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Cablegate: Central Bank Rate Cut Reinforces Market's

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





E.O. 12958: N/A


1, (U) Summary: After a range-bound summer, Turkish markets
have rallied in early September.
First the stock market rallied on increasingly favorable
signals regarding EU accession and an IMF
program, then the Central Bank cut its short-term rates
200-400 basis points. By its action, the Central
Bank appears confident the end-year inflation target will be
met, and does not appear overly concerned
about the growing current account deficit. The rate cut,
surprising markets by its magnitude and timing,
in turn broadened the rally to the government securities
market in a gloabal market environment where
funds are still flowing to emerging markets. Though a
Central Bank rate cut would normally cause a
currency to weaken, market bullishness caused the lira to
strengthen through foreign inflow. On
Friday, September 10, second quarter GDP growth came it at a
whopping 11.9 percent, confirming
that the economy is likely to grow well above its 5 percent
target for 2004, but reinforcing concerns
about overheating and the current account deficit. End

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First, a Stock Market Rally:

2. (U) Following the spurt of volatility in April and May
after a shift in expectations regarding global
interest rates, markets settled into a mostly range-bound
summer. The exchange rate has been remarkably
stable, hovering around 1.5 million TL to the dollar and the
benchmark bond has been stuck in the
mid-twenties of percent, with increasingly positive inflation
numbers seemingly having little effect on
nominal rates. The benchmark bond, which was yielding over
27 percent at the end of June, had only
improved to 25.13 percent at the end of August. The more
volatile, and less meaningful, stock market
gradually moved up from its late spring lows, while remaining
below the level it achieved in April,
prior to the volatility.

3. (U) Even the long-awaited, market-critical decision in
August that the GOT would definitely seek a follow-on
disbursing Standby arrangement from the IMF, failed to move
markets. But at the beginning of September, as
Turks drifted back from vacation, the Turkish stock market
began moving upwards on increasing optimism over
Turkey,s prospects of getting a date to begin EU accession
negotiations. After rising 2.95 percent the week of
August 23-27, the IMKB-100 rose 4.63 percent to 20,775 the
week of August 30-September 3, after positive
comments on Turkey,s EU accession prospects by UK Foreign
Minister Straw and EU Enlargement
Commissioner Verheugen.

4. (U) The stock market optimism, however, failed to make a
dent in the foreign exchange or government
securities markets. The yield on the benchmark bond, for
example, was actually slightly higher, at 25.41
percent at the close September 7 then it had been on August
27, when it traded at 25.13. Likewise, the
lira was at 1.505 million to the dollar September 7, versus
1.504 million on August 27.

Then, a Surprising Interest Rate Cut:

5. (U) On Wednesday, September 8, the Central Bank surprised
markets by cutting its overnight lending rates
by 200 basis points. Most analysts were surprised both by
the timing and magnitude of the rates. The Bank
had been gradually cutting rates in 2003 and the first
quarter of 2004, in line with the fall of inflation, and
markets were expecting further rate cuts until the April-May
volatility spooked Turkish financial markets and
put Bank rate-cutting on hold.

6. (U) The rate cut, and the convoluted accompanying
announcement, left many analysts scratching their
heads, particularly as regards the timing. The Central Bank
has on several occasions waited until the GOT
reached agreement with the IMF staff on a review before
cutting rates, yet this time the Bank cut two weeks
prior to the planned arrival of an IMF mission to begin
negotiating a follow-on program. Moreover, the August
inflation numbers, announced a few days prior to the rate
cut, surprised on the high side. The Central Bank is
reportedly being criticized by AKP economists on the grounds
that the Central bank caused the Treasury to
borrow at higher yields in the recent Treasury auctions,
where Treasury borrowed at av. 25-26%.

7. (SBU) These factors were apparently outweighed in the
Bank,s thinking by some combination of the

--First and foremost, though the August inflation numbers
came in above expectations, most analysts still
believe the year-end twelve percent inflation target is
attainable. With CPI for the first eight months of
2004 at only 3.9 percent (though WPI and year-on-year numbers
are higher) the Bank,s confidence seems
justified. Central Bank Markets Department Deputy General
Manger Emrah Eksi stressed the expected
continuation of the disinflation trend in his private
comments to Economic Specialist.

--The GOT,s decision to pursue an IMF program. In its
statement, the Bank Central Bank Governor Serdengecti
had been publicly urging the GOT to seek a follow-on program
for months, so much so that Deputy Prime
Minister Sener rebuked him in August (without referring to
him by name) saying a "bureaucrat" should not tell
the Government what to do. The Central Bank is reportedly
being criticized by AKP economists on the grounds
that the Central bank caused the Treasury to borrow at higher
yields in the recent Treasury auctions, where
Treasury borrowed at av. 25-26%. The Bank may have been
waiting for the GOT decision to make an overdue
rate cut, but did not want to juxtapose too closely its rate
cut to the GOT,s IMF decision.

--Signs of market confidence, favorable hints on EU
accession. As noted above, the stock market was
beginning to rally over bits of good news on the EU front.
With signs of increased market bullishness
increasing flows of lira-strengthening short-term portfolio
investment, the Bank may have felt the timing
was right to lower rates, which would normally dampen such
flows and work against a possible overvaluation of the lira.

--Finally, the Bank, like most Central Banks, likes to keep
markets guessing on its timing. If this was one
of its goals, it was highly successful.

Government Securities and Lira rally:

7. (U) The previously-immobile Government Securities market
took heart from the rate cut though the yield
on the benchmark bond fell only 95 basis points (half the
central Bank,s rate cut) on the first day after the cut.
Benchmark rates fell a further 23 basis points the following
day (September 9), however, reaching 24.23 percent,
the lowest level since before the upward shift in global
interest rates in late April. Rates have stayed roughly at
level since, with the benchmark at 24.37 at the close
September 14. In the external debt market, the GOT
capitalized on the uptick in sentiment towards Turkey to
announce issuance of $600 million in Euro-denominated
Eurobonds, yielding only 5.75 percent.

8. (U) More surprisingly, since lower interest rates would
normally lead to a weakening of the currency, the lira
rallied on September 8 and 9, appreciating from 1.503
million TL per dollar to 1.485 million TL. The broader
bullishness on Turkey, and apparently a market assumption
that the Central Bank would not have cut rates without
knowing things were getting better, led markets to buy into
lira, even despite normally lira-depressing large purchases
of foreign exchange by local corporates on September 9. On
Friday and early this week, the lira lost some of its
gains, however, depreciating to TL 1.491 million at the close
September 14.

9. (U) The rate cut and broader market bullishness
overwhelmed surprisingly harsh comments from EU
Commissioners Fischler on September 5 and Bolkestein on
September 7, as their views are widely reported
to represent those of a minority of commissioners opposed to
giving Turkey a date. The IMKB 100 reached
21,398 at the close September 9. On Friday, the 10th and
Monday and Tuesday, the stock market traded slowly
downward as markets became increasingly over the potential
effects of the adultery law debate on EU accession
prospects, before rebounding to 21,705 at the close September
14 on news suggesting the GOT might shelve it's
controversial adultery law proposal.

Strong GDP growth Reinforces Concerns about the Current
Account Deficit:

10. (U) Two days after the rate cut, on September 10, the
State Statistical Institute announced second
quarter GDP and GNP growth numbers that were well above
analysts, expectations. In the second
quarter, GDP grew 13.4 percent and GNP 14.4 percent in real
terms. For the first six months of the
year, GDP grew 11.9 percent and GNP 13.5 percent. Though
most analysts expect growth to slow
somewhat in the second half, the new numbers confirm that
Turkey,s economy will grow well above
the 5 percent growth target for 2004. Most private analysts
have now revised their full-year 2004
forecasts upward, with most predicting an extraordinarily
strong 8 or 9 percent real growth.

11. (U) Though the signs of strong growth would normally be a
welcome sign of the economy's continued
recovery from the 2000-2001 crisis, they reinforce concerns
about the growing current account deficit.
Along with many private analysts (reftel) former Treasury
Undersecretary Faik Oztrak added his voice to
those raising concerns about excessively strong growth and
the link to the current account deficit, in an
op-ed September 13.

12. (Sbu) IMF staff, however, seem to be among the least
alarmed about the growing current account
deficit. IMF Resrep Hugh Bredenkamp, however, and his Deputy
Christoph Klingen, at a meeting just
prior to the announcement of the growth numbers, said Fund
staff is concerned but that there is no clear
consensus in favor of immediate action. Bredenkamp and
Klingen said so far the Fund favors only
maintaining the 6.5 percent primary surplus target to dampen
domestic demand (and therefore imports),
allowing the automatic stabilizer of the floating exchange
rate regime to work, passing through world oil
price fluctuations without delay, and building up Central
Bank and Treasury reserves as a precaution.

Comment and Conclusion:

13. (Sbu) The Central Bank rate cut reinforced the uptick in
market sentiment. The market bullishness,
combined with the strong growth numbers that followed,
however, can only exacerbate concerns that the
current account, and the possibility of a sharp fall in the
lira and reversal of portfolio investment flows in late
2004 or 2005, particularly if Turkey faces an exogenous
shock. Many analysts consider the lira overvalued,
and its continued strength augurs ill for the hoped-for
moderation in import growth. With markets headed
for a volatile period because of the drip of news on both the
IMF negotiations and the prospects for a date
for EU accession talks, the build-up of imbalances from the
current account is likely to increase Turkey's
vulnerability to a sharp correction.


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