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Cablegate: Turkey:What If Investors Head for the Door?

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

111106Z Apr 05





E.O. 12958: N/A


B. ANKARA 1318

This cable was coordinated with Congen Istanbul.

1. (SBU) Summary: The acceleration of--and Turkey's
dependence on--short-term portfolio investment flows has
revived fears of what could happen if these investors head
for the exits. If an exogenous shock is big enough, this
"hot money" will indeed flee. Structural changes since 2001,
however, mean that there is a very low probability of a
full-blown financial crisis. Among the key structural
changes are the floating exchange rate regime, an independent
central bank under capable management, and a stronger banking
sector. Turkish Treasury would be able to service its debt
and there is little systemic risk to the banking sector
though there could be an indirect impact on banks through
corporate foreign exchange exposure. On the other hand, a
precipitous fall in the exchange rate could provoke a slower,
non-financial but ultimately politically-difficult
disruption. End Summary.

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Surging Portfolio Flows Revive Fears of a Sudden Reversal
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2. (SBU) As previously reported, the first quarter of 2005
has seen a surge of portfolio investment into Turkey, with
inflows in January and February alone roughly 45% of inflows
for all of 2004. Turkey not only remains dependent on these
flows to finance its large current account deficit (reftels)
but the inflows have caused the lira to appreciate in 2005,
exacerbating its presumed overvaluation and widening the
current account deficit. The March mini-sell-off brought a
correction in the exchange rate but inflows could easily
resume, as could the currency appreciation. This surge
revived longstanding fears of what could happen if these
investors suddenly rush to the exits en masse. This fear has
been exacerbated by substantial anecdotal evidence that a
portion of the increased flows stems from new classes of
investors who did not take on Turkish risk--particularly in
the domestic Turkish financial market--prior to the December
17 EU decision. These investors are more likely to be
skittish in the event of a significant exogenous shock.

Exogenous (or Endogenous) Shock

3. (SBU) In Turkey, there is an ample supply of potential
shocks. Fed tightening leading to a global sell-off in
emerging market debt; government-military or
government-presidency tensions; splits in the governing
party; earthquakes; rifts with the IMF, EU or U.S.; terrorist
attacks; or spillover from instability in Iraq or the broader
region are among the more obvious possibilities. The
question of which of these would be the source of the shock
is very difficult to predict. Instead, this cable focuses on
what would happen in the event such a shock were significant
enough cause the short-term portfolio investors to try to get
their money out of Turkish markets.

Low Probability of a Financial Crisis

3. (SBU) Given the structural changes since 2001, none of our
contacts assign a significant probability to a crisis
situation like occurred in 2000-1, even in the mass exit
scenario described above. Since, unlike in 2001, there is no
fixed exchange rate to defend, we define a "crisis" as a
situation in which the Turkish Treasury has trouble servicing
its debt or in which there are systemic problems in the
banking sector that threaten to spill over into the real
economy. There could, however, be significant disruption to
the economy, mostly arising from a sudden, precipitous fall
in the exchange rate as the investors dump their lira assets.

The Lira Would Take a Dive

4. (SBU) The most disruptive element of the this scenario
would be a sharp fall in the exchange rate, perhaps on the
order of 20 or 30 percent. The lira is widely considered to
be overvalued, driven up by the portfolio flows. The absence
of these inflows, combined with a rush to purchase foreign
exchange, would send the currency tumbling quickly. The
Central Bank--recently seconded by a public statement by
Minister Babacan--has repeatedly warned that it will not
facilitate investors' attempts to exit the market by buying
up lira. Though the Central Bank has justified its
occasional interventions in the FX market by citing "excess
volatility" in 2004 and 2005 it has only intervened in one
direction: buying up foreign exchange when the lira
appreciated too quickly. By intervening against the lira,
the Central Bank builds up its foreign exchange reserves.
These reserves have grown in recent months to $38
billion--more than adequate to meet any foreseeable foreign
exchange requirement in the coming months. The Bank insists,
quite credibly, that it will not use its precious reserves to
break the fall of the lira.

5. (SBU) The absence of help from the Central Bank means that
when fleeing investors look for foreign exchange in Turkey's
thin market, it will be scarce, and the exchange rate could
fall very far very quickly. One potentially mitigating
factor on the swiftness of the lira's fall, however, is that
even in a severe shock scenario some investors may opt to
keep some of their positions rather than take large losses in
thin Turkish markets. Several market-watchers have made the
point to us that Turkish markets are so thin that losses can
be sizable in a sell-off; yet Turkey has come back so many
times that investors have learned the way to make money is to
not panic in a correction. Consequently, even if most
investors flee, others are likely to to hang on, reducing the
size of the outflow.

Banking System Less Vulnerable Now

6. (SBU) The banking sector as a whole is likely to withstand
a sudden, deep fall in the exchange rate. First, the 2001
crisis knocked out the weaker banks, leaving most of the
remaining banks either better-managed or attached to strong
corporate groups. Having gone through the experience of
2001, both bank executives--and especially bank
regulators--pay more attention to risk management. Under
pressure from BRSA, banks have been building up their capital
adequacy ratios and gradually reducing their exposure to
related companies (related company lending was a major cause
of the 2001 banking crisis). Banks' balance sheets were also
helped by three years of favorable macroeconomic conditions,
and a profitable period of capital gains from government
securities during a period of rapidly falling interest rates.
According to BRSA data, the total banking sector's owner's
equity has increased 30% in lira terms (more in dollar terms,
because of the lira appreciation) from year-end 2003 to
year-end 2004. State-owned banks' owners equity matched the
overall sector's growth rate of 30% as well. Several Turkish
banks reported record profits in 2004 and January data
suggest they continue to enjoy healthy profits--the sector's
net income totaled nearly YTL 1.2 billion (about $900

7. (SBU) With regard to the specific issue of banks' exposure
to a fall in the exchange rate, the BRSA monitors banks open
positions--i.e. their exposure to exchange rate risk--as a
priority. Open positions fell to almost nothing in February,
but have come back up to around $1.5 billion recently--still
not a large number in relation to the size of the Turkish
banking sector. BRSA Chairman Bilgin once told us he does
not worry about banks on-balance sheet exposure, since this
is kept quite low, but about unreported off-balance sheet
exchange rate risks that are hidden. HSBC economist Ahmet
Akarli told us the latter risks can be estimated by looking
at the total size of the Turkish lira swap market, which he
put at about $3 billion. Akarli believes this amount of risk
could be accommodated by the banking sector in the event of a
sharp fall in the exchange rate. In relation to the sector's
total capitalization of about $34 billion this amount of
exposure would not appear to be system-threatening.

Corporate Open Positions a Risk

8. (SBU) The principal risk to the banking sector, as well as
to the economy as a whole, is widely considered to reside in
the corporate sector. Until recently, it was simply not
economic to borrow in Turkish Lira, given astronomic lira
interest rates. If they did not borrow in low-interest rate
foreign currencies, corporations either received credit from
suppliers, from owners or not at all. Though no one knows
how exposed the corporate sector really is, many local
economists believe that Turkish corporates have taken on
substantial foreign exchange risk by borrowing in dollars or
euros. The business daily Referans, without explicitly
sourcing its information, recently put the net foreign
exchange exposure of the corporate sector at $28 billion. If
the lira loses 20 or 30 percent of its value, those
corporates that have taken on substantial foreign exchange
risk may have difficulty servicing their loans. If enough of
these corporates run into financial problems, it will have a
spillover effect on the banking sector, running up
non-performing loans.

9. (SBU) Though corporate open positions probably pose the
single largest risk in a bad scenario, there are mitigating
factors which will limit the most severe damage to a
relatively small group of upper-middle tier companies.
First, small- and medium-sized enterprises simply do not have
access to borrow foreign exchange. Turkish banks are still
cautious to extend credit to companies other than blue chips,
having been burned in the 2001 crisis and not yet having
sufficient confidence in local financial statements,
especially those of SME's. At the other end of the spectrum,
the giant conglomerates that dominate the Turkish economy:
Sabanci, Koc, Dogan, etc. are generally considered to be in
good financial shape. The CEO of Akbank, for example, told
us that his bank has little outstanding credit to the bank's
own group (Sabanci) because its companies tend to be quite
liquid. Another mitigating factor is that some of the
corporates with large foreign exchange borrowings are
exporters, whose risk is cushioned by the natural hedge of
their foreign exchange flows from exports. Both State
Planning Organization Deputy Undersecretary Birol Aydemir and
former Treasury U/S Faik Oztrak separately told us that many
companies are in effect "borrowing from themselves" by
repatriating foreign exchange denominated assets. With large
sums of Turkish money either offshore or in foreign
exchange-denominated accounts in Turkey, many wealthy Turkish
individuals or corporations can borrow foreign exchange from
related parties. In sum, even if the $28 billion figure
cited in Referans is right about the order of magnitude, the
corporates at risk to a fall in exposure to foreign exchange
borrowings are only likely to be a small group of companies
that are both big enough to borrow in foreign exchange, weak
enough financially to run into trouble, and neither cushioned
by a flow of foreign exchange earnings or by the lender being
a related party.

Treasury Expected to Muddle Through

10. (SBU) Turkish Treasury's obligations continue to be
heavily skewed to short-term instruments that have to be
constantly rolled over. In a rush-for-the-exits scenario,
Treasury will be hurt in two ways: by the effect of a
depreciating lira on foreign exchange-denominated debt and by
a spike in interest rates. A close look suggests that
Treasury will have to make sharply higher interest payments
for a time, but will manage to do so.

11. (SBU) Treasury has a gigantic "open position" through the
large proportion of its borrowings that are denominated in
foreign exchange. As of February 2005, about 39.6% of its
total debt (external and domestic) is either foreign
exchange-denominated or foreign-exchange-linked, down from
50.9% in September 2003. In a lira depreciation scenario,
the stock of debt relative to government revenues or GDP will
rise sharply. Though this will tend to dampen ministerial
statements about converging towards the Mastricht criteria,
it will have little effect on Treasury's ability to service
its debt in the short run, because the foreign exchange debt
has a much longer maturity structure and much lower interest
rates than TL debt. With interest on its domestic foreign
exchange-denominated borrowings currently only around 5%,
after a 30% depreciation the TL amount of interest payments
on this debt would still be far lower than the 17-18%
interest rate it pays on an equivalent amount of lira
borrowing, and could be serviced. Though a 30% increase in
principal on foreign-exchange-denominated debt is
significant, the FX debt--even domestic FX debt--is of far
longer maturity than TL debt such that in the short run there
would be negligible impact on the level of principal

12. (SBU) As demand from foreign buyers evaporates, TL
interest rates will spike. The spike in yields on government
securities in secondary markets would have no immediate,
direct effect on Treasury--the problem would be the 40% of
Treasury debt in floating rate instruments. A spike in rates
just before a quarterly redemption, for example, would be
costly. On the other hand, as with FX debt, Treasury
benefits from these floating rate instruments' much longer
maturity, such that little principal has to be repaid in the
short run, and generally lower interest rates than on
discount bonds.

13. (SBU) Treasury is likely to be able to make its interest
payments, and to deal with reduced appetite for new issuances
for several reasons. First, access to foreign exchange is
not at issue: the Central Bank has built up record foreign
exchange reserves. Even if the Central Bank's reserves were
inadequate, the floating exchange rate regime allows
permanent access to foreign exchange--you just have to pay a
market-clearing price. In terms of the Treasury's own
reserves, Director General for domestic debt Tulay Saylan
says Treasury targets a reserve level of one-half of upcoming
redemptions. Treasury does not try to accumulate more than
this amount because it is difficult and expensive--the
Central Bank pays no interest on Treasury deposits. To deal
with any shortfalls that arise if the reserves plus no
issuances can't cover redemptions, Saylan has control over
all state spending. In other words, if she has to, she can
slow down state payments temporarily to deal with cash
shortages. As for the likelihood of the fall off in demand
for issuances to be so severe, that she simply cannot fund
redemptions, note that even in corrections such as the
April-May 2004 sell-off Treasury has been able to issue new
paper. Turkish banks always need a supply of this paper:
though they are developing their lending business, it still
cannot cover Turkish banks' deposit base, such that banks
need government securities in which to invest their deposits.

14. (SBU) In 2005, Treasury has taken advantage of favorable
market conditions to issue more long-dated paper, thereby
reducing its need to constantly roll over such a large share
of its debt. Tulay Saylan told us that the average maturity
of new domestic issuances for the first quarter of 2005 is 2
years, up from only 14 months in the same period last year.
The average maturity of all outstanding domestic debt as of
February was 21 months. For the first time in memory,
Treasury issued a domestic, TL-denominated 5-year bond in
February, coming on top of a path-breaking 3-year issue in
October, 2004 (since repeated). One factor that has helped
Treasury, by deepening the market for long-dated TL Treasury
paper is foreign banks' issuance of TL-denominated debt. A
portion of the proceeds of the foreign banks' issuances is
reportedly invested in long-dated Turkish Treasuries--with
over $4 billion of these issuances in recent months this is a
significant new source of demand.

Longer-term effects

15. (SBU) The ability of Treasury and the banking sector to
muddle through in the short run does not mean there is no
risk of disruption to the economy and the GOT's efforts to
strengthen its financial position. If the lira fell 20 or 30
percent and stayed at a new lower-level equilibrium for a
sustained period there is likely to be substantial disruption
in the "real economy." A recession would likely result from
a series of sudden shocks: suddenly-expensive imports would
stress importing companies, bring back inflationary
pressures, and hit the man on the street with a double-whammy
of overnight reduced purchasing power and job losses. Stress
on importing companies and low- and middle-income Turks could
engender a new wave of difficult political problems. Instead
of a short-run, financial crisis requiring a financing
package, in this scenario there would be a slower-developing
but still potentially destabilizing social-political crisis.
The resurgence of inflation pressures would postpone the
final success of the Central Bank's disinflation campaign,
but the Bank could deal with price pressures by tightening up
monetary policy. One Istanbul analyst said that if such a
scenario occurred, it would be the first real test of the
Central Bank's mettle. It would also test the Government's
shaky commitment to the independence of the Central Bank.

16. (SBU) The effect on fiscal policy could be more dramatic.
The GOT would have to further postpone its dreams of
consituency-placating expenditure. Tax revenues are highly
pro-cyclical, i.e. they tend to overperform in a strong
economy and underperform in a slowdown. This is particularly
true in Turkey's case, given that 70% of its revenues derive
from indirect taxes like VAT or other consumption taxes. The
GOT will be extremely hard-pressed to maintain fiscal
austerity in shock-induced recession.

Comment: Anchors Help

17. (SBU) The above analysis applies regardless of the how
the GOT is doing with the IMF and the EU. Even if things
seem stalled with both, a crisis can probably be avoided in
the short run. To the extent the GOT is seen to be moving
forward with one or the other anchor, it will dampen the
severity of the disruption. Moreover, if the GOT is not
moving forward with either the IMF or EU when the bad
scenario develops, the authorities' past behavior suggests
they will suddenly be galvanized to market-pleasing action,
as they were in March 2003.

18. (SBU) But we should not let this analysis lead us to
match the GOT's complacency with our own. The GOT's
half-hearted commitment to economic reform needs to be
constantly encouraged. Though Turkey's vulnerability to a
purely financial crisis has declined, good policies are vital
to cushion the severity of the fall of the exchange rate in a
shock scenario.


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