Cablegate: Turkey: Why Investors Are Nervous

P 030948Z JUN 08



E.O. 12958: N/A


1. Summary: Both economic and financial indicators show the
honeymoon is over for the Turkish economy. Expectations are
negative and Turkish assets are losing value. Our investment
banking contacts see more nervousness from investors,
occasionally setting Turkey apart from other emerging
markets. For example, Turkish equities have lost 32.3% in
dollar terms since December 31, 2007, versus an increase for
Brazil of 22.3% over the same period. It appears investors
are taking into account the Justice and Development Party
(AKP) closure case risks in an environment where global
conditions are also getting worse and investor risk appetite
is decreasing. GOT policies are also to blame for
investors, nervousness. GOT polices are inflationary, with
increasing expenditures on the fiscal side in anticipation of
local elections scheduled for March 2009. The Central Bank
of the Republic of Turkey (CBRT) and the GOT are no longer
working together to manage inflation and blame each other for
poor results. The IMF stand-by agreement ended May 10, and
the GOT has not yet negotiated a new arrangement, which
investors would likely see as a positive sign. Investors
believe the EU accession process, while slow, has resulted in
positive changes in the economy and their worst-case scenario
for the closure case is a future GOT policy that would end
Turkey-EU talks. End Summary.

Inflation is Up

2. Monthly inflation data released May 2 showed inflation
rose by 1.7% last month, higher than the 1.4% market
consensus. On an annual basis, inflation has risen to 9.7%,
up from 9.2%. Producer prices rose by more than twice
consensus forecasts, putting annual producer price inflation
at 14.6%, up from 11.7%. Transport prices continue to spike,
driven by the surge in global energy prices. Pass-through
from recent Turkish Lira (TRY) weakness continued to generate
considerable cost-push inflation pressure, leading to a
substantial 4.5% monthly increase in producer prices.

3. Following a six-month period of monetary easing from
September 2007 to February 2008, and a subsequent two-month
period of no changes in rates, the Central Bank shifted to
monetary tightening, amid inflationary concerns and
unfavorable global market conditions at the May 15 Monetary
Policy Committee (MPC) meeting. The MPC increased the
benchmark policy interest rates by 50 basis points, which
increased the overnight borrowing rate to 15.75% percent from
15.25%. In its accompanying statement announcing the rate
decision, the CBRT seemed to focus on the 6.7% inflation
forecast for 2009, while signaling for further rate hikes.

GOT Focus is on Growth

4. On May 3, the GOT announced the mid-term fiscal
framework, where it revised the primary surplus target down
to 3.5% from 4.2% of GDP for 2008. The move was viewed by
investors as fiscal loosening and showed that the GOT,s
priorities have shifted to local elections and growth, while
inflation management is a distant memory. This decision put
the Central Bank in a difficult position at a time when the
Turkish economy is suffering from globally high oil and food
prices. On May 26, CBRT Governor Durmus Yilmaz bluntly said
the GOT is loosening its fiscal policy and, in the monthly
inflation report released at the end of May, warned the GOT
on the need to maintain discipline. The Finance and Treasury
Ministers claimed that decreasing the primary surplus target
does not signal fiscal loosening, since these funds will go
to finance the Southeast Anatolian Project (GAP). The GAP
was announced by the Prime Minister on May 27 and is detailed
in Reftel A. The Central Bank did not buy this argument even
though the GOT claimed that the intention was to use the
additional fiscal resources solely to promote employment and
growth. In May, the Central Bank revised its inflation
forecasts upward through 2010, projecting year-end inflation
at 9.3% in 2008, 6.7% in 2009, and 4.9% for 2010. This
official shift in inflation expectation caused local bond
rates to increase to 20% with the expectation of future rate

Deficit is Rising; Unemployment is Up

5. Economic market indicators also continued to deteriorate.
The current account deficit expectation increased to $44.9
billion, up from $43.1 billion. The March current account
deficit was $4.2 billion versus the market expectation of
$3.7 billion. For the January to March 2008 period, the
deficit jumped to $12.04 billion. Net FDI, which is a major
source of income for Turkey and bellwether for investors,
decreased 50.5% from same period in 2007, ending the quarter
at $4.04 billion. Meanwhile, unemployment continued to
increase, reaching 11.6% in the first quarter of 2008.

Investors Explain their Jitters

6. We met in Istanbul with some leading investors on May 27
and 28. All noted they did not expect a crisis, but said the
honeymoon was over, and current global market conditions
suggest the GOT should be extremely cautious. Investors feel
insecure both with GOT economic policies and the AKP closure
case. All our contacts agreed that the second AKP
administration is very different from the first, with less
focus on the economy and more focus on populist measures and
attracting votes. Conflicting policy measures, delayed
economic and EU reforms, little progress on privatization,
and the growing tension between the CBRT and the GOT caused a
credibility slippage. Investors have lost much confidence in
the economic team of Deputy Prime Minister Nazim Ekren,
Treasury Minister Mehmet Simsek, and Finance Minister Kemal
Unakitan. Investors note they are not influential on key
policies, and the Prime Minister continues to make all key
decisions, which creates a serious bottleneck and delays.
The future of GOT-IMF relations remains unclear. Investors
see little GOT support for the Central Bank's efforts to
fight inflation, and the GOT has clearly chosen growth over
inflation by expanding its fiscal policy. The CBRT cannot
exercise control over oil and food prices, but the bank hiked
up its policy rates to control the prices in its domain.
Market rates jump from 17-18% to over 20%. JP Morgan Chief
Economist Yarkin Cebeci says lack of policy coordination
between the CBRT and GOT makes investors nervous, because the
conflict signals the GOT has lost its focus on economic
issues. Cebeci also noted the AKP closure case was just
starting to be priced in by investors. Cebeci pointed out
that in his recent road show to the U.S., he noticed a loss
in appetite by U.S. investors for Turkish assets.

7. Kubilay Cinemre, Head of Merrill Lynch in Istanbul, told
us that high oil and commodity prices constitute a big risk
for the Turkish economy given a high current account deficit
(6.2% of GDP) and rising inflation. Under the current global
environment, political risks are seen as a major cause for
higher risk premiums. Cinemre says the continued capital
inflows are a result of still popular "carry trade"
(leveraged capital investment: borrowing cheaply in Japan and
investing for high yields in Turkey and other emerging
markets). Cinemre and other investment bankers agree the AKP
closure case had some impact on pricing of Turkish assets and
increased the risk premium for Turkey. They noted, however,
that the global economic situation and the GOT,s recent
economic policies had a played a larger role in the pricing.
Murat Gulkan from Deutsche Securities pointed out the AKP
closure case was announced the same day as the Bear Stearns
meltdown news broke, giving the AKP news much less press
coverage than anticipated. Both Cinemre and Gulkan said that
any signal for economic slowdown in Europe resulting from the
global recession (EU is Turkey's major export partner) would
also be perceived negatively and seen as another threat to
Turkey's already high current account deficit. Speakers at
the TUSIAD (Turkish Industrialists and Businessmen
Association) banking conference on May 28 agreed that Turkey
has made much progress since the crisis of 2001. One bright
spot remains in the banking sector, where restructuring and
reforms have kept the capital adequacy ratio over 16%,
keeping the sector highly liquid.

8. Comment: Investors see higher risks in Turkey and are
demanding higher risk premiums to invest in Turkish assets.
They are also concerned the AKP closure case and the future
direction of Turkey's economic polices without the AKP. A
slow but steady rise in unemployment is ominous for the GOT
and the AKP,s political prospects. Seven to eight hundred
thousand people join the labor force each year and job
creation MUST be a continuing priority for the GOT. The
labor participation rate is going down because some people
give up and stop looking for work. Private sector investment
essentially stopped at the beginning of 2008 and productivity
is not rising. Zafer Ali Yavan, TUSIAD Ankara
representative, told the Ambassador that large companies
invested heavily from 2004-2007, increasing capacity
sufficient to last until 2009. If investment does not pick
up in 2009, unemployment is likely to spike. One positive
aspect of lower growth may be less energy consumption, and
the GOT needs to develop a game plan to operate in the new
high-cost environment. If inflation passes through to the
rest of the economy, CBRT will be forced to hike its rates,
which will attract more carry trade.

9. There will also be large Treasury debt rollovers in July
and August. While we do not expect the GOT to have problems
getting access to funds, we do expect that borrowing from
both domestic and foreign markets will be more expensive.
Although no one has a definitive number, total corporate
sector foreign-denominated debt is estimated to be $100
billion. Investors expect a further Turkish Lira
depreciation if the AKP is closed down and Erdogan is banned
from politics. Any rapid currency depreciation may
constitute a credit risk for the banking sector and create a
default risk for the corporate sector, which is likely to
stem growth. A further rapid depreciation in the Turkish
Lira would also have a pass through affect over inflation,
causing inflation to get worse. A precautionary stand-by
agreement with the IMF is seen as a safety measure by
investors, but the GOT has still not given any clue about its
intent to negotiate a new standby arrangement. Most
investors concede that the process of Turkey's EU accession,
and resulting change in many laws, has been good for business
and believe the worst-case scenario would come from an end to
Turkey-EU talks. End comment.

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