US embassy cable - 04ANKARA2077

UNCLAS SECTION 01 OF 03 ANKARA 002077 
 
SIPDIS 
 
 
SENSITIVE 
 
 
STATE FOR E, EB/IFD, AND EUR/SE 
TREASURY FOR OASIA - JLEICHTER AND MMILLS 
NSC FOR MBRYZA AND TMCKIBBEN 
 
 
E.O. 12958: N/A 
TAGS: EFIN, ECON, TU 
SUBJECT: MARKET CORRECTION DESPITE CONTINUED POSITIVE MACRO 
NUMBERS 
 
REF: ANKARA 1926 
 
 
1. (Sbu) Summary: On April 8, Turkish financial markets 
experienced one of the few significant corrections in recent 
months, with interest rates blipping back up over 22 percent, 
the lira falling to TL 1.334 million to the dollar and the 
stock market falling 3.10 percent.  A confluence of negative 
factors are blamed for the correction: an increase in Central 
Bank TL auctions, negative comments on Turkey's EU accession 
bid by the French Foreign Minister, anti-Annan Plan 
announcements by both Greek and Turkish Cypriot leaders, the 
increased fighting in Iraq, and the upcoming Easter weekend 
for Western investors. The announcement of 
better-than-expected numbers for the first quarter primary 
surplus and February Industrial Production failed to buoy the 
market.  The correction comes after a sustained period of 
gradually improving markets, including successful moves by 
the Turkish Treasury in March to issue some slightly 
longer-dated lira-denominated bonds.  End Summary. 
 
 
Markets Dip April 8: 
------------------- 
 
 
2. (U) Equity, fixed income and foreign exchange markets all 
fell sharply April 8.  The IMKB 100 stock exchange index fell 
3.10 percent on the day to 19,419, perhaps because the stock 
market had benefited the most from the recent spate of market 
bullishness: analysts, bankers and hedge fund managers have 
all told econoffs that the best "Turkey play" is equities, 
since there is more upside than in fixed income assets, which 
are constrained from falling too far by inflation, and bank 
funding costs.   Government securities prices and the lira 
exchange rate also fell sharply (see below). 
 
 
Government Debt Market Developments: 
----------------------------------- 
 
 
3. (Sbu) Interest rates on the benchmark bond rose back over 
22 percent to 22.40 at the close April 8, with an unusually 
high trading volume of TL 2.2 Quadrillion on the benchmark 
bond.  Interest rates had slowly trended lower in recent 
weeks, with the benchmark getting below 23 percent only on 
March 19--following the Central Bank's 200 basis point rate 
cut March 17.  The benchmark gradually inched downwards, 
getting below 22 percent March 30, and hitting a low of 21.41 
April 2, before coming back over 22 percent on April 8. 
Despite the Central Bank rate cut, both Istanbul analysts and 
Treasury officials say rates could not fall further, 
especially short-term rates, because bank funding costs 
(which key off of the Central Bank's overnight rate, 
currently 24.60 percent on a compound basis) are still higher 
than government securities rates.  The gently downward 
sloping (i.e. inverted) yield curve means that banks are 
betting on further rate cuts in the future.  Without further 
cuts, banks would have a "negative carry" on their government 
securities portfolios.  These contacts explain that 
banks--the dominant players in the government securities 
market--lack access to medium- or long-term funding, and even 
their portfolios of bonds with maturities of 12 to 18 months 
represent a maturity mismatch: they are funding medium-term 
government bonds with short-term deposits. 
 
 
4. (Sbu) Both Treasury domestic debt manager Volkan Taskin, 
and Istanbul market analysts say that it is for this 
reason--the absence of domestic buyers of longer-dated paper 
due to buyers' short-term funding--rather than a Treasury bet 
on lower interest rates, that has prevented more issuance of 
long-dated TL-denominated paper to the market.  For this 
reason the average maturity of TL-denominated debt 
outstanding in the market--not including FX-linked paper or 
TL paper placed with non-market investors such as the state 
banks and other public institutions--stayed more or less 
constant in late 2003 and early 2004 at about 12 months. 
Since the beginning of March, however, Treasury has issued 
several bonds with maturities exceeding twelve months, such 
as the issuance of an additional $1.54 billion of TL 
benchmark bonds, maturing August 24, 2005 on April 6. 
 
 
5. (Sbu) Taskin, some Istanbul bankers, and Central Bank 
markets department head Akil Ozcay separately said Treasury 
did a good job of exploiting favorable market conditions 
during the first quarter of 2004 to front-load debt issuance 
for the 2004 borrowing program. During the first three months 
of 2004, Treasury's rollover rate has been 94 percent, well 
above the targeted average for 2004 of 87 percent. Treasury's 
heavy issuance early on will place its domestic TL debt 
managers in a stronger position for the remainder of the 
year, only needing to rollover an estimated 84 percent of its 
debt, on average.  Repeating an ongoing concern of Central 
Bank officials, however, Ozcay said Treasury's focus on 
lowering its rollover rate means the Central Bank has to do 
more to mop up excess liquidity in the market for monetary 
policy reasons. 
 
 
Lira Falls out of Trading Range... 
-------------------------------- 
 
 
6. (Sbu) In a departure from recent years' exchange rate 
volatility, for the past few months the lira has been trading 
 in a relatively narrow range, typically just above 1.3 
million lira to the dollar.  The stability of the lira has 
been maintained, in part by the Central Bank's policy of 
fine-tuning its auctions of foreign exchange.  The Central 
Bank fine-tuning has depended on the level of TL liquidity, 
arising in part from inflows of foreign portfolio investors' 
money and partly from continued reverse currency substitution 
(i.e. people keeping more of their holdings in TL than in the 
past).  Though the Central Bank denies that it is trying to 
influence the level of the lira, it has claimed it is merely 
trying to dampen exchange rate volatility.  Privately, Ozcay 
explained that the Central Bank also adjusts its foreign 
exchange auction as a monetary policy tool, to sterilize 
inflows of foreign portfolio investment that would otherwise 
work against the Bank's monetary tightening. 
 
 
7. (Sbu) Having increased its FX purchase auctions (TL sales) 
from $80 million to $100 million a few weeks ago, the Central 
Bank upped them to $140 million late in the day on April 7. 
Earlier the same day, Ozcay told econoffs the Central Bank 
was considering intervening, but later settled on the milder 
action of increasing the auctions.  In retrospect, the 
Central Bank may have gone too far.  The following day, 
helped by French Foreign Minister Michel Barnier's negative 
statements on Turkey's EU accession prospects, calls by both 
Greek Cypriot leader Pappadopoulos and Turkish Cypriot leader 
Denktash for voters to oppose the Annan plan, and increased 
fighting in Iraq, the lira tumbled from 1.314 to the dollar 
and 1.603 to the Euro at the close on the 7th to 1.335 and 
1.615 at the close on the 8th.  The approach of the Easter 
weekend for Western investors may have also played a role, as 
some foreign investors did not want to hold Turkish exposure 
over the long weekend (long in Western Europe and America, 
that is). Economist Baturalp Candemir of HC Istanbul 
privately grumbled to econoff that the main culprit in the 
sell-off was the Central Bank, since the markets understood 
that Barnier's comments mainly reflected domestic political 
posturing and that Denktas' and Pappadopoulos' statements 
were expected.  Other analysts, such as Deutsche Bank's 
Tevfik Aksoy, attributed the sell-off to multiple factors, 
but with the Central Bank's action the single most important. 
 On the other hand, Central Bank officials privately 
downplayed the impact of their auctions. putting more weight 
on the geopolitical developments. Candemir said many of his 
firm's clients had lost money on April 8, and would not 
quickly return to Turkish markets.  Comment: Given the almost 
uninterrupted bull market in recent months, the slap on "hot 
money" investors' wrists is probably healthy.  End Comment. 
 
 
 
 
...Despite Favorable Macroeconomic Data: 
--------------------------------------- 
 
 
8. (Sbu) Ironically, on the day of the sell-off additional 
positive macroeconomic numbers were released, building on 
some favorable news in recent weeks.  In the afternoon of 
April 8, Finance Minister Unakitan announced a 
better-than-expected primary surplus of TL 7.21 Quadrillion 
($5.52 billion) for the first quarter of 2004. This means 
that not only is the GOT's fiscal situation being helped by 
lower-than-expected interest costs but that the broader 
fiscal situation--excluding interest payments--did well in 
the first quarter.  On the same day, the State Statistical 
Institute announced better-than-expected industrial 
production numbers for February: a 15.6 percent rise over 
February 2003.  Though the number was encouraging, coming in 
well above the consensus estimate of 10 percent, economists 
point out that the increase industrial production was boosted 
by the base effect arising from very weak production early in 
2003.  Economists therefore remain of mixed views on how 
optimisitic to be about full-year 2004 GNP growth. 
 
 
Markets Ease Back up on April 9: 
------------------------------- 
 
 
9. (Sbu) On April 9, helped by the good news on fundamentals, 
the markets recovered, but only very slightly. At the close, 
the lira had come back a hair to 1.332 to the dollar and 
1.612 to the Euro, while the benchmark interest rate eased to 
22.06 and the IMKB 100 stock market index was up 0.44 percent 
to 19.505. 
EDELMAN