P 030948Z JUN 08
FM AMEMBASSY ANKARA
TO SECSTATE WASHDC PRIORITY 6441
INFO CIA WASHDC PRIORITY
DEPT OF TREASURY WASHDC PRIORITY

UNCLAS ANKARA 001026 
 
 
DEPARTMENT FOR EUR/SE AND EEB 
TREASURY FOR ROSE 
 
E.O. 12958: N/A 
TAGS: ECON EFIN TU
SUBJECT: TURKEY: WHY INVESTORS ARE NERVOUS 
 
REF: A. ANKARA 996  B. ANKARA 1014 
 
 
¶1.  Summary:  Both economic and financial indicators show the 
honeymoon is over for the Turkish economy.  Expectations are 
negative and Turkish assets are losing value.  Our investment 
banking contacts see more nervousness from investors, 
occasionally setting Turkey apart from other emerging 
markets.  For example, Turkish equities have lost 32.3% in 
dollar terms since December 31, 2007, versus an increase for 
Brazil of 22.3% over the same period.  It appears investors 
are taking into account the Justice and Development Party 
(AKP) closure case risks in an environment where global 
conditions are also getting worse and investor risk appetite 
is decreasing.  GOT policies are also to blame for 
investors, nervousness.  GOT polices are inflationary, with 
increasing expenditures on the fiscal side in anticipation of 
local elections scheduled for March 2009.  The Central Bank 
of the Republic of Turkey (CBRT) and the GOT are no longer 
working together to manage inflation and blame each other for 
poor results.  The IMF stand-by agreement ended May 10, and 
the GOT has not yet negotiated a new arrangement, which 
investors would likely see as a positive sign.  Investors 
believe the EU accession process, while slow, has resulted in 
positive changes in the economy and their worst-case scenario 
for the closure case is a future GOT policy that would end 
Turkey-EU talks.  End Summary. 
 
Inflation is Up 
--------------- 
 
¶2.  Monthly inflation data released May 2 showed inflation 
rose by 1.7% last month, higher than the 1.4% market 
consensus.  On an annual basis, inflation has risen to 9.7%, 
up from 9.2%. Producer prices rose by more than twice 
consensus forecasts, putting annual producer price inflation 
at 14.6%, up from 11.7%.  Transport prices continue to spike, 
driven by the surge in global energy prices.  Pass-through 
from recent Turkish Lira (TRY) weakness continued to generate 
considerable cost-push inflation pressure, leading to a 
substantial 4.5% monthly increase in producer prices. 
 
¶3.  Following a six-month period of monetary easing from 
September 2007 to February 2008, and a subsequent two-month 
period of no changes in rates, the Central Bank shifted to 
monetary tightening, amid inflationary concerns and 
unfavorable global market conditions at the May 15 Monetary 
Policy Committee (MPC) meeting.  The MPC increased the 
benchmark policy interest rates by 50 basis points, which 
increased the overnight borrowing rate to 15.75% percent from 
15.25%.  In its accompanying statement announcing the rate 
decision, the CBRT seemed to focus on the 6.7% inflation 
forecast for 2009, while signaling for further rate hikes. 
 
GOT Focus is on Growth 
---------------------- 
 
¶4.  On May 3, the GOT announced the mid-term fiscal 
framework, where it revised the primary surplus target down 
to 3.5% from 4.2% of GDP for 2008.  The move was viewed by 
investors as fiscal loosening and showed that the GOT,s 
priorities have shifted to local elections and growth, while 
inflation management is a distant memory.  This decision put 
the Central Bank in a difficult position at a time when the 
Turkish economy is suffering from globally high oil and food 
prices.  On May 26, CBRT Governor Durmus Yilmaz bluntly said 
the GOT is loosening its fiscal policy and, in the monthly 
inflation report released at the end of May, warned the GOT 
on the need to maintain discipline.  The Finance and Treasury 
Ministers claimed that decreasing the primary surplus target 
does not signal fiscal loosening, since these funds will go 
to finance the Southeast Anatolian Project (GAP).  The GAP 
was announced by the Prime Minister on May 27 and is detailed 
in Reftel A.  The Central Bank did not buy this argument even 
though the GOT claimed that the intention was to use the 
additional fiscal resources solely to promote employment and 
growth.  In May, the Central Bank revised its inflation 
forecasts upward through 2010, projecting year-end inflation 
at 9.3% in 2008, 6.7% in 2009, and 4.9% for 2010.  This 
official shift in inflation expectation caused local bond 
rates to increase to 20% with the expectation of future rate 
hikes. 
 
Deficit is Rising; Unemployment is Up 
------------------------------------- 
 
¶5.  Economic market indicators also continued to deteriorate. 
 The current account deficit expectation increased to $44.9 
billion, up from $43.1 billion.  The March current account 
deficit was $4.2 billion versus the market expectation of 
$3.7 billion.  For the January to March 2008 period, the 
deficit jumped to $12.04 billion.  Net FDI, which is a major 
source of income for Turkey and bellwether for investors, 
decreased 50.5% from same period in 2007, ending the quarter 
at $4.04 billion.  Meanwhile, unemployment continued to 
increase, reaching 11.6% in the first quarter of 2008. 
 
Investors Explain their Jitters 
------------------------------- 
 
¶6.  We met in Istanbul with some leading investors on May 27 
and 28.  All noted they did not expect a crisis, but said the 
honeymoon was over, and current global market conditions 
suggest the GOT should be extremely cautious.  Investors feel 
insecure both with GOT economic policies and the AKP closure 
case.  All our contacts agreed that the second AKP 
administration is very different from the first, with less 
focus on the economy and more focus on populist measures and 
attracting votes.  Conflicting policy measures, delayed 
economic and EU reforms, little progress on privatization, 
and the growing tension between the CBRT and the GOT caused a 
credibility slippage.  Investors have lost much confidence in 
the economic team of Deputy Prime Minister Nazim Ekren, 
Treasury Minister Mehmet Simsek, and Finance Minister Kemal 
Unakitan.  Investors note they are not influential on key 
policies, and the Prime Minister continues to make all key 
decisions, which creates a serious bottleneck and delays. 
The future of GOT-IMF relations remains unclear.  Investors 
see little GOT support for the Central Bank's efforts to 
fight inflation, and the GOT has clearly chosen growth over 
inflation by expanding its fiscal policy.  The CBRT cannot 
exercise control over oil and food prices, but the bank hiked 
up its policy rates to control the prices in its domain. 
Market rates jump from 17-18% to over 20%.  JP Morgan Chief 
Economist Yarkin Cebeci says lack of policy coordination 
between the CBRT and GOT makes investors nervous, because the 
conflict signals the GOT has lost its focus on economic 
issues.  Cebeci also noted the AKP closure case was just 
starting to be priced in by investors.  Cebeci pointed out 
that in his recent road show to the U.S., he noticed a loss 
in appetite by U.S. investors for Turkish assets. 
 
¶7.  Kubilay Cinemre, Head of Merrill Lynch in Istanbul, told 
us that high oil and commodity prices constitute a big risk 
for the Turkish economy given a high current account deficit 
(6.2% of GDP) and rising inflation.  Under the current global 
environment, political risks are seen as a major cause for 
higher risk premiums.  Cinemre says the continued capital 
inflows are a result of still popular "carry trade" 
(leveraged capital investment: borrowing cheaply in Japan and 
investing for high yields in Turkey and other emerging 
markets).  Cinemre and other investment bankers agree the AKP 
closure case had some impact on pricing of Turkish assets and 
increased the risk premium for Turkey.  They noted, however, 
that the global economic situation and the GOT,s recent 
economic policies had a played a larger role in the pricing. 
Murat Gulkan from Deutsche Securities pointed out the AKP 
closure case was announced the same day as the Bear Stearns 
meltdown news broke, giving the AKP news much less press 
coverage than anticipated.  Both Cinemre and Gulkan said that 
any signal for economic slowdown in Europe resulting from the 
global recession (EU is Turkey's major export partner) would 
also be perceived negatively and seen as another threat to 
Turkey's already high current account deficit. Speakers at 
the TUSIAD (Turkish Industrialists and Businessmen 
Association) banking conference on May 28 agreed that Turkey 
has made much progress since the crisis of 2001.  One bright 
spot remains in the banking sector, where restructuring and 
reforms have kept the capital adequacy ratio over 16%, 
keeping the sector highly liquid. 
 
¶8.  Comment:  Investors see higher risks in Turkey and are 
demanding higher risk premiums to invest in Turkish assets. 
They are also concerned the AKP closure case and the future 
direction of Turkey's economic polices without the AKP.  A 
slow but steady rise in unemployment is ominous for the GOT 
and the AKP,s political prospects.  Seven to eight hundred 
thousand people join the labor force each year and job 
creation MUST be a continuing priority for the GOT.  The 
labor participation rate is going down because some people 
give up and stop looking for work.  Private sector investment 
essentially stopped at the beginning of 2008 and productivity 
is not rising.  Zafer Ali Yavan, TUSIAD Ankara 
representative, told the Ambassador that large companies 
invested heavily from 2004-2007, increasing capacity 
sufficient to last until 2009.  If investment does not pick 
up in 2009, unemployment is likely to spike.  One positive 
aspect of lower growth may be less energy consumption, and 
the GOT needs to develop a game plan to operate in the new 
high-cost environment.  If inflation passes through to the 
rest of the economy, CBRT will be forced to hike its rates, 
which will attract more carry trade. 
 
¶9.  There will also be large Treasury debt rollovers in July 
and August.  While we do not expect the GOT to have problems 
getting access to funds, we do expect that borrowing from 
both domestic and foreign markets will be more expensive. 
Although no one has a definitive number, total corporate 
sector foreign-denominated debt is estimated to be $100 
billion.  Investors expect a further Turkish Lira 
depreciation if the AKP is closed down and Erdogan is banned 
from politics.  Any rapid currency depreciation may 
constitute a credit risk for the banking sector and create a 
default risk for the corporate sector, which is likely to 
stem growth.  A further rapid depreciation in the Turkish 
Lira would also have a pass through affect over inflation, 
causing inflation to get worse.  A precautionary stand-by 
agreement with the IMF is seen as a safety measure by 
investors, but the GOT has still not given any clue about its 
intent to negotiate a new standby arrangement.  Most 
investors concede that the process of Turkey's EU accession, 
and resulting change in many laws, has been good for business 
and believe the worst-case scenario would come from an end to 
Turkey-EU talks.  End comment. 
 
 
Visit Ankara's Classified Web Site at 
http://www.intelink.sgov.gov/wiki/Portal:Turk ey 
 
WILSON