US embassy cable - 04ANKARA6135

C O N F I D E N T I A L SECTION 01 OF 04 ANKARA 006135 
 
SIPDIS 
 
STATE FOR E, EUR/SE, EB/IFD 
TREASURY FOR INTERNATIONAL AFFAIRS - RADKINS AND MMILLS 
NSC FOR BRYZA AND MCKIBBEN 
 
E.O. 12958: DECL: 10/28/2009 
TAGS: EFIN, ECON, PGOV, TU 
SUBJECT: IMF BOARD VOTE UNLIKELY BEFORE EU DECISION 
 
REF: A. ANKARA 5999 
     B. ANKARA 5835 
     C. ANKARA 6026 
     D. ANKARA 6085 
 
Classified By: DEPUTY CHIEF OF MISSION ROBERT DEUTSCH FOR REASONS 1.4 ( 
B) AND (D). 
 
 1. (C) Summary. Contrary to its expectations of concluding a 
letter of intent by October 26, the IMF team negotiating a 
new Stand-by program left Turkey having made little progress 
on key program components.  These include: specific tax 
measures for 2005 (with the GOT keen on a Fund-opposed VAT 
rate cut); the new banking law; GOT action to save 2004 
fiscal overperformance; GOT endorsement of social security 
reforms; reorientation of the state bank privatization 
strategy; business climate reforms; tax administration 
reform; and the amount of financing to be provided by the 
IMF.  Although IMF staff could return November 8 if the GOT 
demonstrates a readiness to make progress on these issues, it 
seems more probable that the team would not return until 
after Thanksgiving, making a board vote before the December 
17 EU Council decision on Turkish accession unlikely. End 
Summary. 
 
2. (C) The morning after the IMF team left, the IMF Resrep 
described the very substantial work agenda still remaining 
before agreement could be reached on a letter of intent. 
While the early breakthrough on the headline targets to be 
included in the 2005 budget was encouraging, the Resrep drew 
a picture of substantial disagreement on major details in 
fiscal policy and much work still to be done on the 
structural agenda. 
 
VAT Rate Cut Proposal in a Context of Higher Revenue Targets: 
--------------------------------------------- ----- 
 
3.   (C) Though the GOT announced a 6.5% primary surplus 
target for 2005 early in the mission, just before the 
deadline for submission of the budget to parliament (ref b), 
the IMF staff is still not convinced GOT tax policies will 
achieve this target.  Note: Though Prime Minister Erdogan 
recently made similarly market-pleasing comments about having 
a 6.5% target for 2006 and 2007, Babacan told the IMF mission 
that the PM had said "around 6.5%," which  means the out-year 
target may not yet be nailed down.  End Note. 
 
4.  (C ) For 2005, the budget calls for a substantial 
increase in total revenues in real terms, such that total 
public sector revenues/GDP would increase.  Given that this 
ratio is not high compared to other countries, IMF staff 
accepts the principle of increasing revenues in order to 
finance higher public investment, a GOT priority.  The 
problem is that, at the same time the government is targeting 
sharply higher revenues it wants to raise these revenues 
almost entirely from increases in the special consumption tax 
(SCT) on products like alcohol, tobacco, autos and petroleum 
products while cutting both corporate income tax rates and 
value-added tax rates from 18 to 15%. 
 
5.  (C ) The IMF accepts the corporate income tax rate 
cut--it,s already in the budget--but has profound 
philosophical differences over increasing the reliance on 
excise taxes like the SCT while cutting the VAT.  In addition 
to being anti-exporter (exporters can deduct VAT taxes paid), 
the GOT approach risks exacerbating the difficulty of 
harmonization with EU tax policies.  The Resrep said 
Turkey,s current VAT rate is in line with EU averages 
whereas its reliance on excise taxes is excessive by EU 
standards.  A VAT rate cut could also stimulate domestic 
consumption, thereby increasing the current account deficit. 
Finally, from a purely philosophical standpoint, IMF staff 
argues that it would make more sense to cut payroll taxes in 
order to encourage employment.  (The IMF is not actually 
proposing payroll tax cuts because of the practical 
difficulty of extracting this item form a package of social 
security-related reforms.) 
 
6.  (  C)  The impetus for a VAT cut comes from the Prime 
Minister who reportedly feels the need to make a significant 
cut in a tax like the VAT, which he believes is resented by 
ordinary Turks.  GOT technocrats also argue that a reduction 
in the rate would help with notoriously weak compliance, 
whereas the IMF is not convinced a mere 3 percentage point 
cut will have a significant effect on revenues.  Furthermore, 
Fund staff also believes it would be imprudent to cut rates 
before tax administration reforms demonstrate that they can 
improve compliance--otherwise the cut will result in sharply 
reduced revenues.  The Fund is not convinced the GOT can 
afford the VAT cut and still hit the fiscal targets: each 
percentage point cut in the rate costs about 0.3% of GDP. 
 
Saving 2004 Fiscal Overperformance: 
---------------------------------- 
 
7. (C)  An additional fiscal issue concerns what to do with 
2004 overperformance in the primary surplus.  The GOT has not 
complied with a July agreement that any 2004 fiscal 
overperformance would be saved in order to avoid excess 
stimulus that would exacerbate the current account deficit. 
The GOT was supposed to "write over" special revenues into 
the general budget to prevent these revenues from being 
spent. Aside from partial actions just before the board vote, 
the GOT has continued to stall.  Fund staff is taking a hard 
line in order to maintain IMF credibility at the outset of a 
new program. 
 
Banking Law: 
----------- 
 
8. (C)  The Resrep said that, thanks to Minister Babacan's 
intervention, BRSA Chairman Bilgin had to back down on his 
out-of-left-field proposal by BRSA of a completely different 
banking law draft that would have transferred responsibility 
for deposit insurance to the bankers' association.  BRSA, 
however, continues to resist a key IMF demand arising from a 
recommendation of the independent commission on the Imar Bank 
collapse: that sworn bank auditors not have a monopoly of 
on-site bank inspection.  Another IMF-supported commission 
recommendation is to organize BRSA by the bank being 
monitored, that would integrate off-site and on-site (i.e. 
sworn auditor) inspectors' work. 
 
SDIF Role: 
--------- 
 
9. (C) Separately, the IMF and GOT are discussing 
modifications of the role of the Savings Deposit Insurance 
Fund (SDIF).  The IFIs cannot accept BRSA proposals that 
would strip SDIF of its deposit insurance function or even 
the right to set deposit insurance premia, and Fund and Bank 
banking experts have been talking about how the SDIF will 
handle disposal of its asset portfolio.  The Turkish side has 
proposed that all assets not sold in 3 years be put on the 
balance sheet of SDIF-owned Bayindir Bank which would then be 
sold off.  The Resrep said the World Bank experts have found 
a better formula in other countries--notably Korea--in which 
packages of assets are put into special purpose entities 
which are jointly held by the SDIF and private managers. By 
divesting the management function to the private sector, the 
sales work better, but SDIF's retention of ownership allows 
the public sector to obtain some of the upside of asset 
sales.  The Resrep said SDIF management is considering this 
approach, and has generally made a better impression on the 
IMF than has BRSA. 
 
State Bank Privatization: 
------------------------ 
 
10. (C) The Resrep also confirmed that the IFI's were 
reopening some of the issues regarding State Bank 
privatization.  Fund staff is wondering whether it is 
realistic to target privatization--especially of Ziraat 
Bank--within the program's three-year time frame.  Instead, 
the emphasis should be on the GOT doing a better job of 
managing the state banks in the transition period and 
ensuring a level playing field with private banks, to avoid 
state banks distorting the market.  The IFIs question a 
central element of the study on state bank privatization 
prepared by Mckinsey for the Treasury and World Bank: 
acceptance of state banks' rapidly growing their loan 
portfolios to replace their large government securities 
holdings.  The IFI's would like to take a harder look at 
possibly selling pieces of Ziraat's branch network and/or 
narrowing Ziraat's role to merely taking deposits and holding 
government debt rather than considering it a full-fledged 
bank.  Babacan seemed open to some of these ideas, but the 
Resrep admitted that state bank privatization issues were 
very much in flux. 
 
Social Security Reform: 
----------------------- 
 
11. (C) The Social Security Reform, according to the Resrep, 
is currently under discussion in the Council of Ministers. 
While the Fund thought the specifics proposed by the High 
Planning Council were broadly acceptable, World Bank experts 
thought they needed tightening.  Meanwhile, the Resrep said 
he understands there was some controversy in the Council of 
Ministers' discussion, probably in the areas that will 
require either increased revenue or reduced benefit.  What 
with the current Social Security system bleeding red ink and 
unsustainable, clear GOT endorsement of the Social Security 
reforms will be needed for the IMF program. 
 
Privatization and Business Climate: 
---------------------------------- 
 
12. (C) The GOT and Fund staff have yet to work out 
privatization benchmarks for the program, nor have they 
agreed on specific measures to improve the business climate. 
The Resrep did not seem to be aware of the increased 
likelihood that the GOT will create an importers' association 
(or a foreign trade association) that holds the potential to 
become an additional barrier to trade. 
 
Tax Administration Reform: 
------------------------- 
 
13. (C) Because of the importance of broadening the tax base, 
by capturing the unregistered economy and improving 
collections, the IMF will need to secure a clear GOT 
endorsement of the draft Tax Administration reform law.  The 
law is stuck in the Prime Minister's office. There is 
reportedly a disagreement between the Prime Ministry 
Undersecretary and the Ministry of Finance over the law, 
though the Resrep was not sure whether the Prime Minister was 
involved or exactly what the differences were. The Prime 
Ministry U/S reportedly has issues with the structure of the 
tax administration. 
 
Amount of IMF Financing: 
----------------------- 
 
14. (C) Critically, the IMF and GOT do not agree on how much 
financing the IMF should provide.  The Resrep said that 
calculations of the financing gap are hyper-sensitive to the 
projected rollover rate for government debt in the domestic 
market.  He said the debate centers on whether the rollover 
rate should be 92 versus 93 percent. Even this single 
percentage point results in the IMF either financing the 
bottom of the notional range or, as the GOT advocates, the 
top.  Note: We understand the board-discussed range is from 
$7.6 billion to $10.9 billion End Note. 
 
Timing: 
------ 
 
15. (C) Fund staff views the ball to be in the GOT's court 
and have stressed that the IMF will not return until the GOT 
shows that it is serious about concluding a draft letter of 
intent.  If the GOT takes sufficient action, staff will come 
the week of November 8.  Otherwise, staff is not inclined to 
come to Turkey until after the November 12-16 Bayram holiday 
and after Thanksgiving.  In that scenario, the Resrep said it 
would be too late to have a board meeting before the EU 
Council's December 17 meeting at which it will decide whether 
to give Turkey a date for accession negotiations.  Given 
Managing Director Rato's desire to chair the Turkey board 
meeting, the Resrep said this would put the Board vote into 
January.  If, as some believe, it is important to the EU 
process to have an IMF deal in hand before December 17, the 
Resrep wondered whether agreement with staff and Fund 
management on a LOI would not be sufficient.  In the interim, 
the Resrep and a Turkish Treasury debt management official 
separately expressed the opinion that there was no financing 
need for new IMF money for the remainder of 2004. 
 
 
Comment: 
------- 
 
16. (C) The GOT has its work cut out for it.  These are major 
areas of disagreement and major work remains to be done.  The 
GOT claims and wants ownership of the reform agenda, but does 
not pursue the policy framework except under IMF urging.  We 
repeatedly see it adapting to IMF requirements, at least 
technically, when backed in a corner.  Though Babacan 
purports to be fully on board, the Resrep said they keep 
getting signs of an absence of urgency on the part of other 
GOT leaders, especially Unakitan.  Before the sudden, 
unexplained turnaround on the 6.5% fiscal target for example, 
the Resrep said the mission had warned IMF Management that 
the GOT seemed to be returning to earlier "non-starter" 
policies, such that the IMF had even wondered if the GOT 
really wanted a new program.  In the end, agreement is likely 
to be reached only if and when the GOT feels a sense of 
urgency under pressure from partners, the markets or 
financing requirements.  It is likely to take time and be 
difficult.  It is not clear to us whether the December 17 EU 
summit is an effective end-date to induce acceptance of 
needed performance measures. 
EDELMAN