VZCZCXRO3545
RR RUEHAG RUEHDF RUEHIK RUEHLZ
DE RUEHAK #5092/01 2441420
ZNR UUUUU ZZH
R 011420Z SEP 06
FM AMEMBASSY ANKARA
TO RUEHC/SECSTATE WASHDC 8385
INFO RUEATRS/DEPT OF TREASURY WASHDC
RUEHIT/AMCONSUL ISTANBUL 1194
RUEHDA/AMCONSUL ADANA 1055
RUCNMEM/EU MEMBER STATES COLLECTIVE

UNCLAS SECTION 01 OF 02 ANKARA 005092 
 
SIPDIS 
 
TREASURY FOR JROSE 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN TU
SUBJECT: TURKEY: LIMITED IMPACT OF INTEREST RATE HIKES 
 
ANKARA 00005092  001.2 OF 002 
 
 
¶1.  (SBU)  Summary.  In its August 24 meeting, Turkey's interest 
rate setting Monetary Policy Committee (MPC) decided to keep Central 
Bank interest rates on hold at 17.5%.  Since the global emerging 
market turmoil in May, however, the MPC has increased interest rates 
by a total of 4.25%, reversing the post 2001 financial crisis trend 
that had seen rates decline from 62% in February 2002.  The MPC's 
firm response played a key role in staunching the outflow of foreign 
portfolio investment, stabilizing the exchange rate, and restoring 
some of the policy credibility that had had been lost since Central 
Bank Governor Durmus Yilmaz took over as chairman in April.  Yet, 
observers have argued that the rate hikes and will have a depressing 
effect on real economic activity and growth at a time of increasing 
political sensitivity as 2007 presidential and parliamentary 
elections approach.  While it does seem that GDP growth will slow 
this year and next from the torrid pace of recent years, most local 
economists see a relatively limited impact of the 4.25% increase on 
growth and employment, trimming a percentage point or so off their 
forecasts.  Instead of 5-7% growth this year, growth will probably 
be in the 4-6% range.  Growth will stay positive next year.  End 
Summary. 
 
--------------------------------------------- ---- 
Large Rate Hikes Part of Firm Response to Turmoil 
--------------------------------------------- ---- 
 
¶2.  (SBU)  After a bumbling its initial response to May's and June's 
market turmoil, the MPC made the decisive decision beginning June 8 
to reverse the downward trend in the Central Bank's policy rates.  A 
cumulative rate increase of 425 basis points and a resumption of the 
Central Bank's daily liraauction intended to extract "excess 
liquidity" from foreign exchange markets seems to have a positive 
impact on markets' inflation expectations and to have stabilized the 
level of the currency, which had hit a low of 1.76 TL to the dollar. 
 The government's commitment to further tighten its fiscal surplus 
under the IMF program also helped reassure that Turkey had not lost 
its inflation-fighting zeal in the run-up to 2007 presidential and 
parliamentary elections. 
 
¶3.  (SBU)  At the same time, local and foreign economists began to 
worry that the aggressive response to market turmoil would lead to a 
slow-down in the economy through curbed demand and delays in planned 
investment decisions as the cost of money increased.  Indeed, the 
increase in market interest rates charged in the fast-expanding 
consumer loan sector had an immediate impact on consumer demand. 
Banks saw a booming credit card and housing loan growth come to an 
abrupt stop that was also reflected in a drop in domestic automobile 
sales (which was a big part of consumer demand growth).  They 
worried that a spending slowdown could encourage populist political 
responses that would further stir markets. 
 
--------------------------------------------- ----- 
Economists Relaxed, Seeing Continued Strong Growth 
--------------------------------------------- ----- 
 
¶4.  (SBU)  Yet, most economists who observe the Turkish economy up 
close are sanguine about the impact of the rate hike, even in the 
short-term.  For instance, Hakan Kara, Deputy Director of the 
Central Bank's Research Department, told us that the Bank did not 
see rate hikes having a large negative impact on growth, although he 
agreed that there would be a relative slow-down in consumer and 
business spending.  He noted that part of the real interest rate 
increase would be offset by the increase in inflation expectations. 
Also, he thought that banks were likely to trim their interest rate 
margins and cut rates to spur lending as they accumulated new 
deposits.  He pointed out that changes in banking regulations have 
decreased banks' ability to stash surplus funds in government 
securities, essentially obliging them to absorb increased interest 
costs instead of passing them on to customers. 
 
¶5.  (SBU)  Another element offsetting a decrease in domestic demand 
would be a spur to external demand coming from the exchange rate 
depreciation.  Most observers, including the Central Bank 
economists, expect this to be seen more in slower import growth than 
an increased rate of export growth.  As noted to us by Central Bank 
Advisor Ercan Turkan, this could lead to industrial cost increases 
and a consequent slow-down in production since Turkey's domestic and 
export industries are heavily dependent on imported inputs. 
However, this has not yet been observed in the industrial production 
or corporate profitability statistics.  Indeed, industrial 
production has surprised many economists with its continued 
strength, surpassing expectations in both June and July.  At the 
same time, a reduction in Turkey's large current account deficit 
should have a positive impact on markets' perceptions of Turkey's 
financial vulnerabilities, theoretically leading to a lower risk 
premium and lower borrowing costs. 
 
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ANKARA 00005092  002.2 OF 002 
 
 
GDP Growth Forecasts Trimmed Only Slightly 
------------------------------------------ 
 
¶6.  (SBU)  There seems to be a consensus that the impact of the rate 
hikes will be felt most in the second half of 2006, when real GDP 
growth rates should fall below the 6.4% annual pace recorded in the 
first half.  As a result, local forecasters seem to have trimmed on 
average about one percentage point off their 2006 outlooks.  So, 
instead of 5-7% growth this year, economists are betting on a 4-6% 
range.  At the low end, Fitch rating agency's local director told us 
her forecast was for 4.5% growth this year, similar to Global 
Securities' Murat Ucer's 4.4% prediction.  Meanwhile, Baturalp 
Candemir, a widely quoted analyst for EFG Securities in Istanbul 
said he is expecting 5.5%.  The Central Bank's Turkan expects growth 
to exceed five percent.  This is a slowdown only when compared to 
last year's 7.4% pace.  All of these economists expect the slowdown 
to continue to be felt in 2007, but with rate hike impact gradually 
diminishing. 
 
--------------------------------------------- --- 
Comment: Markets More Sophisticated About Turkey? 
--------------------------------------------- --- 
 
¶7.  (SBU) In this troubled region and neighborhood, only the very 
brave forecast economic growth beyond the very short-term.  Still, 
there appears to be a strong consensus that economic growth will 
remain strongly positive in 2006 and 2007 and that the impact of the 
recent rate hikes will be passing.  Indeed, several of the 
economists we spoke to said that risks were "on the upside." 
Nevertheless, Turkey's economic and financial vulnerabilities 
remain including its large current account deficit and still 
substantial foreign-currency linked government debt that leave the 
country especially exposed to swings in global markets. 
Interestingly, however, a senior London-based Goldman Sachs Turkey 
watcher told us he saw markets growing more sophisticated in their 
approach to political risk in Turkey.  He did not see major market 
fluctuations resulting from the inevitable political uncertainties 
in a pre-election period.  He thought this was due both to greater 
sophistication by investors as well as greater sensitivity of 
policymakers to the impact their comments have on markets.  The 
recent smooth transition in the military command structure was, he 
thought, evidence of this. 
Wilson