THE NEW GOVERNMENT'S ECONOMIC CHALLENGES, AND SOME

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TAGS: ECON EFIN EINV PGOV TU
SUBJECT: THE NEW GOVERNMENT'S ECONOMIC CHALLENGES, AND SOME
BENCHMARKS



1. (SBU) Summary: The new Turkish Government's most
pressing economic challenge is to bolster market confidence
sufficiently to avoid another financial crisis and begin to
step away from the financial precipice on which Turkey has
been perched for the past two years. Other challenges
include: reducing inflation, maintaining growth through
creation of a better investment environment, tax reform, and
a stronger banking sector; promoting a new business model
based on competitiveness and sound corporate governance; and
beginning to address the country's poverty. Dealing with a
potential external shock would of course be another
challenge, but it would not fundamentally change the economic
steps Turkey needs to take. We have identified several near
and medium-term benchmarks for gauging the new government's
economic performance. End Summary.


Economic Challenges
--------------



2. (SBU) The incoming government's most important and urgent
economic challenge will be to obtain sufficient financing, at
reasonable rates, to meet its debt obligations in 2003, begin
to reduce its debt/GNP ratio, and reduce its vulnerability to
external or internal shocks. This will require maintaining a
large primary budget surplus and bolstering market confidence
sufficiently to (a) lower nominal interest rates to an
average of 45-47 percent for the year, (b) convince domestic
holders of t-bills to roll over more than 90 percent of the
domestic debt, and (c) obtain substantially increased access
to the Eurobond and private bank credit markets. If the
government can do this, it should be able to reduce Turkey's
sky-high debt/GNP ratio from the current 82-83 percent to
some 78 percent by end-2003. Failure would probably mean
another financial crisis. Progress, or at least the absence
of negative developments, on Cyprus and EU accession would
certainly help boost confidence.



3. (SBU) The government will face a host of other, related
economic challenges. Two key ones are relatively short-term
(i.e., need to be done next year):


-- Reducing inflation: The Central Bank now expects to
achieve or surpass its 35 percent end-year inflation target
for this year, but both the Bank and private analysts wonder
if it can achieve next year's target of 20 percent.
Defeating inflation -- meaning bringing it down to single
digits -- is essential if Turkey is to have any chance of
maintaining financial stability and generating the productive
investment needed to enjoy sustained growth. Because
expecations play such a huge role in determining inflation
here, the government must maintain the current positive
momentum by meeting its 2003 target.
This will require continuation of tight fiscal and monetary
policy, avoidance of a sharp depreciation of the lira,
continued structural reform to encourage competitive pricing,
and a clear public message from the new government that it is
committed to defeating inflation.


-- Maintaining growth: The country desperately needs solid
growth to create jobs, maintain support for the reform
program, and keep its debt sustainable. Although Turkey is
likely to surpass its initial 3 percent GNP growth target for
this year (probably reaching 4 or 4.5 percent),the recovery
remains weak. Sustaining growth in 2003-2004 will require,
in addition to macroeconomic stability, continued efforts to
strengthen the banking sector (which is doing very little
commercial lending),further tax reform, and improve the
dismal investment environment. Foreign investment inflows
through the first eight months of this year totaled a pitiful
$180 million, and anecdotal evidence indicates Turkish
companies are equally unenthusiastic about investing.



4. (SBU) Two other challenges are longer-term (note: our
list of challenges is not meant to be exhaustive):


-- Promoting a new business model: One of the fundamental
weaknesses of the Turkish economy -- and a key contributor to
the recent economic crisis -- is the reliance of much of the
private sector on political patronage/favoritism rather than
efficiency and competitiveness to make money. Although there
are many solid businesses in Turkey, too many companies have
made money for years through subsidized lending,
politically-connected contracts, protection from competition,
and -- in the case of agriculture -- guaranteed purchases by
the State. The reforms of the past 18 months have made it
much more difficult to do business this way, but corporate
Turkey has just begun to change its mentality. The new
government can facilitate this essential change in mentality
(and practice) by making clear that it will not return to the
old ways of doing business, by promoting a sound,
pro-competition regulatory environment, by reducing the role
of the State in the economy, and by publicly stressing the
need for businesses to adapt to the "new rules of the game."


-- Begin to address poverty: Large segments of the Turkish
population, particularly in the rural East and Southeast but
also in the cities, remains impoverished. This is an issue
of both regional disparity and of rural development.
Defeating inflation and promoting growth are necessary but
not sufficient to address this problem. There is no easy
solution to the problem of underdevelopment, of course, but
one area in which the new government might focus is promoting
agricultural productivity. Currently, more than 40 percent
of the Turkish population is engaged in farming, but they
produce only 15 percent of GNP. This lack of productivity is
a drag on the entire economy and a key contributor to poverty.


Benchmarks
--------------

5. (SBU) We have come up with a brief list of benchmarks to
help us gauge the new government's efforts to meet these
challenges, with particularly attention to steps the
government could take to bolster market confidence.


Short-term (by end-2002)
--------------


-- Invite IMF back to complete the 4th review as quickly as
possible.


-- Present 2003 budget that meets primary surplus target of
6.5 percent of GNP (and, as much as possible, ensure that
necessary fiscal measures are taken in the coming weeks to
ensure GOT meets this year's primary surplus target).


-- Move ahead with scheduled privatization of Petkim,
strategic sale of part of Tupras, approve privatization plans
for state sugar company, Tekel, Turk Telekom.


-- Pass direct tax reform legislation.


-- Reduce the number of ministries and state ministers.




Medium-term (2003)
--------------


-- Announce, at the senior political level, full support for
the end-2003 20 percent inflation target.


-- Make clear through public statements as well as actions
government's full support for independent regulatory boards
(energy, banking, and telecom) as well as full independence
of Central Bank. (This also means not taking steps -- as AK
has indicated it might -- to weaken the bank regulatory
board.)


-- Accelerate privatization, including by selling Erdemir
(steel),Tekel, Turk Telekom (or parts of it),and sugar
companies.


-- Implement social security reform to prevent a major fiscal
problem as retirements accelerate over the coming years.


-- Announce accelerated liberalization of fixed telecom
services (now scheduled to be open to competition at
end-2003),and grant licenses to companies in
already-liberalized sectors such as GSM and local wireless
services.


-- Appoint strong official to lead Capital Markets Board, and
give that person a mandate to promote improved corporate
governance and broadened capital markets.
-- Create public-private sector commission to develop
national energy policy.


-- Resolve at least some of pending foreign investment
problems, including Cargill, cola tax, long-pending energy
contracts, and pharmaceutical-related IPR issues.


-- Either establish a true one-stop shop for foreign
investment or appoint a senior official (preferably in the
Prime Ministry's office) to resolve foreign
investment-related problems.


-- Privatize the Istanbul Stock Exchange


-- Create a technical-level marketing advisory board to help
farmers, who have long sold their crops to the state, shift
toward selling to domestic and international markets.


-- Encourage development by private sector of business plans
for Qualifying Industrial Zones, assuming U.S. Congress
passes QIZ legislation.


Important First Steps
--------------



6. (SBU) The key right now is for AK Party, as it prepares
to assume the reins of government, to build on the positive
momentum resulting from its election victory (and the initial
market reaction). If it reassures markets that it will
follow sound economic policies, including taking some of the
steps identified above, it will have a good chance of keeping
interest rates on their downward track. The new government
would then have significantly better prospects for achieving
greater financial stability in 2003 and thus for addressing
Turkey's many other economic challenges.
PEARSON