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Cablegate: Agreement with Imf On Draft Letter of Intent,

This record is a partial extract of the original cable. The full text of the original cable is not available.

171525Z Mar 04





E.O. 12958: N/A

B. ANKARA 1578

1. (Sbu) Summary: Deputy ResRep confirmed to Econoffs that
the IMF and GOT have reached agreement on a draft letter of
intent (LOI), with only minor follow-up steps needed for the
GOT to sign the actual LOI. Not coincidentally, on March 17
the Central Bank cut overnight interest rates by 2 percentage
points. Two-thirds of the fiscal gap was filled from
expenditure reduction and one-third from increased excise tax
revenues on tobacco, alcohol, petroleum products, and
liquified petroleum gas. After much discussion, natural gas
and electricity taxes and prices were not increased. The
Deputy ResRep admitted the quality of the fiscal adjustment
was not good, but said there were few near-term alternatives
to the measures taken. The GOT has also committed to
promulgate bankruptcy regulations, appoint the head of a
commission to study the Imar Bank failure, and take steps
towards state bank privatization. The IMF program will have
only three more reviews, each with a $660 million
disbursement, with the final board vote scheduled for January
2005. The GOT seems increasingly open to an IMF role after
2004. End Summary.

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Agreement Reached on a Draft LOI:

2. (Sbu) In a March 16 meeting, IMF Deputy Resident
Representative Christoph Klingen confirmed press reports that
the recently-departed Seventh Review Mission had reached
agreement with the GOT on a draft LOI. As with past reviews,
Klingen said there were some follow-up actions the GOT needed
to take before they could finalize the LOI, but that these
were not major.

3. (Sbu) Klingen specified that, other than some minor
procedural actions, the GOT needed to take three steps before
the Seventh Review could go to the IMF Board: appoint the
head of a commission to study the Imar Bank collapse, a
longstanding IMF demand; withdraw capital from state-owned
Ziraat Bank, and, depending on the structure of the planned
Halk Bank-Pamuk Bank merger, from Halk Bank; and promulgate
regulations implementing the new bankruptcy law passed by
parliament in February.

End-game of the Fiscal Gap Saga:

4. (Sbu) After months of complex negotiations over measures
to close the fiscal gap, the Fund and GOT finally agreed to a
package with two-thirds of the gap made up from the
expenditure side and one-third from increased revenues. As
previously reported, the gap was opened by a combination of
shortfalls in 2003 and the Prime Minister's decision to
increase the minimum wage and pension payments. Klingen
specified that the Fund stuck with its estimate of a TL 7
Quadrillion (about 1.75% of GDP) gap, declining to get into a
debate over the appropriateness of its estimate. Klingen said
the GOT still did not have final 2003 data for the entities
outside the Central Government. For the Central Government
the 5 percent primary surplus target had been slightly
exceeded, but when final numbers are available for the
Consolidated Public Sector the Fund expects a primary surplus
of 6.2 percent of GDP, a slight shortfall from the 6.5
percent target.

5. (Sbu) On the spending side, the gap-filling measures
totalled TL 4.4 Quadrillion, according to Klingen, with TL
3.9 Quadrillion from the 13 percent across-the-board cut in
discretionary spending, and TL 500 Trillion in earmarked
spending from the Special Revenue accounts. Klingen said
these accounts, which are being brought on-budget by the
Public Financial Management on Control Law, consist largely
of university and other school expenditures, drawing on
earmarked school fees.

6. (Sbu) On the revenue side, Klingen shed light on the
ever-changing and sometimes contradictory press reports. In
the end, the package includes increased tax revenues from
tobacco products, petroleum products, alcohol, and liquid
petroleum gas. In recent weeks, Energy Minister Guler had
repeatedly denied press reports that natural gas and
electricity prices would be increased, and Klingen confirmed
that natural gas and electricity were not in the final
package. He said the Fund had advocated inreased excise
taxes on natural gas. In the end, Klingen said the GOT had
pushed for only raising taxes on Liquified Petroleum Gas
(LPG), because LPG prices had fallen 25 percent on
international markets such that the GOT could more easily
assess higher taxes. He said the IMF had reluctantly agreed,
subject to review in six months. Klingen pointed out
however, that the budget assumed natural gas prices would
rise over the course of 2004 in line with projected wholesale
price inflation, so the GOT may need to raise gas prices
later in the year.

7. (Sbu) Klingen explained that the revenue increase from
tobacco derives from price increases rather than a higher tax
rate. The additional revenue from tobacco products is
expected to be about TL 1.1 Quadrillion. He said that with
most of the end price to the consumer deriving from VAT and
other excise taxes on tobacco products, a price increase has
a significant tax collection impact. Klingen confirmed that
the Fund's initial idea of increasing tax rates had led to
GOT fears that state-owned Tekel might be hurt if its private
competitors did not fully pass on the tax increases to
customers. The GOT solved the problem by "talking to" the
private companies and getting them to raise their prices.
Klingen admitted this was not an ideal approach but was one
of the compromises the Fund went along with. Klingen added
that the IMF insisted that in August, any end-user price
increase will come from increasing excise taxes rather than

Quality of Fiscal Adjustment:

8. (Sbu) Klingen admitted that the quality of the fiscal
adjustment was "not good." He argued that the GOT decision
to raise the minimum wage and pension payments had left few
good options in the short run. Over a longer time horizon,
the Fund was working on improving tax collection. Klingen
said the GOT is also due to have a Public Expenditure Review
under its IFI programs. Though normally conducted by the
World Bank, the IMF felt the review should not wait and is
taking the lead on an initial review in the coming months,
followed by a fuller World Bank-led review later in the year.

Banking Issues:

9. (Sbu) Klingen said the LOI specifies an ambitious schedule
for the revisions to the Banking Act, calling for the
introduction to parliament before the summer recess. The
changes would provide for better coordination between off-
and on-site bank inspection, immunities for BRSA and SDIF
staff for their official acts, and a tightening of the "fit
and proper" criteria for bank owners. Klingen said the Fund
now has more faith in BRSA Chairman Bilgin. The new SDIF
leadership seems to be moving in the right direction, but
Klingen said that the Fund's Bank experts have doubts about
the SDIF leaders' competence. Regarding the continued
attempts of failed bank owners to come back into the banking
system, Klingen said IMF M.D. Kohler had warned Prime
Minister Erdogan about the Demir Bank case, and that the
delay in the Court of Accounts' decision on Demir may be a
positive sign. Klingen said the Fund is monitoring Cukurova
Group, who might try to play newly-separated BRSA and SDIF
off against each other.

10. (Sbu) Klingen said the Bankruptcy legislation was a
longstanding IMF requirement and that bankers had fought a
provision spelling out the mechanism for a pre-packaged
bankruptcy feature facilitating out-of-court settlements.
The bankers believed that if the law got too specific about
the mechanism it would undermine banks' leverage in debt
workouts. According to Klingen, having lost the battle over
the legislation, bankers might try a rearguard action on the
implementing regulations, hence the IMF's requirement that
the regulations be announced before the IMF Board vote.

Fewer IMF Reviews:

11. (Sbu) With the schedule of reviews pushed back by the
delays in the Fifth, Sixth and Seventh Reviews, the IMF and
GOT agreed to shrink the number of reviews remaining under
the existing Standby. Instead of five, there will be three
more reviews, with each releasing a $660 million--rather than
$500 million--disbursement. Klingen said the final review
would be negotiated in December but would not go to the Board
until January 2005.

Post-program IMF role:

12. (Sbu) Klingen said the GOT is showing increasing signs of
accepting an IMF role beyond the end of the Standby. At a
minimum, IMF rules require a post-program monitoring
arrangement for countries having borrowed over 100 percent of
their quota. In Turkey's case, Klingen said the Board would
probably require three or four reviews a year under such an
arrangement. One step up from such post-program monitoring
would be a Precautionary Standby. Klingen said Babacan has
said the GOT will take a decision in mid-year.

Central Bank Cuts Rates:

13. (Sbu) Undoubtedly because of the agreement with the IMF,
the Central Bank announced a 200 basis point rate cut March
17. The Central Bank's press release said nothing about the
IMF, but highlighted the importance of fiscal policy
complementing monetary policy, and even sounded a
Greenspanesque note favoring spending-side cuts over tax
increases. Many private analysts have been saying for some
time that a rate cut is overdue based on fundamentals, and
the markets had clearly priced in the cut: rates on
government securities hardly budged after the Central Bank
announcement. The timing, coupled with Governor Serdengecti's
frequent private comments to econoffs about the need to
maintain pressure on the Government over fiscal policy and
the IMF program, suggests the Bank waited for agreement on a
LOI to announce the cut.


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