Inflation has risen to a 20-year high, exacerbated by global supply constraints and buoyant domestic and external demand. In 2022, consumer price inflation stood at 72.3% (Figure 2) and producer price inflation exceeded 128%. The sharp rise in energy prices – Türkiye is a net importer -- and other commodity prices triggered by the pandemic and subsequently Russia’s war against Ukraine contributed significantly to overall inflation. Lira depreciation has added pressures on import prices.

The central bank has cut its base rate by 10 percentage points since September 2021. It has also relied on a new approach to monetary policy, with special arrangements and differentiated macro-prudential rules, to direct loans to productive and exporting sectors. As a result, credit conditions have tightened for some sectors.

Looking ahead, growth is projected to slow to around 3% per annum (Table 1). Weak external demand and persistent geopolitical uncertainties will weigh on investment and export growth. Consumer price inflation is projected to decline somewhat due to base effects but to exceed 40% over the projection period, reflecting gradual pass-through of recent lira depreciation, producer price inflation and wage increases. High inflation will dent household purchasing power and private consumption will slow.

Risks are unusually high and tilted to the downside. The current account deficit is expected to be around 5½ per cent of GDP in 2022 and its funding has shifted from relatively stable sources to more volatile ones. Further pressures on the Lira could turn the exchange rate protection on deposits into an additional liability for public finances, with adverse effects on inflation and confidence.

To bring inflation back to target, the central bank should raise its policy rate. Increasing confidence in the independence of the central bank is vital. Changes to the central bank’s board have been frequent. Inflation expectations have remained well above target, and the lira has lost more than half of its value vis-à-vis the dollar since the start of 2021.

Türkiye should systematically cover risk scenarios and implicit liabilities in its annual Fiscal Policy Reports. Prudent fiscal policy has been a crucial policy anchor over the past two decades in Türkiye and public debt is relatively low as a share of GDP. However, contingent liabilities are expanding, including from public-private partnerships (PPPs), raising Türkiye’s vulnerability to shocks. The burden on the budget may increase significantly, since such PPP projects have guarantees for foreign-currency-denominated payments. The new guaranteed lira saving deposit scheme also generate contingent liabilities. Spending efficiency should improve and the revenue base should be broadened. Türkiye has one of the lowest tax-to-GDP ratios in the OECD.

The government should continue to address the adverse distributional impacts of higher energy prices while preserving fiscal sustainability. The government is supporting lower-income households suffering from rising living costs. This support is warranted but should be temporary and targeted to the most vulnerable to keep fiscal costs manageable. It should also be designed in a way that avoids distorting price signals. The authorities should assess the pros and cons of existing price subsidies and gradually replace them by better-targeted social transfers to vulnerable households.

Inward FDI and equity investment have slowed in recent years and are low in international comparison. At the same time, the contribution of total factor productivity to GDP growth has decreased over the past decade reflecting barriers to effective resource allocation. Going forward, faster income convergence will require addressing underlying structural weaknesses associated with competition and regulations. This would improve the business climate and enable resources to flow to the most promising activities and firms.

There is a need to promote more open competition in product markets. Strict regulations shield incumbents from competition and limit the entry of new firms. Particularly, complex and burdensome administrative procedures to obtain permits, licences or concessions, hamper the creation of formal businesses. Türkiye should consider creating a one-stop shop issuing all licenses and authorisations. There is also room to ease barriers to international trade and investment, particularly restrictions on foreign ownership, which are stricter than in other countries.

Labour market regulations hamper the creation of more and higher quality jobs. Despite progress over the past decade, a considerable share of the workforce, in particular women and youth, still do not actively participate in labour markets. Even though informality has decreased significantly over the past decade, it remains high, particularly among youth, refugees and women. Rigid labour regulations and an expensive severance pay system provide protection to those with a formal job against the fallout of an economic crisis. However, they impede formal job creation for those currently without one. High labour tax wedges and high minimum wages relative to median wages discourage formal job creation. Minimum wages are set at the national level while ample disparities in living standards across regions prevail. Better protecting people, by giving the unemployment insurance system a larger role and by improving the scope and quality of active labour market policies, is a prerequisite for introducing much needed labour market flexibility.

Innovation performance lags behind other OECD countries and there are indications that technological upgrades to production have slowed over the last decade. This is linked to poor educational outcomes and important skills mismatches. Moreover, spending on research and development (R&D) remains low in international comparison, despite an almost doubling over the past decade.

Despite considerable improvements in tertiary and secondary enrolment, around 40% of youth do not complete upper secondary education. Learning outcomes for 15 year-olds are below the OECD average. Moreover, important skill mismatches have emerged, with the number of unfilled vacancies increasing despite high unemployment. While skill shortages are most prevalent for medium-level skills, blue-collar work suffers from a poor reputation. The recent initiative to provide a free-to-use website that allows to compare the labour market prospects of higher education programmes may help reduce skills mismatches.

Increasing the provision and broadening the access to quality early childhood education would help improve educational outcomes. It would also pave the way for women to participate more actively in the labour force. Currently, the labour force participation rate of women is very low and women take up most of childcare and other housework.

Support for innovation needs strengthening. R&D support programmes should be redesigned if they prove to be inefficient and additional support be provided where needed. In particular, schemes that promote collaborative research projects between universities and companies should be reinforced.

Greenhouse gas emissions per capita are low in international comparison but have grown fast in recent years. Coal accounts for around one third of Türkiye’s total greenhouse gas emissions.

Türkiye has promoted renewable energy, with capacity doubling over the past decade. Government policies have been supportive, including via preferential feed-in tariffs, procurement auctions for renewable energy, support to investment and subsidies for rooftop solar installations. Still, much of the potential remains unexploited. The first nuclear power plant is under construction and is expected to meet around 10% of total electricity needs.

Coal combustion accounts for almost a third of electricity generation. Gradually phasing out coal-fired power is essential to achieve the government’s net zero target. Still generous support to the domestic coal sector should gradually be reduced.

Carbon emissions are priced below the levels seen in most other OECD countries. Türkiye does not have an explicit carbon pricing system and effective carbon prices consist mostly of fuel excise taxes. A large share of greenhouse gas emissions from energy use in the electricity and industry sectors is not taxed.