US embassy cable - 04ANKARA136

C O N F I D E N T I A L SECTION 01 OF 03 ANKARA 000136 
 
SIPDIS 
 
 
STATE FOR E, EB/IFD AND EUR/SE 
TREASURY FOR OASIA - LOEVINGER, MILLS AND LEICHTER 
NSC FOR MCKIBBEN AND BRYZA 
STATE PASS USTR FOR NOVELLI/ERRION 
 
 
E.O. 12958: DECL: 01/05/2013 
TAGS: EFIN, EINV, PGOV, ETRD, TU 
SUBJECT: TURKEY'S ECONOMY: WHY WE NEED TO KEEP UP THE 
PRESSURE FOR REFORM 
 
 
(U) Classified by Charge d'Affaires Robert Deutsch.  Reasons: 
1.5, (b,d) 
 
 
1.  (C) Summary:  Government leaders are celebrating a 
successful economic year, with inflation dropping to 18.4 
percent, growth near the 5 percent target, and interest rates 
on the massive public debt falling dramatically.  The sense 
of crisis has faded.  The AK Government deserves some credit 
for progress, as it learned from early mistakes, stuck to 
tight fiscal policy, and completed, albeit slowly, key IMF 
reviews.  External factors -- the rapid conclusion of our 
Iraq operation, a global surge in demand for emerging market 
assets, and the U.S. assistance offer -- also were critical 
to this year's success, as was the Turkish lira's unexpected 
strength.  Despite progress, the economy is not out of the 
woods.  Public debt remains dangerously high, the current 
account deficit is large and growing, and any significant 
scare -- whether due to lack of reform, failure to make 
progress with the EU, or a political or external shock -- 
could send the lira tumbling and the economy back toward 
crisis. 
 
 
2.  (C) At the political level, an absence of understanding 
and commitment to the structural reforms that are essential 
to the sustained growth Turkey needs remains.   In 2003, 
privatization again failed, there was no movement on 
developing energy markets, independent regulatory boards were 
weakened, and there was no measurable progress in dealing 
with corruption and rule of law, or in resolving trade and 
investment problems.  The government has an opportunity in 
2004 to push the economy further away from crisis and toward 
sustained growth; however, it is unlikely to do so without 
strong international pressure.  The IMF will provide pressure 
on narrow fiscal/financial issues, but with little focus on 
structural reform.  The World Bank is more willing to 
condition its loans on structural reform implementation, but 
has less leverage and needs G-8 support.  The economic 
conditionality in our financial agreement could be effective 
leverage to ensure Turkey goes beyond its narrow IMF mandate 
and implements the structural reforms that are needed.  We 
also need to push hard on our trade and investment issues. 
End Summary. 
 
 
3.  (SBU) Turks celebrating the New Year have forgotten how 
dire their country's economic situation looked nine months 
earlier, when the lira was rapidly weakening, interest rates 
on government t-bills hit 77 percent, and market analysts 
wondered aloud whether the Treasury would be able to borrow 
enough money to make domestic debt payments in April.  The 
year ended with inflation at 18.4 percent, growth at or above 
its 5 percent target, the public debt/GNP figure dropping 
from 78 to near 70 percent, and exports up nearly one-third. 
The lira appreciated from TL 1.75 million/dollar in late 
March to TL 1.4 million/dollar, and yields on government 
securities fell to just over 25 percent.  The main stock 
index closed the year up nearly 80 percent.  More broadly, 
the sense of crisis that had pervaded economic discussions 
since late 2000 faded, to the point that Treasury's 
announcement of $11 billion in domestic debt redemptions in 
January barely caused a ripple. 
 
 
4.  (C) AK Government leaders claimed full credit for this 
success, and in fact deserve some of it. After a bad start, 
the government followed the IMF's prescription and minimized 
populist pronouncements.  It took the fiscal steps needed to 
come close to -- if not reach -- the 6.5 percent primary 
surplus target, and it completed, albeit with delays, key IMF 
program reviews.  Conversations with the business community 
and financial markets suggest that confidence in the 
government's economic management grew during the year. 
 
 
5.  (C) On the other hand, many analysts argue that much of 
2003's economic success was due to developments outside of 
the government's control.  The rapid end of the Iraq war, 
combined with the sharp increase in Turkish exports to 
post-war Iraq, made the operation a boon to the Turkish 
economy, rather than a cost.  The turning point in the 
financial markets was the USG's announcement of an $8.5 
billion financial assistance package.  Even though Turkey has 
yet to draw from that money, the announcement alone caused 
interest rates on government t-bills to fall 9 percentage 
points in 48 hours, kicking off a rally that continues to 
this day.  That rally has been fed by the global flow of 
funds to emerging markets and substantial reverse currency 
substitution (i.e., Turks trading their foreign exchange 
holdings for lira).  The unexpected strength of the lira has 
helped disinflation efforts, reduced the public debt/GNP 
ratio, and -- because of its enormous psychological import to 
Turks -- generally increased confidence. 
 
 
6.  (C)  These developments have given Turkish leaders an 
exaggerated sense of their economic policy prowess and 
disguised the economy's underlying vulnerabilities.   Few in 
Turkey's leadership understand even now that the economy is 
far from being out of the woods.  The debt/GNP ratio remains 
dangerously high (with much of 2003's decline due to the 
lira's strength), external debt has increased significantly, 
the current account deficit is large and rising, inflation 
has not yet been defeated, the banking sector remains weak 
and vulnerable (if stronger than it was 1-2 years ago), and 
there are serious questions about the sustainability of 
export growth if the lira remains strong. (There are also the 
longer-term problems of excessively-high tax rates, a narrow 
tax base, and a huge informal economy.)  Particularly in the 
context of a growing current account deficit, anything that 
significantly affects market confidence -- a failure to 
implement reforms, a lack of progress on Cyprus/EU accession, 
a public perception that the U.S. $8.5 billion (and a 
perceived continuing level of U.S. support) might not be 
forthcoming, or some other political or external shock -- has 
the potential to send the lira tumbling, interest rates 
soaring, and to return the economy to crisis or near-crisis 
mode. 
 
 
7.  (C)  The government has an opportunity in 2004 to reduce 
the economy's vulnerability further and to take another large 
step toward the sustained, low-inflation growth that Turkey 
needs to get out from under its debt overhang and create 
jobs.  To achieve this, it needs to take the right political 
steps on Cyprus/EU and to maintain good relations with the 
United States.  Economically, it needs to avoid populist 
temptations -- the recent decision to raise the minimum wage 
34 percent and pensions 21 percent is a flashing warning 
light in the run up to March municipal elections -- and 
improve the quality of its fiscal adjustment, which so far 
has been based too heavily on tax increases and not enough on 
spending cuts.  The government also must go beyond its tepid 
implementation of the narrow range of IMF-mandated policies 
to pursue the full menu of structural reforms that are the 
key to attracting investment and unlocking the country's 
growth potential.  Unfortunately, the government in 2003 did 
a poor job of implementing those reforms.  For example: 
 
 
-- Although the GOT convinced nearly everyone that it was 
serious about privatization, 2003 was another year of failure 
in this area.  The government canceled the Tekel tobacco 
privatization (price was too low), delayed the Tupras 
privatization, and did not implement the Petkim privatization 
(wrong buyer).  It ended the year with privatization sales 
worth less than $900 million (actual proceeds were less), 
when it easily could have achieved results in the $2.5-3 
billion range.  The main problem was that the government got 
hung up about valuations, and failed to understand that the 
real reason to privatize is to create efficiency, not raise 
revenues. 
 
 
-- The GOT made no progress on developing the critical energy 
market.  For political reasons, the Prime Minister refused to 
approve a shift to a regional tariff structure, an essential 
part of creating a cost-based market.  The GOT also did not 
to raise prices in line with inflation/costs, failed to honor 
its commitment to begin transferring natural gas import 
contracts from BOTAS to the private sector, and harassed 
existing BOT electricity producers in a misguided effort to 
force them to lower prices. 
 
 
-- The GOT failed to support -- and arguably weakened -- 
independent regulatory boards, the creation of which was a 
critical step in the 2001-2002 reform process.  It forced 
BRSA Chairman Akcakoca to resign; this would have been 
acceptable, given BRSA's failure to catch the Imar Bank 
fraud, had not the GOT made clear from the beginning that it 
wanted to control the agency.  It also failed to support the 
Energy Market Regulatory Agency, which by law is supposed to 
set prices, instead allowing the Energy Ministry to maintain 
authority over this and other critical energy market issues. 
 
 
-- Despite a legal requirement to implement telecom 
liberalization as of January 1, 2004, the Telecom Authority 
still has not issued implementing regulations.  Moreover, 
industry analysts say the Authority does not have the 
expertise and clout to regulate the market effectively. 
 
 
-- There was no measurable progress in addressing corruption 
and rule of law issues (albeit these are long-term projects), 
and virtually no discussion within the government about how 
to promote competition and productivity. 
 
 
-- The government did virtually nothing to resolve our 
foreign investment disputes and problems or to eliminate 
WTO-inconsistent market access barriers. Although these 
issues are not highlighted in either the IMF or World Bank 
programs, they have a direct impact on Turkey's ability to 
attract investment and develop a market-based, competitive 
economy. 
 
 
8.  (C) The economy's structural problems are reflected in 
its inability to generate or attract investment.  Central 
Bank figures indicate that foreign direct investment inflows, 
which were a pathetic $562 million in 2002, fell to less than 
$400 million in 2003.  Our discussions with the business 
community suggest that -- with the exception of some 
exporters -- local businesses are investing only enough to 
maintain existing capacity.  Without a significant increase 
in foreign investment, it is hard to see how Turkey will 
achieve sustained 5-6 percent growth, particularly now that 
much of the slack capacity from the 2001 capacity has been 
brought back into use.  Central Bank Governor Serdengecti 
argues that Turkey's ability to attract more foreign 
investment will determine whether it grows at 4 percent or 6 
percent annually. 
 
 
9.  (C) Unfortunately, no one at the political level in this 
government understands the importance of structural reforms, 
so there is no champion (at least one with clout) for 
implementing those reforms.  As a result, we can expect 
uneven and inconsistent reform implementation.  As has long 
been the case, consistent international pressure -- i.e., 
effective use of economic policy conditionality by foreign 
official lenders -- is going to be key to achieving progress 
on the reform agenda.  The IMF will no doubt continue its 
conditionality, but the Fund is focusing on a narrow, if 
important, range of issues, and its leverage is decreasing. 
We can expect the World Bank -- with which the GOT shows 
signs of re-engaging -- to condition its lending on 
implementation of structural reforms, but the Bank has always 
lacked real leverage here and will need our support. 
 
 
10.  (C) We can do our part by continuing to engage actively 
on behalf of the IMF and World Bank-supported programs, and 
by wisely using the economic conditionality in our Financial 
Agreement, if and when Turkey ratifies it.  Specifically, we 
should press the GOT to proceed with important structural 
reforms, including privatization, support for independent 
regulators, and tangible steps toward development of energy 
and telecommunications markets.  We also need to continue to 
press the GOT to eliminate WTO-inconsistent market access 
problems and to resolve the problems affecting U.S. 
investors, with a systemic approach whenever possible.  Prime 
Minister Erdogan's upcoming visit to Washington presents a 
good opportunity to make these points, and to underscore 
Turkey's opportunity to highlight at the June Istanbul summit 
all the economic progress Turkey can achieve over the next 
six months. 
DEUTSCH