The recovery from the 2001 crisis has been impressive. Over the 2002-05 period, output increased by a third, representing the strongest pace of growth among OECD countries. At the same time, annual inflation fell steadily, reaching single digits in 2004 for the first time in three decades, while sound fiscal and monetary policies improved confidence and reduced risk premia, thereby enhancing business investment and FDI inflows. Thus good progress has been made towards a shift to a stronger and more sustainable growth path. Indeed, the process of real income convergence seems to have begun, following the disappointing periods of the late 1980s and the 1990s. If this path can be maintained, this would represent a significant break from the past decades of short-lived economic booms, followed by sharp downturns or recessions.

The Turkish economy has grown by a third since the 2001 crisis. Far-reaching macroeconomic and structural reforms have helped to increase confidence, reduce risk premia and stimulate domestic and foreign investment. However, Turkey was one of the countries most affected by the decline in the risk appetite of the international financial markets earlier this year and a number of challenges must still be addressed to minimize the risk of falling back into a boom-bust cycle and to ensure that strong growth is sustainable. The priorities are to further strengthen fiscal, monetary and prudential policy institutions in order to make the economy more resilient to shocks, and to accelerate the pace of reform in labour, product and agricultural markets and in the social security and education systems in order to overcome the deep dualities which hinder the long-term growth performance.

Since the crisis of 2001, an impressive package of fiscal consolidation and institutional reform has created a strong foundation for economic growth. As a result, GDP growth has been strong and stable, inflation has fallen, and the public debt burden has been significantly reduced. Yet the current account deficit is large, exchange rate movements have been volatile, and the recent increase in inflation and rising levels of private sector external debt draw attention to Turkey’s vulnerabilities and to the need for additional policies to contain risks. This chapter summarises the vulnerabilities of the Turkish economy and the steps that can be taken to improve macroeconomic resilience to shocks.

Turkey’s business sector has achieved high growth over the past few years and – on average – has coped well with increased competition. However, some labourintensive sectors lost competitiveness prior to the currency depreciation in mid-2006 and faced employment losses, raising political pressure for interventionist policies. This chapter argues that the government should resist such pressure and instead follow a broad-based strategy to improve framework conditions for firms, irrespective of their size, sector and legal status. Overcoming the duality between the formal and informal sectors should be the central point of this strategy. In particular, the cost of labour should be reduced and regulatory hurdles in labour and product markets should be minimised, to help formal firms to remain competitive and increase employment. This would also make it easier for the many small and medium-sized firms to move into the formal sector, thereby raising productivity through economies of scale. This would increase the growth potential of the whole economy, broaden the tax base and level the playing field for doing business in Turkey, not only for the wide variety of domestic firms but also for foreign investors.

Recent social security reform has significantly improved the long-run sustainability of the pension system. However, the pension system continues to serve as an important barrier to a more rapid expansion of the formal-sector economy in two ways. First, early-retirement incentives (including severance payments) continue to push many middle-aged workers into the informal sector. Second, even when the transition to the new pension rules is complete, net replacement rates will remain very high by OECD standards, requiring high social security contribution rates that make it too expensive for firms to employ low-skilled labour in the formal sector. Thus, further pension reform is one of the keys to overcoming Turkey’s economic duality. Finally, since the pension system does not cover the informal sector, it does little to alleviate poverty among the wider population of older people. This chapter discusses a number of reforms that would increase the retirement age, reduce intergenerational inequities, and permit a significant cut in the tax wedge on labour, while better addressing old-age poverty concerns at all levels of income.

In recent decades the access of the school-age population to education has been expanded significantly. However, the quality of education remains low at the majority of schools, and the education system focuses predominantly on providing good quality education to the most able students, who are channelled towards university and work in the formal sector. As a result, the most binding human capital shortages are at the middle and low end of the labour market. Despite this, resources continue to be skewed towards the “high end”. Although it was originally conceptualised as a merit-based system, the way the system works favours students from higher-income families with more resources and this raises efficiency and equity concerns. This chapter documents these problems and discusses the fundamental challenge of reorienting the key focus of the education system and the changes to the allocation of funding and school governance that this will require.

The productivity and competitiveness of Turkish agriculture have been constrained by socio-economic weaknesses in rural areas and a protective trade and subsidy regime, which has created a status quo of highly fragmented, low-skilled, low-technology and domestic-market-driven farming. A major reform based on cutting distortive price and input subsidies and replacing them with direct income support was introduced in 2000-01, but there are risks that the reform will be less successful than anticipated. The reform effort should be reinvigorated and backed by improved framework conditions – legal infrastructure, technology transfer services, irrigation and other infrastructures – needed for the stronger development of commercial agriculture.