US embassy cable - 04ANKARA5187

UNCLAS SECTION 01 OF 04 ANKARA 005187 
 
SIPDIS 
 
SENSITIVE 
 
STATE FOR EB/IFD AND EUR/SE 
TREASURY FOR INTERNATIONAL AFFAIRS - MMILLS AND RADKINS 
NSC FOR MBRYZA AND TMCKIBBEN 
BRUSSELS FOR USEU 
 
E.O. 12958: N/A 
TAGS: EFIN, PREL, ECON, TU 
SUBJECT: CENTRAL BANK RATE CUT REINFORCES MARKET'S 
INCREASING BULLISHNESS 
 
REF: ISTANBUL 1371 
 
1, (U) Summary:  After a range-bound summer, Turkish markets 
have rallied in early September. 
First the stock market rallied on increasingly favorable 
signals regarding EU accession and an IMF 
program, then the Central Bank cut its short-term rates 
200-400 basis points.  By its action, the Central 
Bank appears confident the end-year inflation target will be 
met, and does not appear overly concerned 
about the growing current account deficit.  The rate cut, 
surprising markets by its magnitude and timing, 
in turn broadened the rally to the government securities 
market in a gloabal market environment where 
funds are still flowing to emerging markets.  Though a 
Central Bank rate cut would normally cause a 
currency to weaken, market bullishness caused the lira to 
strengthen through foreign inflow.  On 
Friday, September 10, second quarter GDP growth came it at a 
whopping 11.9 percent, confirming 
that the economy is likely to grow well above its 5 percent 
target for 2004, but reinforcing concerns 
about overheating and the current account deficit. End 
Summary. 
 
First, a Stock Market Rally: 
-------------------------------- 
 
2. (U) Following the spurt of volatility in April and May 
after a shift in expectations regarding global 
interest rates, markets settled into a mostly range-bound 
summer. The exchange rate has been remarkably 
stable, hovering around 1.5 million TL to the dollar and the 
benchmark bond has been stuck in the 
mid-twenties of percent, with increasingly positive inflation 
numbers seemingly having little effect on 
nominal rates.  The benchmark bond, which was yielding over 
27 percent at the end of June, had only 
improved to 25.13 percent at the end of August.  The more 
volatile, and less meaningful, stock market 
gradually moved up from its late spring lows, while remaining 
below the level it achieved in April, 
prior to the volatility. 
 
3. (U) Even the long-awaited, market-critical decision in 
August that the GOT would definitely seek a follow-on 
disbursing Standby arrangement from the IMF, failed to move 
markets.  But at the beginning of September, as 
Turks drifted back from vacation, the Turkish stock market 
began moving upwards on increasing optimism over 
Turkey,s prospects of getting a date to begin EU accession 
negotiations.  After rising 2.95 percent the week of 
August 23-27, the IMKB-100 rose 4.63 percent to 20,775 the 
week of August 30-September 3, after positive 
comments on Turkey,s EU accession prospects by UK Foreign 
Minister Straw and EU Enlargement 
Commissioner Verheugen. 
 
4. (U) The stock market optimism, however, failed to make a 
dent in the foreign exchange or government 
securities markets.  The yield on the benchmark bond, for 
example, was actually slightly higher, at 25.41 
percent at the close September 7 then it had been on August 
27, when it traded at 25.13.  Likewise, the 
lira was at 1.505 million to the dollar September 7, versus 
1.504 million on August 27. 
 
Then, a Surprising Interest Rate Cut: 
-------------------------------- 
 
5. (U) On Wednesday, September 8, the Central Bank surprised 
markets by cutting its overnight lending rates 
by 200 basis points.  Most analysts were surprised both by 
the timing and magnitude of the rates.   The Bank 
had been gradually cutting rates in 2003 and the first 
quarter of 2004, in line with the fall of inflation, and 
markets were expecting further rate cuts until the April-May 
volatility spooked Turkish financial markets and 
put Bank rate-cutting on hold. 
 
6. (U) The rate cut, and the convoluted accompanying 
announcement, left many analysts scratching their 
heads, particularly as regards the timing.   The Central Bank 
has on several occasions waited until the GOT 
 reached agreement with the IMF staff on a review before 
cutting rates, yet this time the Bank cut two weeks 
prior to the planned arrival of an IMF mission to begin 
negotiating a follow-on program.  Moreover, the August 
inflation numbers, announced a few days prior to the rate 
cut, surprised on the high side.  The Central Bank is 
reportedly being criticized by AKP economists on the grounds 
that the Central bank caused the Treasury to 
borrow at higher yields in the recent Treasury auctions, 
where Treasury borrowed at av. 25-26%. 
 
7.    (SBU)  These factors were apparently outweighed in the 
Bank,s thinking by some combination of the 
following: 
 
--First and foremost, though the August inflation numbers 
came in above expectations, most analysts still 
believe the year-end twelve percent inflation target is 
attainable.  With CPI for the first eight months of 
2004 at only 3.9 percent (though WPI and year-on-year numbers 
are higher) the Bank,s confidence seems 
justified.  Central Bank Markets Department Deputy General 
Manger Emrah Eksi stressed the expected 
continuation of the disinflation trend in his private 
comments to Economic Specialist. 
 
--The GOT,s decision to pursue an IMF program.  In its 
statement, the Bank Central Bank Governor Serdengecti 
had been publicly urging the GOT to seek a follow-on program 
for months, so much so that Deputy Prime 
Minister Sener rebuked him in August (without referring to 
him by name) saying a "bureaucrat" should not tell 
the Government what to do.  The Central Bank is reportedly 
being criticized by AKP economists on the grounds 
that the Central bank caused the Treasury to borrow at higher 
yields in the recent Treasury auctions, where 
Treasury borrowed at av. 25-26%.   The Bank may have been 
waiting for the GOT decision to make an overdue 
rate cut, but did not want to juxtapose too closely its rate 
cut to the GOT,s IMF decision. 
 
--Signs of market confidence, favorable hints on EU 
accession.  As noted above, the stock market was 
beginning to rally over bits of good news on the EU front. 
With signs of increased market bullishness 
increasing flows of lira-strengthening short-term portfolio 
investment, the Bank may have felt the timing 
was right to lower rates, which would normally dampen such 
flows and work against a possible overvaluation of the lira. 
 
--Finally, the Bank, like most Central Banks, likes to keep 
markets guessing on its timing.  If this was one 
of its goals, it was highly successful. 
 
Government Securities and Lira rally: 
------------------------------- 
 
7. (U)  The previously-immobile Government Securities market 
took heart from the rate cut though the yield 
on the benchmark bond fell only 95 basis points (half the 
central Bank,s rate cut) on the first day after the cut. 
Benchmark rates fell a further 23 basis points the following 
day (September 9), however, reaching 24.23 percent, 
the lowest level since before the upward shift in global 
interest rates in late April. Rates have stayed roughly at 
that 
level since, with the benchmark at 24.37 at the close 
September 14.   In the external debt market, the GOT 
capitalized on the uptick in sentiment towards Turkey to 
announce issuance of $600  million in Euro-denominated 
Eurobonds, yielding only 5.75 percent. 
 
8. (U)  More surprisingly, since lower interest rates would 
normally lead to a weakening of the currency, the lira 
rallied on September 8 and 9, appreciating from  1.503 
million  TL per dollar to 1.485 million TL.   The broader 
bullishness on Turkey, and apparently a market assumption 
that the Central Bank would not have cut rates without 
knowing things were getting better, led markets to buy into 
lira, even despite normally lira-depressing large purchases 
of foreign exchange by local corporates on September 9.  On 
Friday and early this week, the lira lost some of its 
gains, however, depreciating to TL 1.491 million at the close 
September 14. 
 
9. (U) The rate cut and broader market bullishness 
overwhelmed surprisingly harsh comments from EU 
Commissioners Fischler on September 5 and Bolkestein on 
September 7, as their views are widely reported 
to represent those of a minority of commissioners opposed to 
giving Turkey a date.  The IMKB 100 reached 
21,398 at the close September 9.  On Friday, the 10th and 
Monday and Tuesday, the stock market traded slowly 
downward as markets became increasingly over the potential 
effects of the adultery law debate on EU accession 
prospects, before rebounding to 21,705 at the close September 
14 on news suggesting the GOT might shelve it's 
controversial adultery law proposal. 
 
Strong GDP growth Reinforces Concerns about the Current 
Account Deficit: 
-------------------------------------- 
 
10. (U)  Two days after the rate cut, on September 10, the 
State Statistical Institute announced second 
quarter GDP and GNP growth numbers that were well above 
analysts, expectations. In the second 
quarter, GDP grew 13.4 percent and GNP 14.4 percent in real 
terms.  For the first six months of the 
year, GDP grew 11.9 percent and GNP 13.5 percent.  Though 
most analysts expect growth to slow 
somewhat in the second half, the new numbers confirm that 
Turkey,s economy will grow well above 
the 5 percent growth target for 2004.  Most private analysts 
have now revised their full-year 2004 
forecasts upward, with most predicting an extraordinarily 
strong 8 or 9 percent real growth. 
 
11. (U) Though the signs of strong growth would normally be a 
welcome sign of the economy's continued 
recovery from the 2000-2001 crisis, they reinforce concerns 
about the growing current account deficit. 
Along with many private analysts (reftel) former Treasury 
Undersecretary Faik Oztrak added his voice to 
those raising concerns about excessively strong growth and 
the link to the current account deficit, in an 
op-ed September 13. 
 
12. (Sbu) IMF staff, however, seem to be among the least 
alarmed about the growing current account 
deficit.  IMF Resrep Hugh Bredenkamp, however, and his Deputy 
Christoph Klingen, at a meeting just 
prior to the announcement of the growth numbers, said Fund 
staff is concerned but that there is no clear 
consensus in favor of immediate action.  Bredenkamp and 
Klingen said so far the Fund favors only 
maintaining the 6.5 percent primary surplus target to dampen 
domestic demand (and therefore imports), 
allowing the automatic stabilizer of the floating exchange 
rate regime to work, passing through world oil 
price fluctuations without delay, and building up Central 
Bank and Treasury reserves as a precaution. 
 
Comment and Conclusion: 
-------------------------------- 
 
13. (Sbu)  The Central Bank rate cut reinforced the uptick in 
market sentiment.   The market bullishness, 
combined with the strong growth numbers that followed, 
however,  can only exacerbate concerns that the 
current account, and the possibility of a sharp fall in the 
lira and reversal of portfolio investment flows in late 
2004 or 2005, particularly if Turkey faces an exogenous 
shock.  Many analysts consider the lira overvalued, 
and its continued strength augurs ill for the hoped-for 
moderation in import growth.  With markets headed 
for a volatile period because of the drip of news on both the 
IMF negotiations and the prospects for a date 
for EU accession talks, the build-up of imbalances from the 
current account is likely to increase Turkey's 
vulnerability to a sharp correction. 
 
 
 
 
EDELMAN