Cablegate: Inflation Trouble in Turkey

DE RUEHAK #1045/01 1571141
R 051141Z JUN 08




E.O. 12958: N/A

Ref: Ankara 1026

1. Summary: Following May CPI inflation data that signaled the
return of double-digit inflation for the first time since 2004, the
Central Bank of Turkey (CBRT) significantly revised upward its
official inflation target for 2009, 2010, and 2011 to 7.5%, 6.5%,
and 5.5%, respectively. Inflation management has been on track
since 2002, but was hit hard by high energy and food prices and
loose GOT fiscal policy. The May announcement took annual rates
(May 2007-May 2008) of CPI and PPI inflation to 10.7% and 16.5%,
respectively. In an exchange of public letters, both the CBRT
Governor Durmus Yilmaz and Treasury Minister Mehmet Simsek suggested
the target revisions were timely and were made in compliance with
current market conditions and the Medium-Term Economic Program that
will be made public later in June. Immediate markets reaction to
the May inflation data and new targets was negative. End Summary.

Inflation Data

2. On June 3, the Turkish Statistics Agency (TUIK) announced May
inflation data, moving Turkey back to double digits. In May, CPI
increased 1.5% month on month, above the consensus estimate of 1.1%,
while the PPI increased 2.1% month on month. These monthly rates
took the annual rates of CPI and PPI inflation to 10.7% and 16.5%,
respectively. Year to date (January-May 2008) inflation became
6.38% for CPI and 13.39% for PPI. In May, clothing prices increased
by a whopping 12%.

Background on Inflation Targeting

3. To put these numbers in perspective, it is interesting to note
that inflation in Turkey was 84.6% in 1998, 25.3% in 2004, and has
been under 10% since 2005. The CBRT adopted the inflation targeting
regime under the 19th IMF stand-by arrangement in 2005. Despite
setting inflation targets of 4% for 2006 and 2007, Turkey was only
able to reach year-end levels of 9.6% and 8.4%, respectively. Since
2007, the CBRT has been struggling with GOT overspending on
elections. Since the end of 2007, global increases in oil and food
prices have hit Turkey hard, and the previous targets were no longer

New Inflation Targets

4. After the TUIK announcement, the CBRT revised its inflation
targets for 2009, 2010, and 2011 to 7.5%, 6.5%, and 5.5%,
respectively, up from 4% across the board, noting that current
inflation targets no longer served as a short-term nominal anchor.
The CBRT said persistent supply shocks and global economic
uncertainties have increased risks on the inflation outlook, and it
will take until at least 2012 to reach 4%. The CBRT had already
signalled a possible amendment in its inflation target and these
revisions were expected. They justified making the announcement now
to meet the GOT's need for accurate inflation guidelines for its
Medium-Term Economic Program, which is expected to be announced in
June, and which will be used to formulate the 2009 budget.

5. Under Article 4 of the Central Bank Law, inflation targets are
determined jointly by the Central Bank and the Government. This is
done transparently by an exchange of public letters. In its June 4
letter, the CBRT said "our assessments suggest that, even under the
maintenance of a cautious policy stance, reaching the four percent
target is likely to take an extended period. Food and energy prices
continue to pose risks to the medium term inflation outlook, and
there is no clear evidence that this trend will reverse in the short
term". Treasury Minister Simsek wrote back to the CBRT that the GOT
considered the proposed targets "appropriate" and vowed to support
the independent institution in its fight against inflation. Despite
on-going tensions between the GOT and the CBRT over looser fiscal
policy, Simsek agrees the CBRT is doing the right thing on inflation


6. Higher inflation and the revision announcement caused Turkish
markets to react negatively on June 4. The Turkish lira (TRY)
depreciated 1.6% against the USD to 1.24, and government bond rates
increased to their highest level since March 16, reaching 20.28%.
Equities lost about 1%. Although it was expected, economists and
analysts regarded the Central Bank's change in the inflation target
as a credibility loss and claimed that monetary policy management is
now weaker than in earlier years. Ferhat Emil, former CBRT vice
governor and now an Ankara University professor, said he did not

ANKARA 00001045 002 OF 002

expect monetary tightening to succeed sufficiently to down inflation
without the application of tight fiscal discipline, especially in a
world of rising food and energy prices. Central Bank Markets
Department Manager Cigdem Kose told us there is not much room for a
CBRT price stability program under current global conditions as long
as there is increased government spending. The CBRT must have
support and tight fiscal policies from the GOT to succeed with its
inflation management goals.

7. EFG Economist Baturalp Candemir pointed out that double-digit
inflation will also lead to an inflation compensation payment to
civil servants. He expects an across-the-board 1.4%-4.8% civil
servant wage increase. By his calculations, each percentage point
of inflation compensation will cost the GOT a budget-busting TRY 250
million (USD 201.6 million). (Note: News sources report that
Simsek said the GOT will provide inflation compensation for civil
servants. End note.)

Expected Outcomes

8. On the market side, Murat Gulkan from Deutsche Securities said
he saw carry investors focusing more on short-term bonds. Rising
inflation, a Central Bank frustrated by loose GOT fiscal policy, and
political uncertainty will make it challenging to roll over GOT debt
totaling TRY 25 billion (USD 20.2 billion) in July. As a result, he
expects to see a further rise in government bond rates to a range of
21-23%. Gulkan also points out that rising rates are bad news for
equities and current circumstances will make investors reluctant to
buy long-term government bonds.

9. Comment: Revising inflation targets, although needed, have
caused a credibility loss for the CBRT and the GOT. With the
inflation targets of the past two years missed and the 2008 target
clearly out of reach, economists have been arguing that the 4%
target was no longer perceived as an anchor by the markets, business
circles, or even the GOT. Market players expect further rate hikes
when the Central Bank's Monetary Policy Committee meets on June 16.
The GOT's loose fiscal policy might promote growth, but it plays
havoc with inflation management. End Comment.

© Scoop Media

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