US embassy cable - 04ANKARA129

C O N F I D E N T I A L SECTION 01 OF 04 ANKARA 000129 
 
SIPDIS 
 
 
STATE FOR E, EUR/SE, AND EB/IFD 
TREASURY FOR OASIA - JLEICHTER AND MMILLS 
NSC FOR MBRYZA AND TMCKIBBEN 
 
 
E.O. 12958: DECL: 01/07/2009 
TAGS: EFIN, ECON, PGOV, TU 
SUBJECT: IMF CONCERNS: POPULIST MEASURES CLOUD FISCAL 
OUTLOOK 
 
Classified by Economic Counselor Scot Marciel for reasons 
1.5(b) and (d). 
 
 
 
 
1. (C) Summary: According to IMF officials and market 
analysts, GOT decisions to increase both minimum wage and 
2004 pension payments well above projected inflation have 
significantly complicated the outlook for achieving fiscal 
targets, and possibly inflation targets as well.  Fund staff 
estimates the total effect in 2004 of these two measures and 
revenue shortfalls as roughly 2 percent of GDP, requiring 
difficult compensatory fiscal measures.  It now appears 
likely that the 6.5 percent primary surplus target for 2003 
was missed by about half a percent of GDP, as revenues have 
been lower than projected, a phenomenon that is likely to 
continue into 2004.  The populist measures were adopted with 
little consultation with IMF staff and little regard for the 
effect on the overall quality of fiscal adjustment.  The IMF 
is going ahead with its Seventh Review mission, but is 
planning a two-stage process with no expectation of a Letter 
of Intent during the first stage.  Though markets dropped 
Tuesday on concerns about these measures, they resumed their 
optimistic tone by Wednesday afternoon after the IMF 
announced its imminent mission.  Fund staff is also concerned 
about banking issues and the lack of progress on structural 
reforms. End Summary. 
 
 
Minimum Wage Increase: 
--------------------- 
 
 
2. (C) In mid-December, the Turkish press reported that Prime 
Minister Erdogan supported a whopping 55 percent increase in 
the minimum wage.  Though senior GOT technocrats have told us 
they recommended against a large increase in the minimum 
wage, in the end the GOT approved a 34 percent increase--far 
exceeding projected CPI inflation of 12 percent for 2004.  To 
ease employers' concerns about the cost of the increase, the 
GOT agreed to absorb 20 percent of the employer's share of 
the Social Security premium on minimum-wage employees.  Many 
market analysts cautioned that the 34 percent increase could 
hamper disinflation efforts, as did the chief implementer of 
those efforts--Central Bank Governor Serdengecti--who warned 
publicly last week of the need for an incomes policy to 
support disinflation. 
 
 
3. (C) In a meeting with Econoffs January 7, IMF Resident 
Representative Odd Per Brekk and deputy Christoph Klingen 
said that Turkish Treasury's estimates are lower, but that 
the IMF estimates the fiscal impact of the reduced Social 
Security Premia to be around 1.3 or 1.4 Quadrillion TL (about 
$1 billion USD or 0.3 percent of GDP). Brekk revealed that on 
the evening before the IMF Board vote on the Sixth Review, 
the Fund had threatened to postpone the vote unless the GOT 
committed to hold the minimum wage increase to a reasonable 
level and work with Fund staff on compensatory fiscal 
measures.  Despite high-level GOT commitments to do so--and 
Deputy Managing Director Krueger calling Erdogan (at 
Babacan's secret request) to press the issue--the Prime 
Minister dug in his heels and went ahead with the large 
minimum wage increase. 
 
 
Pension Payment Increase: 
------------------------- 
 
 
4. (Sbu) Despite the Central Bank Governor's warning about 
incomes policy, and GOT economic officials knowing that the 
minimum wage agreement's fiscal impact exacerbated the fiscal 
outlook for 2004, Prime Minister Erdogan announced January 6 
that pension payments under the "SSK" (the pension system for 
employees) and "Bag-Kur" (the pension system for the 
self-employed) would be 21 percent for 2004, again exceeding 
the 12 percent 2004 inflation target and raising fiscal and 
inflationary concerns.  As Erdogan pointed out, the estimated 
cost of this measure is TL 2.6 Quadrillion (USD 1.9 billion 
or about 0.6 percent of GDP). 
 
 
5. (C) Brekk told econoffs that there had been only minimal, 
last-minute consultation with the Fund on the pension hikes, 
and that the earlier, IMF-blessed budget had assumed a much 
lower increase in line with CPI projections. 
 
 
Other Populist Measures: 
----------------------- 
 
 
6. (Sbu) Aside from the minimum wage and pension payment 
increases, there are other signs of a re-emergence of 
populist measures: the GOT has announced that it will remove 
names of bad creditors from the banking system's common list, 
arguing that the 2000-2001 crisis caused too many people to 
have credit problems for which they should no longer be 
denied new credit.  According to press reports, state-owned 
Halk and Ziraat Banks have announced reduced interest rates 
on loans to small businesses and farmers, respectively. 
Though some of the reduction can be justified by falling 
market rates, these appear to be below-market (20 percent) 
rates. 
 
 
Markets React, Then Resume Rally: 
-------------------------------- 
 
 
7. (Sbu) On Monday, January 5, after the GOT announced 
better-than-target inflation numbers for 2003, the market 
resumed its 2003 rally: the IMKB 100 index rose sharply, the 
benchmark interest rate fell and the lira continued to 
strengthen.  On Tuesday and Wednesday morning, however, after 
the pension payments were announced, the market fell 
back--the first time markets had dropped significantly on bad 
news in several weeks.  But by Wednesday afternoon, when the 
IMF announced the Seventh Review mission was still coming, 
the bulls--and moral hazard players--returned and the markets 
resumed their forward march.  In mid-day trading Thursday, 
the IMKB 100 was at 19,724, the lira was at 1.367 to the 
dollar, and the benchmark bond was back below 24 percent at 
23.85. In the Eurobond market, the Turkish Treasury's 
announcement of a new 30-year dollar-denominated issue this 
week was greeted with enthusiasm and the issue was 
oversubscribed. 
 
 
 
 
Two-stage Seventh Review Process: 
-------------------------------- 
 
 
8. (C) In view of the GOT's introduction of budget-damaging 
populist measures, with negligible consultation, Brekk said 
the IMF staff is taking a cautious, two-stage approach to its 
Seventh Review mission.  Though the staff will still come as 
planned this coming weekend, the first stage of the mission, 
from January 10-20, is not expected to reach an agreement. 
Brekk noted that in addition to some very difficult fiscal 
issues (see below) the Seventh Review mission will need to 
reach agreement with the GOT on structural benchmarks for 
2004.  Brekk said the Fund plans to send a second mission the 
second week of February, after the Kurban Bayrami holiday. 
Brekk pointed out that Erdogan would be meeting Koehler in 
Washington, and that the much-postponed foreign investors' 
council meeting, including IMF M.D. Koehler, and World Bank 
President Wolfensohn, is to be held March 15 in Istanbul. 
Brekk thought the GOT would surely want to conclude the 
Seventh Review by then. 
 
 
 
 
Difficult 2004 Fiscal Outlook: 
----------------------------- 
 
 
9. (C) Though GOT commitment to fiscal discipline had 
appeared to be its strong suit until the minimum wage 
announcement, the wage and pension increases--combined with 
worse-than-expected revenue collection--mean a much more 
difficult fiscal outlook.  Though final 2003 numbers are not 
yet available, Brekk and Klingen said the latest information 
suggests that the GOT fell short of the 6.5 percent primary 
surplus target, probably by about 0.5 percent.  According to 
Klingen, revenue collections are lower than projected, a 
phenomenon that neither the Fund staff nor the GOT fully 
understand, but one that is likely to continue into 2004. 
The IMF estimates that the shortfall in revenue projections, 
combined with the fiscal costs of the minimum wage deal and 
the pension payments increase will lead to a shortfall of 
between 2 and 2.2 percent of GDP for 2004.  In order to deal 
with this projected shortfall, Brekk said that Economy 
Minister Babacan and Finance Minister Unakitan presented a 
package of compensatory measures to the Council of Ministers 
on January 5, including a 10 percent across-the-board 
reduction in discretionary spending and revenue-enhancements 
such as increased taxes and higher electricity prices. 
Though the Council balked (for now) at the revenue increases, 
the GOT announced the 10 percent discretionary spending cut, 
excluding personnel expenditures.  Although Fund staff have 
not yet studied the measures, Brekk noted that the 
compensatory measures could well exacerbate pre-existing 
problems with the quality of fiscal adjustment, and that the 
10 percent spending cut might not be sufficient. 
 
 
Banking Sector Issues: 
---------------------- 
 
 
10. (Sbu) Aside from the fiscal issues, Brekk said that in 
2004 banking sector issues and other structural reforms will 
be key areas for the IMF.  Brekk admitted that the IMF staff 
has yet to develop a good working relationship with the new 
Chairman of the BRSA (Bank Regulatory Agency), Tevfik Bilgin. 
 Brekk said that BRSA has appealed the court decision 
cancelling BRSA's takeover of Demir Bank.  Though the 
decision is not yet final, Brekk said he understands that the 
GOT and BRSA want to merge intervened Pamuk Bank into 
state-owned Halk Bank, a solution the Fund considers 
acceptable. The Fund is still waiting for the GOT to announce 
who will lead the high-profile inquiry into the Imar Bank 
failure, an important IMF demand.  Brekk said there will be a 
benchmark for May for the inquiry to publish its findings. 
The Fund's legal experts will also be doing a thorough review 
of Turkey's 1999 Banking Act, for possible improvements. 
Brekk deferred to the World Bank on the long-delayed 
privatizations of state-owned Halk, Ziraat and Vakif Banks. 
Though the GOT has announced, with IMF blessing, that it will 
reduce the blanket guarantee on deposits, Fund staff will be 
engaging with the GOT on the details, to be sure a balance is 
struck between reducing moral hazard and creating systemic 
risks.  Continuing work on bankruptcy legislation will also 
be part of the 2004 program. 
 
 
11. (Sbu) Brekk shared econoff concerns about press reports 
and rumors of Cukurova group trying to: a) re-negotiate its 
repayments to the Deposit Guarantee Fund (SDIF) for Pamuk and 
Yapi Kredi Bank; b) participate in one of the two consortia 
bidding on the Tupras privatization; and c) regain control of 
Yapi Kredi Bank.  The IMF had not yet had a chance to check 
out these reports.  Brekk agreed that Cukurova  regaining 
control of Yapi Kredi would be a violation of the provision 
in the Banking Act barring owners of failed banks from 
regaining banking licences. 
 
 
Other Structural Reforms: 
------------------------- 
 
 
12. (Sbu) Brekk said that very little happened in 2003 on 
non-bank structural reforms, so there will need to be a 
"catch-up" in the program.  On privatization, Brekk said the 
incentive structure may be part of the problem, since 
Privatization Administration officials fear being blamed or 
prosecuted if they sell state assets at prices below internal 
valuations.  Another possible flaw is the compensation 
methodology used for outside advisors who do the evaluations. 
 If the advisors get higher fees based on a higher sales 
price, they will tend to overvalue the companies slated for 
privatizations. Brekk also passed on Privatization Authority 
President Metin Kilci's lament that no one looks at the 
hundreds of small parastatals he has sold. 
 
 
13. (Sbu) Brekk said the World Bank will have the lead on 
public sector reforms, though the Fund may require the 
establishment of a Government Ethics Office.  The Fund may 
also draw on the work of its recent technical mission on the 
unregistered economy to incorporate into the program new 
measures for improved tax collection. The program will 
continue its work on closure of special accounts and on the 
SEE redundancy issue, though the GOT and the Fund continue to 
diverge on which positions should be counted. 
 
 
14. (Sbu) Econcouns noted the GOT's weak track record on 
creating competitive markets, whether in telecoms or energy 
or trade, an area in which the GOT has just announced it will 
scrutinize imports at price levels that are deemed too low. 
Brekk and Klingen, who had been on vacation, were not yet 
aware of this announcement and said they would look into it 
since IMF membership requires countries to commit not to try 
to reduce imports by creating barriers.  On the broader issue 
that Econcouns had raised, Brekk said the Fund generally 
tries to limit its structural requirements to those that have 
a strong link to macro issues. 
 
 
Lira Strength and the Current Account Deficit: 
--------------------------------------------- 
 
 
15. (Sbu) Brekk did not seem overly concerned about the 12 
percent real appreciation of the Lira in 2003 and the outlook 
for continued Lira strength and a growing current account 
deficit.  With a floating exchange rate, the vulnerability is 
not what it was in the 2000-2001 crisis when Turkey had an 
overvalued currency and a crawling peg. Nevertheless, he 
agreed that the current account deficit was an indirect 
vulnerability, because a sharp turnaround in the exchange 
rate would greatly exacerbate Turkey's debt problem.  If the 
global appetite for emerging market debt declines and Turkey 
has a large current account deficit, a political shock could 
be a trigger for problems.  Brekk ended by expressing hope 
that top U.S. officials highlight this vulnerability, and the 
consequent need to persist in economic reform, during Prime 
Minister Erdogan's visit later this month. 
DEUTSCH