US embassy cable - 04ANKARA5350

UNCLAS SECTION 01 OF 02 ANKARA 005350 
 
SIPDIS 
 
SENSITIVE 
 
TREASURY FOR INT'L AFFAIRS - MMILLS AND RADKINS 
STATE FOR E, EUR/SE, AND EB/IFD 
NSC FOR MBRYZA AND TMCKIBBEN 
BRUSSELS FOR USEU 
 
E.O. 12958: N/A 
TAGS: ECON, EFIN, PGOV, PREL 
SUBJECT: TURKISH MARKETS FALL SHARPLY ON EU CONCERNS 
ARISING FROM  PENAL CODE REFORM POSTPONEMENT 
 
REF: A. ANKARA 5310 
     B. ANKARA 5187 
 
1. (Sbu) Summary:  No sooner had markets shown signs of 
beginning an autumn rally, than the GOT, 
ss handling of the adultery issue -- resulting in the 
postponement of the penal code reform and negative 
implications for Turkey,s EU accession prospects -- 
caused markets to fall sharply Friday, September 17 and 
Monday, September 20.  The stock market fell 4.3 % Friday, 
and fell 3.5% more Monday morning, to return to the level 
in late August, and the lira fell to its lowest level of 
2004 against the dollar at TL 1.54 million.  Interest 
rates rose back to levels well above those prior to 
the Central Bank,s September 8 rate cut.  With a 
heavy domestic debt redemption calendar this week, 
the interest rate spike will cost the GOT millions 
of dollars in additional interest payments.  End Summary. 
 
Adultery Issue,s Turn for the Worse Scares Markets: 
----------------- 
 
2. (Sbu) The GOT,s moves since late August to amend the 
Turkish penal code to criminalize adultery did not alarm 
markets at first.  Unlike with the Imam Hatip 
controversy in the spring, markets reacted calmly since 
the adultery issue was not perceived to be a significant 
source of friction between the GOT and the military that 
would threaten EU relations.  By Thursday, September 16, 
however, it became evident that a faction of the AKP 
government and parliamentary group were determined to keep 
the issue alive, and when the leadership got caught 
up in the debate (ref a), markets started to take notice. 
When the government pulled the reform draft, which 
contained a range of legal reforms important for meeting 
the EU's Copenhagen accession criteria, many investors 
headed for the exits. 
 
3. (Sbu) Market participants, concerns stem from the 
implications of criminalizing adultery for Turkey,s EU 
accession prospects.  Over the course of last week, 
several EU officials criticized the AK parliamentarians, 
push to criminalize adultery.  Key among these statements 
was EU Enlargement Commissioner Verheugen's comments on 
the need to pass the penal code reform before the EU 
Commission report, expected October 6, in order to 
comply with the Copenhagen criteria.  More importantly, 
however, markets were alarmed by the government's decision 
to pull the draft penal code, which contained other legal 
reforms considered key to a positive EU decision. 
 
Erdogan,s Comments Spark a Sell-Off: 
------------------ 
 
4. (U) On the 16th, the markets began to reverse their 
previously positive tone:  the stock market barely moved 
but the lira retreated from 1.491 million per $ to 1.501 
million, and the interest rate of the Government's 
benchmark bond rose from 24.35 to 24.46. 
 
5.  (Sbu) In the middle of the day Friday, Prime Minister 
Erdogan made public comments that greatly exacerbated 
market worries, at the same time that the entire penal code 
reform--considered an important factor for the October 6 EU 
Commission report on Turkey and, ultimately, the December EU 
decision on Turkey,s candidacy--was pulled.  Erdogan took 
a harsh, defensive tone, saying,  "Let nobody try 
to pressure Turkey by using the EU..." and "Nobody should 
try to impose conditions on us concerning 
the EU."   The shelving of the penal code changes, with 
parliament on recess until October 1, just five days before 
the release of  the EU Commission report, greatly added to 
market worries that the GOT had allowed the debate over the 
adultery issue to greatly reduce the odds of a favorable EU 
report. 
 
6. (Sbu) In late afternoon trading Friday, the markets 
pulled way back. The IMKB 100 stock exchange index fell 4.3% 
on the day, to 20,779.75,a level last seen on September 
3.  The lira depreciated sharply to TL 1.521 million to the 
dollar from 1.501 at the previous day's close.  Interest 
rates, which had finally come down a bit after the Central 
Bank's September 8 rate cut (ref B), began to rise, with 
the benchmark reaching 24.93 at Friday's close, up from 
24.35 at Wednesday's close.  Turkish Treasury's domestic 
debt manager, Volkan Taskin, told us Friday 
that rates between 24.9 and 25%, if sustained during the 
week of September 20, would cost Treasury an additional 
TL 800 trillion (about USD 530 million). 
 
7. (Sbu) Though Erdogan and Gul tried to downplay the 
problem over the weekend, and  there are press reports that 
Erdogan and Verheugen are to meet on Thursday, September 23 
in Brussels, the markets fell in morning 
trading Monday.  The IMKB 100 stock index fell a further 
3.5 % in the morning to 20,294 and the lira fell to a low 
for the year at TL 1.54 million to the dollar.  Of the 
greatest importance, however, for the Turkish state's 
fragile financial situation, interest rates spiked: trading 
on the GOT's benchmark bond yielded interest rates of 
27.10% in Monday morning trading over 170 basis points 
above the level prior to the Central Bank's September 8 
rate cut.  The timing of the increase in rates is 
particularly unfortunate: Treasury has a heavy calendar of 
redemptions (TL 6.8 Quadrillion, or USD 4.53 billion) and 
new borrowings this week. 
 
Comment and Conclusion: 
---------------- 
 
8. (Sbu) The market sell-off and the GOT difficulties in 
dealing with the EU have raised market analysts' concerns, 
but do not (yet) imply a crisis.  Indeed most market 
analysts, while concerned, continue to place a high 
probability on a favorable--if conditional--response from 
the EU in December.  Citibank, for example, reiterated its 
recommendation to investors to increase their holdings of 
Turkish assets.  Nevertheless, the reversal in 
the markets demonsrates the potential for market volatility 
in the run-up to the December EU summit.  From a 
broader perspective(ref A), the GOT,s handling of the 
adultery issue seems to demonstrate that senior GOT 
leadership is either unable or unwilling to avoid missteps 
that risk serious damage to its EU accession strategy. 
 
EDELMAN 
EDELMAN