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

111106Z Apr 05

UNCLAS SECTION 01 OF 05 ANKARA 002070 
 
SIPDIS 
 
SENSITIVE 
 
TREASURY FOR INTERNATIONAL AFFAIRS - MMILLS AND CPLANTIER 
NSC FOR BRYZA AND MCKIBBEN 
 
E.O. 12958: N/A 
TAGS: EFIN TU
SUBJECT: TURKEY:WHAT IF INVESTORS HEAD FOR THE DOOR? 
 
REF: A. ANKARA 1559 
 
     ¶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. 
 
--------------------------------------------- ------------ 
Surging Portfolio Flows Revive Fears of a Sudden Reversal 
--------------------------------------------- ------------ 
 
¶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 
million). 
 
¶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 
payments. 
 
¶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. 
 
 
 
 
EDELMAN