The foreign exchange gap, growth and industrial strategy in Turkey : 1973-1983

The Foreign Exchange Gap, Growth and Industrial Strategy in Turkey: 1973-1983 SWP306 World Bank Staff Working Paper No. 306 November 1978 The views and interpretations in this document are those of the authors and should not be attributed to the World Bank, to its affiliated organizations or to any individu,al acting in their behalf. Prepared by: Kemal Dervis Sherman Robinson Economics of Industry Division Development Economics Department O ; 1978 UB Bank G et, N.W. 881.5 DnCl 204.3- LJ-S , VtA W57 167 0 lo .306   The views and interpretations in this document are solely those of the authors, and should not be attributed to the World Bank, to its affiliated organizations, or to any individual acting in their behalf. WORLD BANK Staff Working Paper No. 306 November 1978 THE FOREIGN EXCHANGE GAP, GROWTH AND INDUSTRIAL STRATEGY IN TURKEY: 1973-1983 T'his study is an examination of the interaction between. trade, trade policy and growth in the Turkish economy. The analysis relies to a great extent on a multi-sector general equilibrium growth model of the economy. T'he model focuses on trade and industry and attempts to capture the basic mechanisms that link economic performance and structure to trade policy in the medium run. The time period covered is 1973 to 1983 with first an evaluation of the past five years- (1973-1977) and then an analysis of future prospects and alternatives (1978-1983). The study was undertaken during the first half of 1978, by the authors, who work in the World Bank's Economics of Industry Division. Prepared by: Kemal Dervi,s Sherman Robinson Economics of Industry Division Development Economics Department Copyright Q 1978 The World Bank 1818 H Street, N.W. Washington, D.C. 20433 U.S.A.   -ii- This study has been prepared in the Economics of Industry Division of the Development Economics Department during the Spring and Summer of 1978. It concentrates on an analysis of the foreign-exchange gap and the interrelationships between trade, growth and industrialization in Turkey. The analysis is largely, but not exclusively, based on results obtained by using a multi-sector general equilibrium growth model of the economy covering the period from 1973 to 1983. All experi- ments were completed in July 1978 and the forward looking projections reflect the data and estimates as they were available at that time. We have benefited from close collaboration with the regional economists and would like to thank Ram Chopra, David Berk, Shakil Faruqi and Adrian Wood for their help and advice. We have worked particularly closely with Adrian Wood and many of his ideas are reflected in the formulation, of the model and discussion of the experiments. Vinod Dubey, Attila Karaosmanoglu, Don Keesing and Larry Westphal made important suggestions which have helped a great deal in writing the first draft. Jaime de Melo gave us extensive comments and much in this study reflects ideas developed with him over the last two years of joint work. Finally, we would like to thank Hollis Chenery for his encouragement and constant interest. We have had the expert research assistance of Murat K6prUi.1i throughout this study and thank him for his help. We are also indebted to Jeff Lewis who did the "sources of growth" computation and prepared the figures in Part 5. Margot Clark typed the whole manuscript and Rob Kish typed the first two drafts. We thank them for their paLience.   -iii- Remaining errors and weaknesses are of course ours alone and the views and policy conclusions expressed in this study are those of the authors alone and should not be attributed to the World Bank, to its affiliated organizations or to any individual acting in their behalf.   The Foreign Exchange Gap, Growth and Industrial Strategy in Turkey: 1973-1983 Page 1. Introduction 1 2. Distinctive Features of the TGT Model 9 2.1 Introduction 9 2.2 Imporl: Demands and Relative Prices 11 2.3 Fixed Exchange Rates and Quantitative Restrictions 14 2.4 Price Level Normalization, Inflation and the Exchange Rate 19 2.5 Production and Supply 22 2.6 The Treatment of Exports 25 2.7 Macroeconomic Aspects and the Flow-of-Funds 27 2.8 Dynam:ic Linkages 34 3. Analysis oi. the Turkish Economy from 1973 to 1977: The Making of a Crisis 38 3.1 Introduction 38 3.2 Summary of Recent Events and Policy Reactions 39 3.3 Exchange Rate Drift and Structural Imbalances: Decomposing the Change in the Equilibrium Exchange Rate 47 3.4 Growth, Trade and Structure: 1973-77 59 3.5 Conclusion 69 4. Prospects f'or the Future: An Economy-Wide Perspective for 1978-1983 72 4.1 Introduction 72 4.2 Constant Price Deflated Exchange Rate Policy 72 4.3 Macroeconomic Consequences of Alternative Trade and Exchange Rate ]'olicies 89 5. Microeconomic Analysis of the Impact of Trade Policy on Industrial Structure and the Sources of Industrial Growth 109 5.1 Introduction: Trade Policy and Resource Allocation 109 5.2 Sectoral Aggregation and Sectoral Trade Characteristics in the TGT Model i1 5.3 Growth and Industrial Structure under Alternative Trade and Exchange Rate Policies 116 5.4 Export Expansion, Import Substitution and the Sources of Growth 128 6. Conclusion 150 7. Appendix A: The Equations of the TGT Model 8. Appendix B: The Data   1. Introduct:Lon The purpose of this study is to analyze Turkish industrialization and growth in the 1970's and to evaluate prospects for the 1980's using a mullti-sector general equilibrium growth model of the economy. The very serious foreign exchange crisis that emerged in 1977 has again emphasized the importance of trade and trade policies as major determinants of Turkey's overall economic performance. It therefore seems appropriate that the major focus of the discussion be on the interaction between foreign trade and growth and the analysis of the foreign exchange constraint. Turkey's growth rate has been impressive in the past, averaging 6.5 percent over three decades (1947-1977). This relatively high growth rate was achieved without the availability of particularly valuable resources such as oil, with only a moderate amount of foreign aid and within the framework of basically democratic political institutions. Finally, while income is quilte unequally distributed (with a very large rural-urban gap and a Gini-coefficient above 0.500), basic needs are reasonably well met and problems of malnutrition, basic health care, basic education and shelter are less acute than in many countries with equal or even higher per capita incomes.L/ - The initial conditions from which Turkey started after World War I were not favorable. For example, both in terms of physical infrastruc- ture and human resources, Egypt was significantly ahead of Turkey at 1/ For an evaluation of Basic Needs in Turkey, see Karaosmanoglu and Durdag (1977). For an analysis of the distribution of income, see Dervi, and Robinson (1977).  - 2 - the beginning of the century.A/ Particularly in terms of human resources, all the Southern European countries such as Bulgaria, Greece, Serbia, Croatia, Spain and Portugal were far ahead of Turkey before and after World War I. Furthermore, the rate of population growth in Turkey remained betweeen 2.5 and 3.0 percent throughout the century and, while on a declining trend, it is still more than double that in the rest of Southern Europe. With a per capita income of about $1000 in 1977, Turkey remains poorer than most countries in the semi-industrial category. Growth, while rapid on average, has not proceeded at a steady pace. The foundations of Turkish industrialization were laid in the decade before World War II and, in spite of the world depression, Turkey achieved substantial growth in the 1930's with important investments in infra- structure and the creation of State Economic Enterprises that successfully led to the beginnings of industrial growth. The war and the diversion of resources and change of priorities it created in spite of Turkey's neutrality were probably the major causes of the complete economic standstill that followed in the 1940's.i/ Since 1950, which marks the beginning of regular national accounting as well as an important political turning point, Turkey seems to have gone through three rather similar cycles. Each starts with a period of quite rapid industrial growth and ends with a major foreign-exchange 1/ See C. Issawi (1978). 2/ See Bulutay and others (1975) for estimates of national income in the 1930's and 1940's. See also Herschlag (1968) and Land (1970).  - 3- crisis, a large devaluation and a transitory slowdown in industrial growth.L/ In Figure 1, two-year moving averages of industrial growth rates have been plotted against time. The three cycles are quite apparent from the graph. Each downswing is associated with an acute foreign-exchange crisis and a major effective devaluation, close to 100% in 1958, about 50% in 1970 and again about 50% in the period from September 1977 to March 1978.-/ Wh:Lle a clear cyclical pattern emerges from Figure 1, one has to be careful in interpreting the cycles in too mechanistic a fashion. Common factors and aspects exist but one crisis has not been a simple repetition of its predecessor. Thus, while the 1958-1960 crisis followed a period of a]Lmost hyperinflation and was followed by a period of remark- able price stability, exactly the opposite is true of the 1970 crisis. It followed a period of relative price stability but was followed by a period of substantial inflatiosi. The impact on export performance has also varied. The 1958 de facto devaluation was not followed by a major upward surge of exports. Between 1957/58 and 1961/62, exports increased by only 23% in value. In contrast export revenue increased by 153% between 1969/1970 and 1973/1974. There was reason for much optimism in the early 1970's. The foreign-exchiange constraint that had plagued the Turkish economy throughout 1/ Economy-wiLde growth has not always followed the movements of industrial growth because of the extreme volatility of agricultural growth, heavily dependent on weather conditions. 2/ See Krueger (1974) for the computation of changes in effective exchange rates in 1958 and 1970. Note that by industrial we are here referring to the non-agricultural sectors including services.  I~~- . . -'-- -.f-1'_- 4- 1'-4'---''. 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I Ij _ _ _ _ - ..II _ _ _ 1 ~ . _ _ _ _ _ _ _  -5- the 1950's and 1960's had all of a sudden disappeared. For the first time ever in post-war history, the current account deficit declined to zero in 1972 and turned into a 484 million dollar surplus in 1973. Foreign exchange reseirves reached 2 billion dollars at the end of 1973, a figure equal to annual imports of merchandise. The major factor responsible for this substantial accumulation of reserves was the sudden and massive in- flow of workers' remittances from Western Europe: while only 141 million dollars in 1969, remittances were 471 million dollars in 1971 and reached a peak of 1426 million dollars in 1974. Tourism revenues and manufactured exports also increased. Total export revenues increased by 15% in 1971, 31% in 1972 and 49% in 1973. Manufactured exports grew at an annual rate of 40% in the same period. Value-added in industry grew at 10.6% in the 1970-73 period. Performance in agriculture was mixed, with a 10% decline in 1973 but a 13% growth-rate in 1971. While the weather is still a major deter- minant of agricultural output, increased use of fertilizer and mechanization proceeded at a very rapid pace in the first half of the seventies and the average growth rate of agricultural output between 1970 and 1975 was 4.5%. The- situation seemed to point to an increase in the possible trend growth rate of the Turkish economy from about 6.5 percent to about 8.0 percent. In fact, between 1970 and 1976, GDP grew at an annual average. rate of 7.7 percent. It was even on an accelerating trend after 1973, seemingly in spite of the oil crisis and the world depression that followed. There was general agreement in Turkey that the Fourth Five Year Plan due to start in 1978 should aim at an annual growth rate of at least 8.0 percent.  -6- This kind of growth rate is perceived to be a necessary minimum for the absorption of underemployment and for a significant narrowing of the absolute income gap that separates Turkey from other Southern European countries, an objective planners hope to achieve by the end of this century. With the full emergence of the current foreign exchange crisis, these goals are seriously called into question. The cumulative current account deficit since 1974 has reached 8 billion dollars, with the 1977 deficit alone about 3 billion dollars. While the current foreign-exchange crisis is similar in many ways to the 1958 crisis, it is probably deeper, with a much greater percentage resource gap. The debt-service ratio has climbed from 11.4 percent of exports and workers' remittances in 1976 to 15.6 percent in 1977 and it will be above 20% for the coming years. Payments for imports have been delayed on a wide scale, foreign exchange reserves equal only one month's worth of imports, industry is lacking crucial imported inputs as well as energy and it appears that growth has come to a halt in the latter half of 1977. Predictions and projections for the future vary widely. In the short-run, that is to say in 1978 and 1979, it seems clear that only a very substantial net new inflow of borrowed funds can allow increased capacity use and prevent fixed investment from actually declining. Can a 5 to 6 percent annual growth rate be achieved in 1978-1979? How much new external finance would appear necessary for the achievement of such a target? What are Turkey's growth prospects in the longer-run? Can an 8  -7- percent growth rate be achieved over the Fourth Five Year Plan now covering 1979 to 1983? What kind of policy package complemented by what amount of foreign resources could be expected to allow the realization of an 8 per- cent growth target? What are the implications for the growth of private consumption and public consumption? What are the implications for em- ployment and sectoral structure? Is the exchange-rate of 25 TL to the dollar arrived at after the March 1978 devaluation a realistic one that should be preserved in real terms or are further devaluations needed? These are the basic questions we want to address in the following sections emphasizing and analyzing the impact of policy. But before attempting to provide projections for the future and evaluating possible alternative policy packages, it is necessary to analyze the nature of the crisis that emerged in 1977. How did Turkey move from a 484 million current account surplus to a 3.2 billion dollar deficit in 4 years? Is the crisis one that is largely due to factors endogenous to Turkey's development policies or can it be explained by exogenous shocks coming from the world economy? Are present problems the necessary outcome of Turkey's inward-looking import-substituting development strategy or would the crisis never have occurred had it not been for the oil price increase and increased dis- bursements for military hardware due to the American embargo? Without at least finding tentative answers to these questions and assigning approximate weights to the various factors that led to the 1977 collapse, one cannot really appraise future prospects and policy alternatives. Part 3 will therefore attempt to provide a quantitative analysis of the 1977 crisis  with special emphasis on the role of the oil price increase. Part 4 will turn to the future and offer an analysis of the impact of alternative policy packages on overall growth and economy-wide performance in the Fourth Five Year Plan period. Part 5 will turn to a microeconomic analysis and will focus on the pattern of sectoral growth and the role of import substitution and export expansion. Both the macroeconomic analysis in Part 4 and the microeconomic analysis in Part 5 will rely to a large extent, although not exclusively, on a computable general equilibrium model of the Turkish economy that allows conditional policy experiments to be conducted and with which we attempt to quantify the general equilibrium mechanisms that link trade, growth and employment to policy variables such as the exchange rate, tariffs, import rationing, export subsidies, taxes and government expenditure patterns. Part 2 below provides a detailed description of the most important features of the model. A complete statement of the model equations is available in Appendix A.  2. Distinctive Features of the TGT Model 2.1 Introduction: General Equilibrium Modelling This section describes the most important features of the general equilibrium growth model of the Turkish economy on which much of the discussion will be based. While of an economy-wide nature, it concentrates on the industrial sector and on issues of trade and in- dustrialization. We shall call it the TGT model (Turkey, Growth and Trade). The model is in the tradition of the non-linear computable general equilibrium (CGE) models that have been built over the past few years for devielopment planning purposes.-/ The original inspiration for this class of models can be found in Chenery and Uzawa (1958) and Leif Johansen's 1960 study of the Norwegian economy, but computational diffi- culties prevented, at that time, the full implementation of these ideas. Since then, computational difficulties have greatly diminished and it has become possible to implement very large and highly non-linear models. Progress, in this field as in others, is not costless. The data re- quirements of large models characterized by price endogenous feedback mechanisms are larger than those of simpler linear models and often the specification is ahead of the data. The availability of Social Accounting Matrices of the sort recently built by Stone, Pyatt and others 1/ See for instance Dervis (1975), Adelman and Robinson (1978), Taylor (1978), De Melo (1978) and Ahluwalia, Lysy and Pyatt (1977). See also Chenery and Raduchel (1971) who, with a 4-sector illustrative model, stressed the importance of modelling price-sensitive direct substitut:Lon mechanisms. For an approach based on linearization rather than expl:Lcit solution see Celasun (1975).  - 10 - is therefore a development from which CGE modelling can greatly benefit.l/ A second area of concern is the difficulty of keeping track of the various causal chains implicit in a complex non-linear model. Nevertheless, while still in their first phase of implementation, the recent models that endogenize prices and incorporate direct substitution constitute a notable advance in the field of development planning because they make possible an explicit analysis of policy packages that work through the price mech- anism. They should therefore, when properly used, allow a much richer dialogue among economic theorists, model builders and policy makers. It is in this dialogue that one should see their most useful function. The model of Turkey builds on recent work we have done and aspects of it can already be found in De Melo and Dervis (1977), Robinson and De Melo (1976) and Dervis (1977a & b)-. But, particularly in the treat- ment of trade policy, the specification of adjustment to a fixed exchange rate, the treatment of exports and the incorporation of macro-accounts, the present model provides several new features. In the next subsection, we describe a number of the distinctive features of the model. The full set of model equations, both static and dynamic, is given in an appendix. We do not discuss the solution 1/ See Pyatt and Thorbecke (1976), Stone (1970), and United Nations (1975). An aggregate social accouting matrix for the model is presented in Section 2.6 below.  - 11 - algorithm but note only that we are able to solve the rather large non- linear general equilibrium system quite economically.l/ 2.2 Import: Demands and Relative Prices Emp:Lrically, one of the most unrealistic assumptions of trade theory is the treatment of foreign and domestic goods of the same sectoral classification as identical. The assumption is essentially harmless when it is used to obtain the many important qualitative results and theorems of trade theory. But when it is incorporated into applied planning or model-building exercises, it leads to extremely unrealistic and misleading results. Under such a homogeneity assumption, the domestic prices of tradables are fully tied to the price of imports and the structure of production and consumption in a given country will be extremely sensitive to slight relative-price variations between foreign and domestic goods, leading to overestimation of the effects of exchange- rate policies as well as a tendency to specialize in the production of a few commodities. An elegant formulation that allows one to keep aggregative commodity categories across countries, but introduces product differentiation by countries of origin into the structure of demand for commodities in any given country, was proposed and implemented in a partial equilibrium 1/ Our solution strategy follows the basic approach described in Adelman and Robinson (1978). We have, however, developed a new algorithm for solving this type of model that seems more robust and easier to apply than previous algorithms.  - .12 - framework by Armington in 1969.1/ The crucial assumption is that "mar- ginal rates of substitution between any two products of the same kind (i.e., commodity category) must be independent of the quantities of the products of all other kinds." Within the framework of a single country model, the basic idea is to define a "composite" commodity that is a C.E.S. aggregation of commodities produced abroad or imports, Mi, and commodities produced and consumed at home, Di. The aggregation takes the familiar C.E.S. form: i= y[6 M-pi + (l - )D-Pi]l/Pi il, . . ., n (1) iii where yi, %i and Pi are the parameters of the C.E.S. function in sector i, with =