Cablegate: Turkey: Economists Stress Economic Progress, but Need For

DE RUEHAK #1010/01 1201324
R 301324Z APR 07







E.O. 12958: N/A

Ref: Ankara 801

This cable has been coordinated with Congen Istanbul.

1. (SBU) Summary: As domestic political risk comes to the fore in
the wake of the weekend's dramatic developments, Turkish economists
underline the economy's remarkable transformation since the 2001
crisis. Strong growth, fiscal consolidation and surging Foreign
Direct Investment underpin a significant reduction in economic
vulnerabilities: debt ratios are stronger, banks are
well-capitalized, and the current account remains easily financed.
This contrasts previous periods of political instability that
coincided with economic weakness and vulnerability in 2001,
1999-2000, 1997, and 1980. While the country's financial cushion
seems sufficient to weather a passing political storm without a
market or economic crash, economists' biggest fear is an extended
period of policy doldrums and disarray that would delay a second
generation of reforms needed to sustain the high growth that will
allow Turkey's living standards to converge with EU averages. They
will be watching closely for signs of a political consensus that
will leave the economic reform agenda intact. End Summary.

The Other Shoe Never Dropped

2. (SBU) In a round of meetings before the weekend's events,
Ankara-based economists in Government agencies, the Central Bank,
the bank regulatory agency and an independent think tank were
uniformly positive in their assessment of the Turkish economy,
stressing in particular how far it has progressed since the 2001
crisis. Turkey has experienced five straight years of growth
averaging over 7%, reduced its public sector debt ratios, attracted
newly-high levels of FDI, and brought inflation down to around 10%.
Although the think tank economists, including former Central Bank
Governor Serdengecti, are more willing to point out the economy's
weaknesses, they also acknowledge the dramatic improvements.

3. (SBU) Moreover, the full-year 2006 data -- and the absence of
public or private financial problems -- have put to rest fears that
the May-June 2006 market correction would damage Turkey's economic
recovery. In the immediate aftermath of the correction, many
analysts wondered whether corporations that had borrowed in foreign
exchange would suffer financial difficulties that might only become
visible with a lag. None of the economists we spoke with had seen
any evidence of financial stress from last year's correction. Bank
Regulatory and Supervisory Agency (BRSA) officials said they did not
seen signs of rising non-performing loans in the banking sector.

Transformed Banking Sector

4. (SBU) Among the areas in which Turkey's vulnerability is
much-reduced is the banking sector. The 2001 crisis was a banking
crisis, with regulators working to clean up the mess for several
years thereafter. Few analysts now worry about the sector's
vulnerability. If the May-June volatility was a test, the Turkish
banking sector passed it with flying colors. Despite initial worries
that the sector would suffer losses arising from its asset-liability
maturity mismatch (long-dated assets and short-dated deposits) the
impact was minor. BRSA officials told us the sector's Capital
Adequacy Ratio (CAR) was 21% as of year-end 2006, the highest in the
OECD. After the May-June correction, no bank had fell below the 8%
statutory CAR, although some had fell below the 12% threshold below
which BRSA will not approve new branch openings. These banks have
since strengthened their capital position to exceed the 12% level.

FDI Takes Off

5. (SBU) Perhaps the most striking change in Turkey has been the
take-off in Foreign Direct Investment (FDI). After averaging less
than $2 billion a year from 1990 to 2004, FDI hit $9.6 billion in
2005 and $20 billion in 2006. Early fears that FDI would drop
sharply in 2007 have yet to materialize, with $13 billion so far

ANKARA 00001010 002 OF 003

this year. Although critics note the absence of significant
greenfield foreign investment and wonder whether FDI will fall off
once all the available banks have been bought and the privatization
process winds down, foreign companies continue to buy into Turkey in
a broad range of sectors, suggesting the FDI wave has far from run
its course. Domestic investment also continues to be strong, in
part because Turkish groups that sold bank assets to foreign are
reinvesting in other sectors.

Downplaying Current Account Deficit Fears

6. (SBU) Among the vulnerabilities that remain, of course, is
Turkey's large current account deficit (CAD) that grew to 7.9% of
GDP in 2006. All of the Ankara-based economists we spoke with
downplayed the seriousness of the CAD issue. First, they pointed to
the relative ease with which Turkey is financing the deficit, with
FDI accounting for 60% of the deficit in 2006 and increased
long-term borrowing, reducing the dependence on short-term funds.
Moreover, the economists point to the fact that it is the private
sector that is borrowing and investing, buying the imported goods
that are driving the current account deficit. They also emphasize
the composition of imports, which are heavily weighted towards
intermediate goods with a very small share of consumption goods.
Central Bank economists said Turkish industry is shifting from
labor- intensive businesses into higher-value, capital-intensive
businesses, a transformation we are seeing in many sectors,
including textiles.

7. (SBU) In contrast, some private sector financial analysts
express concern over the macroeconomic conundrum posed by the need
to maintain nominal interest rates at 17.5% in order to attract the
capital flows that fund the current account deficit. Rates this
high make credit very unattractive for domestic borrowers and stifle
economic growth. A reduction in interest rates would result in
decreased capital inflows and could prompt a sharp decrease in the
value of the lira. These economists dismiss arguments that
productivity gains would fuel growth arguing that a massive
unregistered labor force made labor productivity statistics
virtually useless. Arguments that the composition of imports
(heavily weighted toward capital goods) would eventually lead to
export-led growth were also dismissed as wishful given historical
trend data.

8. (SBU) Most economists are projecting a slight easing in the CAD
as a share of GDP in 2007, to around 7%. The data for the first two
months of 2007 are encouraging, with exports growing 25% and imports
20% in value terms, while export volumes grew even more rapidly. The
Central Bank economists see a link between the slowdown in domestic
demand growth and export growth, making the case that Turkish
manufacturers are able to shift sales from domestic buyers to
international customers. The weakness of the dollar against euro
and the resurgence of growth in Europe, Turkey's principal trading
partner are both helpful. With many of Turkey's inputs
dollar-denominated and 58% of exports to the EU, dollar weakness
against euro helps Turkey's terms of trade. A national accounts
restatement expected at some point this year would be a purely
mathematical improvement, but could give a significant boost to
GDP/GNP and result in major improvements in Turkey's macroeconomic

Fewer Debt or Market Worries

9. (SBU) Turkey continues to reduce its vulnerability to public
sector debt rollover risk. As of December 31, 2006 public sector
net indebtedness was 44% of GDP, of which only 8% is foreign
exchange-denominated. Although this is still above some comparator
countries it represents a striking improvement from 90% in 2001.
The overall deficit of the public sector shrank from 16% in 2001 to
under 3% in 2006. Turkish Treasury and Central Bank officials also
note the improved structure of the debt, as Treasury has succeeded
in extending the yield curve by issuing first 3-year and then 5-year
fixed rate bonds, as well as inflation-linked floating rate notes.
These have brought the average maturity of domestic public debt to
24 months, up from 15 months in 2001.

ANKARA 00001010 003 OF 003

10. (SBU) As a result, fears of Government problems rolling over
its short-term debt have receded. If the markets were to experience
another bout of turbulence, however, both the Central Bank and
Treasury have built up sizable reserves -- $68 billion and $15
billion respectively -- reassuring investors that they stand ready
in case of market problems. In fact, the reserves are so large, and
the vulnerabilities sufficiently reduced, that Institute for
International Finance Economist Jeff Andersen told us Treasury
should use the reserves to reduce debt, thereby shrinking the supply
of government paper and reducing interest rates.

11. (SBU) With regard to the foreign exchange market, Central Bank
officials and other economists pointed out that residents' increased
stock of foreign exchange has created a fundamentally more positive
situation than existed before last spring's sell-off in the lira.
If the lira were to fall sharply, these local investors are widely
expected to come back into lira to take advantage of the buying
opportunity for their home currency. Once Turkey gets past its
election-year political problems, these residents are expected to
come back into lira assets.

Stubborn Inflation

12. (SBU) Although inflation came down dramatically from 2001
through 2005, since then it seems to be stuck around 10% with the
Central Bank struggling to resume the disinflation trend. Higher
energy prices and the exchange rate correction hurt in 2006 as have
drought-induced higher food prices. The Bank is hopeful that the
second half of 2007 will be provide a breakthrough but remains
concerned about the stickiness of services prices, with people
tending to set prices based on backward-looking inflation indicators
rather than based on future expectations which are nearing 7% for
yearend 2007. Even if services prices remain sticky, a Central Bank
economist pointed out services account for 25% of the CPI basket,
such that by bringing down other prices, the Central Bank can bring
down the headline number and gradually influence services
price-setting behavior.

Avoiding Complacency, Continuing Reforms

13. (SBU) With all these improvements, the Turkish economy is in a
fundamentally better position than it was during early periods of
political tension such as 1980, 1997, 1999-2000 or the 2001 crisis.
Despite the stronger fundamentals, observers such as former Central
Bank Governor Serdengecti caution against complacency. He, along
with most observers, attributes the continued very high real
interest rates to political risk. In this regard, the biggest risk
is a return to the policy drift of the "lost decades" of the 1980s
and 1990s, when Turkey was not able to achieve a stable political
consensus. Markets have thrived under the pragmatic policies of a
single party government since 2002. The economic reform process is
far from over, and some of the most politically challenging reforms
have yet to be implemented in areas such as the labor market,
education, and the judiciary. If these reforms -- which have been
driven by the IMF program and EU accession process -- are put off,
Serdengecti and his colleagues expect much lower growth rates than
the 7% per year needed to create jobs needed to and converge income
levels to a level approaching 50% of that of the EU.


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