US embassy cable - 05ANKARA5502

UNCLAS SECTION 01 OF 02 ANKARA 005502 
 
SIPDIS 
 
SENSITIVE 
 
TREASURY FOR INTERNATIONAL AFFAIRS - U/S ADAMS, CPLANTIER 
NSC FOR MCKIBBEN 
 
E.O. 12958: N/A 
TAGS: EFIN, PGOV, BEXP, TU 
SUBJECT: BABACAN SCENESETTER: TURKISH ECONOMY AT A WATERSHED 
 
 
1. (SBU) Summary: Minister Babacan comes to Washington at 
what may be a watershed moment for the Turkish economy.  If 
Turkey officially becomes an EU accession country October 3, 
and recent privatization and FDI deals are consummated, 
Turkey will have taken another important step away from its 
boom-and-bust economic track record.  On the other hand, a 
disruptive scenario can still not be ruled out, and the GOT 
needs to guard against complacency.  Babacan has been a key 
player in Turkey's continued economic progress, keeping the 
reform program going whenever it was bogged down in domestic 
opposition.  As ever with Babacan, the challenge is to get 
beyond his "everything's wonderful" spin and convey the need 
to guard against complacency and push through IMF-sponsored 
structural reforms. End Summary. 
 
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Continued Progress on Economic Stabilization 
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2. (SBU) As Minister Babacan comes to Washington the Turkish 
economy's post-2001 crisis stabilization shows no sign of 
being derailed.  Though growth has slowed to around the 5% 
target for 2005 from its torrid 2004 pace (GNP grew 9.9%), 
last year's pace still reflected pent-up demand from the 
immediate post-crisis period and the effect of 
newly-affordable credit on autos and consumer durables. 
There are encouraging signs the economy is moving from using 
unutilized capacity dating from the crisis to new investment 
to relieve capacity constraints.  At the same time, even 
though overall growth has slowed, signs of a long-awaited 
revival in the construction sector raise hopes for faster 
employment creation which could finally begin to bring down 
Turkey's stubbornly-high unemployment rate (9.2% as of June, 
2005). 
 
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Exchange Rate Appreciation and Current Account Concerns 
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3. (SBU) One factor in the slowdown is the Turkish lira's 
continued real appreciation, particularly against the euro, 
which raises concerns about Turkey's ability to maintain the 
competitiveness of its exports. Coming at the same time as 
higher oil prices, Turkey's trade deficit is worsening in 
2005, exacerbating existing concerns about Turkey's current 
account deficit.  With global markets' yield-hungry 
short-term portfolio investors betting on Turkey's 
stabilization and EU-accession story, Turkey has had no 
difficulty financing its current account deficit (which the 
IMF forecasts will be 5.6% of GNP this year).  However, this 
leaves Turkey vulnerable to a shift in global sentiment on 
emerging markets in general or Turkey in particular, which 
could lead to a "rush to the exits" and a disruptive fall in 
the exchange rate. 
 
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FDI and Privatization Come to Life 
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4. (SBU) While the risk of the above-described disruptive 
scenario remains, 2005 brought major progress on both foreign 
direct investment and privatization--areas of notable 
weakness in recent years.  There have been a series of major 
FDI deals announced that are expected to provide a 
significant source of longer-term stable financing to the 
balance of payments.  One of these deals (GE Capital's $1.56 
billion purchase of a 25.5% stake in Garanti Bank) will be 
the first large U.S. corporate investment in Turkey in years. 
 Combined with the resolution of Cargill's zoning problem, 
and the seemingly close resolution of Motorola's protracted 
effort to settle its $2 billion claim, the track record for 
American companies has improved considerably.  Nevertheless, 
the opaque judicial and regulatory systems continue to need 
reform.  The AKP leadership, including Babacan, support 
judicial reform, but face fierce resistance from the 
powerful, entrenched state bureaucracy. 
 
5. (SBU) Likewise, the AK Party Government, which tried but 
mostly failed to privatize large state enterprises in  2003 
and 2004, finally seems to have turned the corner with a 
series of major privatization tenders that are likely to be 
consummated.  If the deals that have been tendered in 2005 
are not overturned by the judiciary they will total about $14 
billion.  With a Saudi-led consortium winning the Turk 
Telekom tender, and Shell's minority share in the Tupras oil 
refinery, both transactions will lead to some increased FDI 
as well, though spread over several years. As these deals 
have raised nationalist and dirigiste hackles, Prime Minister 
Erdogan and Babacan have shown political courage and publicly 
stood up for the benefits of foreign investment and 
privatization. 
 
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Adding to Market Optimism 
------------------------- 
 
6. (SBU)Good news on privatization and FDI has bolstered 
already-optimistic Turkish financial markets, driven by 
foreign investors who repeatedly bet the GOT will work things 
out with the IMF, the EU, and the U.S.  The Istanbul stock 
exchange keeps breaking new records, while the lira stays 
strong and interest rates slowly but surely move lower.  If 
Turkey, as seems likely, officially begins EU accession 
negotiations October 3, it will only add to the flood of 
short-term portfolio investment, exacerbating the risk of a 
financial market bubble leading to a disruptive scenario if 
investor sentiment suddenly shifts in the future. 
 
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Continued Tight Fiscal and Monetary Policy 
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7. (SBU) Consequently, despite the encouraging signs of more 
long-term financing from FDI, the risk from the current 
account deficit remains, linked as it is to Turkey's 
continued (albeit gradually decreasing) need to continually 
roll over large quantities of short-term debt in financial 
markets.  This concern reinforces the IMF's call for 
continued tight monetary policy, with the GOT sticking to its 
6.5% primary surplus target for 2006 and the independent 
Central Bank sustaining its disinflation policy, which is on 
track to meet this year's targeted 8% rate for CPI.  At the 
same time, both the IMF and business groups like TOBB, 
Turkey's Chamber of Commerce, emphasize the need to keep 
moving forward on structural reforms such as the social 
security reform and tax reform.  The social security reform 
is closely-linked to Turkey's fiscal policy because the 
longer the GOT waits to implement the reform the longer the 
social security deficit (4.5% of GDP) exacerbates Turkey's 
overall budget deficit.  Though Babacan will insist the 
reform will be implemented as soon as parliament returns 
October 1, there are rumors the critical change in the 
pension payment formulae will be postponed from the planned 
January 1, 2006 start date. 
 
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Hence the Need for Movement on the IMF Program: 
--------------------------------------------- - 
 
8. (SBU) All of which points to the importance of the GOT 
avoiding complacency on economic policy, and moving forward 
on its on-again off-again IMF program.  After about four 
months of inactivity on the IMF program at the beginning of 
the year, the GOT worked hard from April through June: 
finally securing board approval for the new $10 billion 
Standby Arrangement in May and pressing parliament to pass 
key legislation in June, only to be derailed by fierce 
delaying tactics by the opposition and the long parliamentary 
recess which ends October 1.  Babacan will insist the GOT 
fully owns the economic reform program and will quickly pass 
the banking legislation (overriding the President's typically 
unhelpful veto) and the social security reform, and quickly 
wrapping up both the first and second reviews. But Babacan's 
gloss masks the ambivalence of many GOT politicians, 
particularly on the structural reforms, and USG officials are 
well-advised to continually raise the IMF program, while 
realizing Babacan is its principal proponent in the Council 
of Ministers. 
 
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Comment: 
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9. (SBU) In this context of continued economic progress 
coupled with continued--albeit lessening--risks, USG 
officials' challenge in meetings with Babacan will be to get 
beyond his ever-glowing spin, to have a substantive 
discussion about how the GOT would deal with a run of bad 
luck. 
MCELDOWNEY