VZCZCXRO1264
RR RUEHDA
DE RUEHAK #1015/01 1201421
ZNR UUUUU ZZH
R 301421Z APR 07
FM AMEMBASSY ANKARA
TO RUEHC/SECSTATE WASHDC 1902
INFO RUEATRS/DEPT OF TREASURY WASHDC
RUCPDOC/USDOC WASHDC
RUEHIT/AMCONSUL ISTANBUL 2600
RUEHDA/AMCONSUL ADANA 1900
RUEHBS/USEU BRUSSELS

UNCLAS SECTION 01 OF 03 ANKARA 001015 
 
SIPDIS 
 
TREASURY FOR INTERNATIONAL AFFAIRS - JROSE 
DEPARTMENT PASS EXIMBANK FOR WILLIAM MARSTELLER 
USDOC FOR 4212/ITA/MAC/CPD/CRUSNAK 
USTR FOR ERRION 
 
SIPDIS 
 
SENSITIVE 
 
EEB ALSO FOR A/S SULLIVAN 
EUR FOR DAS BRYZA 
 
E.O. 12958: N/A 
TAGS: EFIN BEXP ETRD TU
SUBJECT: TURKEY: ECONOMISTS STRESS ECONOMIC PROGRESS, BUT NEED FOR 
MORE REFORMS 
 
Ref: Ankara 801 
 
This cable has been coordinated with Congen Istanbul. 
 
¶1.  (SBU)  Summary:  As domestic political risk comes to the fore in 
the wake of the weekend's dramatic developments, Turkish economists 
underline the economy's remarkable transformation since the 2001 
crisis.  Strong growth, fiscal consolidation and surging Foreign 
Direct Investment underpin a significant reduction in economic 
vulnerabilities: debt ratios are stronger, banks are 
well-capitalized, and the current account remains easily financed. 
This contrasts previous periods of political instability that 
coincided with economic weakness and vulnerability in 2001, 
1999-2000, 1997, and 1980.  While the country's financial cushion 
seems sufficient to weather a passing political storm without a 
market or economic crash, economists' biggest fear is an extended 
period of policy doldrums and disarray that would delay a second 
generation of reforms needed to sustain the high growth that will 
allow Turkey's living standards to converge with EU averages.  They 
will be watching closely for signs of a political consensus that 
will leave the economic reform agenda intact.  End Summary. 
 
---------------------------- 
The Other Shoe Never Dropped 
---------------------------- 
 
¶2.  (SBU)  In a round of meetings before the weekend's events, 
Ankara-based economists in Government agencies, the Central Bank, 
the bank regulatory agency and an independent think tank were 
uniformly positive in their assessment of the Turkish economy, 
stressing in particular how far it has progressed since the 2001 
crisis.  Turkey has experienced five straight years of growth 
averaging over 7%, reduced its public sector debt ratios, attracted 
newly-high levels of FDI, and brought inflation down to around 10%. 
Although the think tank economists, including former Central Bank 
Governor Serdengecti, are more willing to point out the economy's 
weaknesses, they also acknowledge the dramatic improvements. 
 
¶3.  (SBU) Moreover, the full-year 2006 data -- and the absence of 
public or private financial problems -- have put to rest fears that 
the May-June 2006 market correction would damage Turkey's economic 
recovery.  In the immediate aftermath of the correction, many 
analysts wondered whether corporations that had borrowed in foreign 
exchange would suffer financial difficulties that might only become 
visible with a lag.  None of the economists we spoke with had seen 
any evidence of financial stress from last year's correction.  Bank 
Regulatory and Supervisory Agency (BRSA) officials said they did not 
seen signs of rising non-performing loans in the banking sector. 
 
-------------------------- 
Transformed Banking Sector 
-------------------------- 
 
¶4.  (SBU) Among the areas in which Turkey's vulnerability is 
much-reduced is the banking sector.  The 2001 crisis was a banking 
crisis, with regulators working to clean up the mess for several 
years thereafter.  Few analysts now worry about the sector's 
vulnerability.  If the May-June volatility was a test, the Turkish 
banking sector passed it with flying colors. Despite initial worries 
that the sector would suffer losses arising from its asset-liability 
maturity mismatch (long-dated assets and short-dated deposits) the 
impact was minor.  BRSA officials told us the sector's Capital 
Adequacy Ratio (CAR) was 21% as of year-end 2006, the highest in the 
OECD.  After the May-June correction, no bank had fell below the 8% 
statutory CAR, although some had fell below the 12% threshold below 
which BRSA will not approve new branch openings. These banks have 
since strengthened their capital position to exceed the 12% level. 
 
 
------------- 
FDI Takes Off 
------------- 
 
¶5.  (SBU) Perhaps the most striking change in Turkey has been the 
take-off in Foreign Direct Investment (FDI).  After averaging less 
than $2 billion a year from 1990 to 2004, FDI hit $9.6 billion in 
2005 and $20 billion in 2006.  Early fears that FDI would drop 
sharply in 2007 have yet to materialize, with $13 billion so far 
 
ANKARA 00001015  002 OF 003 
 
 
this year.  Although critics note the absence of significant 
greenfield foreign investment and wonder whether FDI will fall off 
once all the available banks have been bought and the privatization 
process winds down, foreign companies continue to buy into Turkey in 
a broad range of sectors, suggesting the FDI wave has far from run 
its course.  Domestic investment also continues to be strong, in 
part because Turkish groups that sold bank assets to foreign are 
reinvesting in other sectors. 
 
----------------------------------------- 
Downplaying Current Account Deficit Fears 
----------------------------------------- 
 
¶6.  (SBU)  Among the vulnerabilities that remain, of course, is 
Turkey's large current account deficit (CAD) that grew to 7.9% of 
GDP in 2006.  All of the Ankara-based economists we spoke with 
downplayed the seriousness of the CAD issue.  First, they pointed to 
the relative ease with which Turkey is financing the deficit, with 
FDI accounting for 60% of the deficit in 2006 and increased 
long-term borrowing, reducing the dependence on short-term funds. 
Moreover, the economists point to the fact that it is the private 
sector that is borrowing and investing, buying the imported goods 
that are driving the current account deficit.  They also emphasize 
the composition of imports, which are heavily weighted towards 
intermediate goods with a very small share of consumption goods. 
Central Bank economists said Turkish industry is shifting from 
labor- intensive businesses into higher-value, capital-intensive 
businesses, a transformation we are seeing in many sectors, 
including textiles. 
 
¶7. (SBU)  In contrast, some private sector financial analysts 
express concern over the macroeconomic conundrum posed by the need 
to maintain nominal interest rates at 17.5% in order to attract the 
capital flows that fund the current account deficit.  Rates this 
high make credit very unattractive for domestic borrowers and stifle 
economic growth.  A reduction in interest rates would result in 
decreased capital inflows and could prompt a sharp decrease in the 
value of the lira.  These economists dismiss arguments that 
productivity gains would fuel growth arguing that a massive 
unregistered labor force made labor productivity statistics 
virtually useless.  Arguments that the composition of imports 
(heavily weighted toward capital goods) would eventually lead to 
export-led growth were also dismissed as wishful given historical 
trend data. 
 
¶8. (SBU) Most economists are projecting a slight easing in the CAD 
as a share of GDP in 2007, to around 7%.  The data for the first two 
months of 2007 are encouraging, with exports growing 25% and imports 
20% in value terms, while export volumes grew even more rapidly. The 
Central Bank economists see a link between the slowdown in domestic 
demand growth and export growth, making the case that Turkish 
manufacturers are able to shift sales from domestic buyers to 
international customers.  The weakness of the dollar against euro 
and the resurgence of growth in Europe, Turkey's principal trading 
partner are both helpful.  With many of Turkey's inputs 
dollar-denominated and 58% of exports to the EU, dollar weakness 
against euro helps Turkey's terms of trade.  A national accounts 
restatement expected at some point this year would be a purely 
mathematical improvement, but could give a significant boost to 
GDP/GNP and result in major improvements in Turkey's macroeconomic 
ratios. 
 
---------------------------- 
Fewer Debt or Market Worries 
---------------------------- 
 
¶9. (SBU) Turkey continues to reduce its vulnerability to public 
sector debt rollover risk.  As of December 31, 2006 public sector 
net indebtedness was 44% of GDP, of which only 8% is foreign 
exchange-denominated.  Although this is still above some comparator 
countries it represents a striking improvement from 90% in 2001. 
The overall deficit of the public sector shrank from 16% in 2001 to 
under 3% in 2006.  Turkish Treasury and Central Bank officials also 
note the improved structure of the debt, as Treasury has succeeded 
in extending the yield curve by issuing first 3-year and then 5-year 
fixed rate bonds, as well as inflation-linked floating rate notes. 
These have brought the average maturity of domestic public debt to 
24 months, up from 15 months in 2001. 
 
ANKARA 00001015  003 OF 003 
 
 
 
¶10.  (SBU) As a result, fears of Government problems rolling over 
its short-term debt have receded.  If the markets were to experience 
another bout of turbulence, however, both the Central Bank and 
Treasury have built up sizable reserves -- $68 billion and $15 
billion respectively -- reassuring investors that they stand ready 
in case of market problems.  In fact, the reserves are so large, and 
the vulnerabilities sufficiently reduced, that Institute for 
International Finance Economist Jeff Andersen told us Treasury 
should use the reserves to reduce debt, thereby shrinking the supply 
of government paper and reducing interest rates. 
 
¶11.  (SBU)  With regard to the foreign exchange market, Central Bank 
officials and other economists pointed out that residents' increased 
stock of foreign exchange has created a fundamentally more positive 
situation than existed before last spring's sell-off in the lira. 
If the lira were to fall sharply, these local investors are widely 
expected to come back into lira to take advantage of the buying 
opportunity for their home currency.  Once Turkey gets past its 
election-year political problems, these residents are expected to 
come back into lira assets. 
 
------------------ 
Stubborn Inflation 
------------------ 
 
¶12.  (SBU) Although inflation came down dramatically from 2001 
through 2005, since then it seems to be stuck around 10% with the 
Central Bank struggling to resume the disinflation trend.  Higher 
energy prices and the exchange rate correction hurt in 2006 as have 
drought-induced higher food prices. The Bank is hopeful that the 
second half of 2007 will be provide a breakthrough but remains 
concerned about the stickiness of services prices, with people 
tending to set prices based on backward-looking inflation indicators 
rather than based on future expectations which are nearing 7% for 
yearend 2007. Even if services prices remain sticky, a Central Bank 
economist pointed out services account for 25% of the CPI basket, 
such that by bringing down other prices, the Central Bank can bring 
down the headline number and gradually influence services 
price-setting behavior. 
 
---------------------------------------- 
Avoiding Complacency, Continuing Reforms 
---------------------------------------- 
 
¶13.  (SBU) With all these improvements, the Turkish economy is in a 
fundamentally better position than it was during early periods of 
political tension such as 1980, 1997, 1999-2000 or the 2001 crisis. 
Despite the stronger fundamentals, observers such as former Central 
Bank Governor Serdengecti caution against complacency.  He, along 
with most observers, attributes the continued very high real 
interest rates to political risk.  In this regard, the biggest risk 
is a return to the policy drift of the "lost decades" of the 1980s 
and 1990s, when Turkey was not able to achieve a stable political 
consensus.  Markets have thrived under the pragmatic policies of a 
single party government since 2002.  The economic reform process is 
far from over, and some of the most politically challenging reforms 
have yet to be implemented in areas such as the labor market, 
education, and the judiciary.  If these reforms -- which have been 
driven by the IMF program and EU accession process -- are put off, 
Serdengecti and his colleagues expect much lower growth rates than 
the 7% per year needed to create jobs needed to and converge income 
levels to a level approaching 50% of that of the EU. 
 
Wilson