sector. As a consequence, the allocation of gt, ernment expenditure ove: consumption and investment is an important determinant of output growth for any given expenditure level. But not all public sector investment projects are as effective in promoting growth. The model highlights, in addition to the amount of public investment, the importance of its composition. Section II.C(ii) provides evidence that public investment in manufacturing actually depresses private investment. Thus the composition of public investment is an important determinant of its impact on private investment and hence on aggregate investment and output growth. Final channels incorporated in the model are the effect of capacity utilization on private investment and, in addition to the impact of investment on output growth, a reverse impact of output growth on private savings and investment. These channels have been important in the past few years as Section III demonstrates, and are therefore incorporated in the model. B. Real Interest Rates. Fiscal Policy. Output Growth: the Way the Model Works If there is imperfect arbitrage between foreign and domestic interest-bearing assets, either because of imperfect substitutability or explicit capital controls, the link between foreign and domestic interest rates is severed. External targets can then be maintained even if fiscal deficits increase, as interest rate policy can be used to generate a matching higher net private savings surplus. If, alternatively, arbitrage causes domestic interest rates to closely follow foreign interest rates corrected for exchange rate depreciation, macroeconomic policy faces much tighter constraints: interest rates can no longer be used as an instrument. ChhibberDisk/chhibber-Turkey Paperla c:07-28-88: 1c  -6- This has become a more important issue with the introduction of foreign exchange deposit acccunts (FX deposits) at the end of 1983. It is clear that interest rates on FX deposits form a floor for the level o.f domestic rates on comparable assets. Domestic rates below the rate obtainable on FX deposits (corrected for exchange rate depreciation) would almost certainly erode the domestic deposit base of the banking system as large scale shifts out of domestic deposits would take place. However, it is not so clear that arbitrage works in the other direction too. The time period since the introduction of FX deposits is too short to allow for formal econometric tests, but the volume of FX deposits would seem too small to force domestic interest rates down by massive shifts into domesUic assets out of the FX deposits if any positive interest rate differential arises. Figure 1 shows that domestic interest rates in Turkey have not been closely tied to foreign interest rates adjusted for depreciation of the exchange rate. The figure compares the nominal interest rate on 6 month time deposits with the nominal rate of interest on similar instruments in the USA. The latter are brought on a comparable basis by correcting them for the rate at which the TL actually depreciated against the US dollar over the period covered by the iLiterest rates.2 The figure shows that the rise in interest iates in 1985 and 1986 was well in excess of what can be explained from changes in foreign interest rates (after exchange rate correction). In fact the foreign rates corrected for depreciation fell significantly below their 1980-1984 average in 1985 and 1986 (see Figure 1A). The discrepancy is even 2/ The domestic equivalent of a foreign interest rate i* thus becomes: [(l+it*)Et+l/Etl - 1 ChhibberDisktchhibber-Turkey Paper/ac:07-28-88: 1c  -7- Figure JA: DOMESTIC/FOREIGN INT RATES 6MO DEPOTS - sosf^So~AE Lo0oING-DCAN@E bkT 0.7 0.2 0.1 0.4 tU 1U |92 t 9U4 igug ANNUAL AO E5 a USA + TUNxY Figure 1B: DOMESTIC/FOREIGN LENDING RATES 0.55OWMWOIOaKAC A 0.3 0. 73 a. 7 0.I5 ; 0.53- 0.41 0.4 lUG0 t92 19*4 INS ANUOL A%R5 A lSRAE 0 USA TUninRKE  -8- more pronounced when lending ratss are used as a basis for comparison (see Figure 1B). This is not surprising, since there is no arbitrage to narrow the gap between foreign and domestic lending rates. There is no competition between foreign and domestic banks in Turkey for business loans; domestic banks enjoy what amounts to a monopoly pos'tion. As long as domestic interest rates are not linked to foreign interest rates (i.e. foreign rates plus exchange rate depreciation) there is an additional degree of freedom in macroeconomic policy. Then ci' es in domestic real interest rates can resolve potential discrepancies between' fiscal deficits and external targets through their impact on the r.et private savings surplus.3 In the process, private investment and hence output growth will be affected. This is an important link between fiscal policy and output growth. The mechanism of this link between fiscal policy and output growth is shown in Figure 2. Underlying this figure is the following identity, derived from the national accounts, but with behavioral content built into private savings and investment: (1) CAS - FS + NPS(r) - FS + Spr(r) - Ipr(r) i/ Changes in deficits will only : '%aire changes in real interest rates to induce private savings surplus if private savings would not rise automatically in response to tax cuts. Such an automatic offset may take place if the private sector recognized that a cut in taxes without a matching cut in expenditure simply raises the taxes they will need to pay in the future. Then a tax cut would have no impact on private consumption. Thus deficits would have a one-for-one impact on private savings and no impact on either real interest rates or external balance. This is known as "debt neutrality" in the economic literature. Empirical tests strongly reject this assumption of "debt neutrality" for Turkey. ChhibberDisk/chhibber-Turkey Paper/ac:07-28-88 lc  -9- The private sector's surplus of savings over investment, NPS-Spr - Ipr. is shown as a function of the real rate of interest. A higher real interest rate will slow down private sector investment and increase private savings, thus increasing NPS. Empirical evidence on these effects is presented in Section II.C. This is represented by the upward sloping line "NPS" in Figure 2. The external deficit that is compatible with given real interest rates (FCA for reasible current account) is then represented by the sum of NPS and the fiscal surplus (FS; this equals minus the deficit). The horizontal line TCA is the target value for the current account. The real interest rate at which the current account target TCA equals the feasible current account FCA is the real rate at which fiscal policy and current account targets are in line. An increase in fiscal deficits represents a decline in the fiscal surplus and hence a downward shift in the feasible current accoutit line FCA. To still meet the same current account target, a higher interest rate is needed to call forth the required extra surpltts of private savings over private investment (r shifts from rA to rB). A cut in fiscal deficits will thus allow lower real interest rates for given current account targets, and hence higher private investment. W%ether real interest rates are indeed endogenously determined out of the interplay between external balance constraints, fiscal deficits and private (net) savings behavior, or whether consistency is achieved by administered setting of interest rates, or, for that matter, by arbitrage between foreign and domestic interest rates, is an issue we do not need to address here. What matters is that (ecoaometrically verified) relations ChhibbotDisk/chhibber-Turkey Paper/ac :07-28-88: lc  -10- FiRure 2 FISCAL DEFICITS, REAL Ouwr GOWH AND REAL INEREST RATES FOR GIVD CURRENr ACCOtMr TARGETS. qh~~~~~~~~~~~~~~~~~~~~e ------ . . X . 0 R / " 5-2s t a co 0~~~~~~~ RM. IfnTuT Si!C cU POINT!) 545 CAS a Current Account Surplus FCA * Feasible Orent Acount Surplus TCA * Targ6v, Owrent Accoat Surplus FS * Fiscal Surplus * inims Fiscal Deficit NPS * Net Private Savig Surplus Private Savings - Private Investment  -11- between private savings and investment behavior and real interest rates imply a restriction on the fiscal deficit-current account target combinations that are possible for any given real interest rate; alternatively, it implies *a restriction on fiscal policy if current account targets are to be met without maintaining real interest rates above those prevailing at world markets (corrected for real depreciation of the Turkish Lira). The analysis so far is not enough to tie the link between fiscal deficits and output growth. It has focused on the impact of the fiscal deficit on private investment; output growth depends on total investment, however, not just on private investment. Clearly, the impact of changes in fiscal deficits on output growth depends on whether the underlying adjustment is made out of public investment or out of public consumption. The model therefore distinguishes between public consumption and investment.| Output growth depends on the sum of public and private investment, a relation that is verified econometrically below (Section III.C(iii)): (2) log(y) - log(y(-l)) - fct((Ig+Ipr(r))/y). For given public sector investment and fiscal deficit, equations (1) and (2) yield a negative link between output growth and improvements on the current account of the balance of payments. This can also be read from Figure 2. In the bottom quadrant, we represent graphically the relation summarized in equation (2). The top quadrants shows how higher real interest rates are necessary for a current account improvement for given fiscal deficit; the bottom quadrant then shows how these higher real interest rates slow down output growth through their impact on private investment. This conflict between external balance and output growth is of course at the core of the macroeconomic problems caused by the debt crisis. ChhibberDisk/chhibber-Turkey Paper/ac:07-28-88: lc  -12- C. Agolication to Turkey: Empirical Preliminaries This Section presents the estimation of the parameters in the behavioral equations of the model. We first present a private consumption function. The next subsection shows the results for an investment function linking private fixed capital formation to capacity utilization, real interest rates and output. Finally we give , and a growth equation linking total fixed capital formation and real GNP growth investment. (i) Private Consumption Private consumption (CONKP, nominal cGnsumption deflated by the CPI) depends on the real interest rate, the real exchange rate, inflation, current income, and a proxy for wealth ("permanent income"). The real interest rate used is defined as the highest (compound) interest rate on time depLsits, net of taxes, and converted into a real rate using CPI inflation. The inflation term is CPI inflation. Permanent income (a proxy for wealth) is approximated by trend growth in private disposable income. This trend is calculated by a regression of the logarithm of private disposable income on time, a constant, and a dummy to distinguish the period before and after 1978. The dummy variable takes the value zero before 1978 and one from 1978 onwards. It captures a level shift in the time path of real income associated with the severe downturn in 1978. Output growth has since recovered to roughly similar growth rates as the ones that characterized the pre-1978 period. Clearly, no catch-up has taken place with what output would have been if the 1978 downturn would not have taken place. ChhibberDisk/chhibber-Turkey Paper/ac :07-28-88: lc  -13- We therefore modeled the shift as a break in the level of income rather than in the coefficient of the time trend. The results of this regression are summarized in equ. (3): (3) log(PERYP) - 4.47 + .058 TIME - 0.10 DUMMY (16.4) (13.5) (2.01) 2 - 0.97, D.W.-0.47 Temporary income TMPYP is defined as the excess of actual income over trend: TMPYP - YP/PERYP YP is actt'al disposable income, and PERYP the permanent component. With these data definitions, the private consumption regression yields the following estimates: (4) log(CONKP) - -1.54 - 0.82 LOG(l + RDEP) - 0.77 CPIinf (1.92) (2.12) (2.37) + 1.35 log(PERYP) - 0.19 log(TMPYP) (7.91) (0.32) R2 - 0.96, DW - 1.72, Sample Period 1970-1986, TSLS The impact of the real after-tax deposit rate RDEP on private consumption is negative, and significantly so. In addition, private consumption depends negatively on inflation, with an almost equal coefficient. This has also been found in consumption analysis for some developed countries: in particular see Bean (1986) for similar evidence on the UK. Finally, the effect of permanent income on consumption is strongly positive, as expected, with a coefficient close to one. The coefficient on temporary income 'q low and insignificant (a t-statistic of only 0.32; significance requires a value of 2 or more). All these results fit in well with accepted theory of consumer behavior. ChhibberDisk/chhibber-Turkey Paper/ac :07-28-88: 1c  -14- (ii) Private Investment The investment equation is based on an eclectic "accelerator" model. Private fixed capital formation (ie investment net of stock changes) depends, first of all, anticipated future sales, proxied here by lagged output (Y(-l); clearly data on current output are not available when investment decisions are taken). In addition, the real after-tax lending rate (RLEND), converted into a real rate using the GNP deflator, is used to capture the cost of funds.4 However prevalence of credit rationing and the use of credit subsidies suggest that quantities, in addition to prices, are likely to be important. This effect was captured, in an admittedly crude way, by including the ratio of credit to the private sector over output (CRD/Y) as an explanatory variable. In addition, capacity utilization in manufacturing (CPUTL) was included as a proxy of the ratio between expected sales and output capacity. The final explanatory variable is less conventional. The (lagged) share of infrastructure investment in total public investment, SHINF, is included in an attempt to assess the impact of allocation of public sector investment on private investment. The econometric results are remarkably good: (5) log(INFKP) - - 15.68 + 1.24 log(CRD/Y) (4.20) (2.52) + 1.21 log(Y(-l)) - 1.69 log(l + LREND) (6.49) (4.17) + 1.45 log(CPUTL) + 0.35 log(SHINF(-3)) (1.40) (1.15) R2 - 0.79, DW - 1.66, Sample Period 1970-1986, TSLS g/ See Chhibber and van Wijnbergen (1988) for documentation of the interest rates and various tax wedges that have been incorporated in the derivation of the lending rate figures, as well as for the theoretical basis and data to estimate the private investment equation. ChhibborDisk/chhibber-Turkey Paper/ac:07-28-88:1c  -15- The regression results show that both the quantity and the cost of credit have a strong and significant impact on private sector capital formation. The real after-tax lending rate has a negative sign and is significantly different from zero: the t-statistic equals 4.17. The credit variable too is highly significant. The precision of the coefficients on capacity utilization and on the share of infrastructure investment in total public sector investment is low, although they have the right sign. (iii) Investment and Output Growth The relation between investment and output growth is based on a simple production function approach. First, a measure of capacity output was derived by combining actual real GNP with the measure of capacity utilization used in the investment equation: YKA - Y/CPUTL TIhis is an imperfect measure, since CPUTL applies to manufacturing only, and it is used to derive aggregate capacity, not just capacity output in manufacturing. No better measure was available however. Also, reliable data on labor use are not available. So in the end the equation estimated simply links capacity output to last period's capacity output and the share of total fixed capital formation in GNP: (6a) log(YKA) - 0.016 + 0.45 (INFT(-l)/Y(-l) (0.20) (1.20) + 0.94 log(YKA(-l)) (28.3) R2 - 0.98, DW - 1.67, Sample Period 1970-1986, OLS This can be rewritten to yield an expression linking investment shares with the rate of output growth: ChhibberDisk/chhibber-Turkey Paper/ac:07-28-88:1c  -16- (6b) log(YKA) - log(YKA(-l) - 0.016 + 0.45 (INFT(-l)/Y(-l)) (0.20) (1.20) - 0.06 log(YKA(-l)) (1.70) In the actual model used for the simulations, (6b) was used, with the coefficient for log(YKA(-l) on the right-hand-side set equal to zero. III. FISCAL POLICY, PRIVATE SAVINGS AND INVESTMENT AND OUTPUT GROWTH A. Th Lole of Fiscal Policy: an Outline The introduction argued that Turkey has adopted a growth-oriented debt strategy rather than rely on sustained high surpluses on the non-interest current account to keep the debt-output ratio in check. The key factor determining success or failure of such a strategy is an internal adjustment program that relies sufficiently on reduced consumption rather than reduced investment to generate the internal surplus that is required. If consumption does not fall, either external targets or output growth will need to be sacrificed; the former if investment is not reduced and the latter if it is. In this section, it is shown how Turkey has by and large succeeded in doing so, and how fiscal policy has contributed to this achievement. However, the analysis also brings out that continued success of this strategy is being jeopardized by a deterioration in fiscal deficits and the ensuing reliance on the issue of high cost internal debt. Any internal adjustment program designed to complement external balance targets has two components. The first issue concerns the extent to which the external transfer will be matched by a reduction in the fiscal deficit rather than an increase in the private sector savings surplus. The ChhibbgrDisk/chhibber-Turkey Papr/ac :07-28-88:lc  -17- second step focuses on the specific manner in which the matching private sector surplus is brought about, and is the subject of this section. It is here that the interaction between private sector savings and investment decisions and fiscal policy becomes important. The way consistency between internal policies and external targets is brought about determines whether fiscal plans and external targets can both be met without jeopardizing output growth: does the private sector run a surplus at high levels of savings and investment or at low levels? If the surplus is achieved by increasing savings for sustained ir.vestment levels, output growth can be maintained. If however the adjustment comes mostly out of investment cutbacks for given private savings rates, external adjustment is bought at the cost of lower output growth. An obvious part of the solution is to shift government expenditure away from consumption towards investment. Table 2 shows the extent to which this was achieved in Turkey. As a consequence, the public sector savings rate (revenue minus current expenditure as a percentage of revenue) increased substantially over the period, in fact to levels not reached at any time since 1967 (see Figure 3). However, not much is gained by such a strategy if, in the end, additional public sector investment simply substitutes for reduced private sector investment. This was probably avoided in Turkey; private investment did not decline as a share of GNP between 1981 and 1985, and actually increased after that (Table 2).5 It is now in fact slightly higher than the level it reached during the period 1972-1980. .. Although almost the entire increase was due to increased housing investment. ChhibberDisk/chhibber-Turkey Paper/ac :07-28-88: 1c  -18- TWO 2 KEY MACROECONOMIC INDICATORS QP_ mutae er. at GNP) lIt EaL Rev. Eat. 190 1861 1962 1963 1#64 1965 1986 1987 1967. Total CAuinmpm 84.1 62.0 61.8 6. 83 60 77.7 77.9 76.5 Privae 71 73 711 73. 74. 72. U 668 67.0 Ogyerinmeut 12.3 10.7 10U 10.2 6.8 84 s 9.0 9.5 Fixd bvgtl eu 19.5 1 1. 1. 1. 20. .6 2.7 24.9 PE. 10*9 11.7 11.5 106 9 11.7 14.0 14.0 13.6 P divate 6 7.2 7.3 8.2 62 . 9. 9.7 11.3 SteakChequ 1.9 26 1.5 1.1 L4 09 1.4 0.1 0.1 P~I1. 0.5 1.5 05 -4.4 0.0 -0 0.1 -0.5 -0.1 Private 1.4 1.1 1.0 1. 1.4 1.0 13 0.6 0.2 Cat Ahvoo&u - -3 -2.2 -5 -2. -1.9 -2 -1.7 -1.5 I.ats at