TURKEY'S ECONOMY: GROWING CONCERNS OVER AK

UNCLAS SECTION 01 OF 03 ANKARA 000160

SIPDIS


SENSITIVE


STATE FOR E, EB/IFD/OMA AND EUR/SE
TREASURY FOR OASIA - MILLS AND LEICHTER
STATE PASS USTR - NOVELLI AND BIRDSEY


E.O. 12958: N/A
TAGS: ECON EFIN PREL TU
SUBJECT: TURKEY'S ECONOMY: GROWING CONCERNS OVER AK
ECONOMIC POLICIES

REF: A. 02 ANKARA 9075

B. FBIS GMP20021231000098


Sensitive but Unclassified. Not for internet distribution.



1. (SBU) Summary: The AK Government's indecisiveness on
economic reforms is continuing to damage market confidence.
The latest evidence was weak demand in T-bill auctions
January 7. The key issue for restoring market confidence
lies in fiscal policy, where the GOT needs to announce and
implement spending cuts. These cuts will pay for already
announced new spending measures (civil servant salary and
pension increases),and will help make the 6.5 percent
primary surplus target, which is needed to pay debt service
this year, more credible. The cuts are also needed to meet a
key condition under the pending IMF program. The budget
shortfalls have already created a short-term cash flow
problem, per Turkish Treasury debt experts, since the GOT
needs to pay debt service of about $2.6 billion on January 8
and meet a GOT payroll of over $1 billion on January 15.
Meanwhile, the AK leadership is talking publicly about
potential USG compensation to Turkey because of Iraq, adding
to the potential moral hazard. End Summary.


The Good News To Date -
Inflation and Monetary Policy
--------------



2. (U) 2002 was a good year for Turkey's macro-economic
fundamentals, as the year-end inflation data demonstrate.
Annual growth, though not known precisely for several more
months, is also estimated to be between 6.5 to 7 percent.
Annual inflation targets were met on both CPI (29.7 percent
versus target of 35 percent) and WPI (30.8 percent versus 31
percent target). This was Turkey's lowest inflation since
1983, better even than under the 2000 crawling peg regime
(which resulted in 32 percent CPI). Furthermore, the Central
Bank appears to be firmly in control of monetary policy. As
the year ended, Central Bank Governor issued a statement
about Iraq scenarios, stating that the 2003 growth and
inflation targets could be achieved, despite any external
shocks, if the GOT implemented the reform program.



3. (SBU) Looking forward into 2003, the challenge of
continuing the disinflationary trend will be difficult.
Monthly CPI inflation appears stuck at about 2 percent in
seasonally adjusted terms. Achieving the 2003 year-end target
of 20 percent CPI will require another break in inflationary
expectations.



4. (SBU) The GOT's recently announced fiscal stimulus
measures - civil servant wage and pension increases - will
have the opposite effect, and make the disinflation targets
even more difficult. Hurriyet columnist Erdal Saglam phrased
it this way in his January 6 column: "As for this
government, we haven't seen any commitment to disinflation
until now, other than empty rhetoric. On the contrary, the
latest pension fund increases - amounting to at least TL 3
quadrillion in new spending - will serve to stimulate pricing
behavior. With this kind of decision, inflation will not
decline but rather will veer upward."


The Bad News - Fiscal Shortfall
--------------



5. (SBU) The economic policy focus of the markets remains on
the GOT's preparations for the 2003 budget, and on
conditions. On the budget, the initial indications are not
good.


-- The GOT fell short of meeting the 6.5 percent of GNP
primary surplus in 2002 by about two percent of GNP (over $3
billion). The current government blames this shortfall,
rightly, on pre-election spending by the prior GOT.


-- However, the first quarter 2003 budget submitted by the
new GOT is also short of meeting the primary surplus target
by at least $1 billion, in the first quarter alone.


-- Furthermore, the GOT has announced new spending
initiatives in 2003: a civil servant wage increase
estimated by the GOT to cost TL 3.5 quadrillion in 2003 (but
may cost more); and a pension benefit increase estimated by
the GOT to cost TL 3 quadrillion, but estimated by the World
Bank to cost TL 4.5 quadrillion.


-- The GOT has not announced any expenditure cuts to pay for
this new spending.

6. (SBU) Ministry of Finance officials have given us some
indications of measures they are planning to take to cut
spending. They are confident that, if the GOT takes all
these proposed spending cut measures, then the 6.5 percent
GNP target is achievable for 2003. (Comment: One credible
market commentator, Bender Securities of Istanbul, believes
that meeting the 6.5 percent primary surplus in 2003 is now
virtually impossible, given the already large 2002 shortfall.
End Comment.)


-- First, Finance Ministry U/S Arioglu told us January 6
that the "tax peace" law just submitted to parliament will
result in about TL 2 quadrillion in tax revenue. (The law
restructures long-standing tax arrears, eliminates some
penalties and, in theory, leads to more tax payments).


-- Second, Finance Ministry budget expert Kesik told us
recently of other measures discussed with the IMF and agreed
to in the Ministry, including: controlling pharmaceutical
costs (by enforcing existing co-payment conditions by
beneficiaries; this condition is usually overlooked);
expanding coverage of social security premium payments (by
making more of the beneficiaries' salaries subject to the
premium payments); cutting unproductive public investments
(e.g., in new hospitals and other buildings in the social
security institutions); stopping the agricultural price
subsidies (and relying only on direct income support payments
to the farmers); and reducing losses in the state economic
enterprises.



7. (SBU) Comment: We agree with Kesik that quickly adopting
and publicizing these measures is the best way to assure
markets of the GOT's solvency in 2003. But the spending cuts
will be difficult politically, and thus the GOT is hesitating
to announce and implement them. The pharmaceutical
co-payment measure was leaked to the press on January 6.


Fiscal Shortfall Translates into
Immediate Cash-Flow Problem
--------------



8. (SBU) The first quarter primary surplus shortfall is
forcing the government to turn more to its domestic debt
market to raise funds for immediate needs. This market is
already facing large debt roll-over demands, and Treasury's
debt expert Volkan Taskin says Treasury's goal is to
roll-over 95 percent of its debt owed to the market this
month. In January, the Treasury domestic debt redemption
schedule focuses on two large payment dates:


Date Payment to Market Total Payment


Jan. 8 $2.0 billion $2.6 billion
Jan. 22 $3.3 billion $3.4 billion


Total domestic debt redemption in January: $7.5 billion
(at exchange rate of TL 1,650,000 to the dollar).



9. (SBU) Treasury's current cash balance is about TL 2.5
quadrillion, per Taskin, and some of this cash can be used to
pay the January 8 redemption, since the January 7 auctions
(see below) did not find enough demand. The Treasury may have
a cash flow problem next week, January 13-15, when it pays
a GOT salary payroll of about TL 1.8 - 2 quadrillion. (The
GOT pays salaries twice monthly, on the 15th and end of
month, but it begins transferring funds to banks to make the
payroll one to two days in advance.) Taskin says Treasury
may schedule a dollar-linked bill auction for later in the
week because, "there is liquidity in the market."



10. (SBU) Results of January 7 T-bill auctions were not
positive.
Yields were slightly higher than market expectations, at 57.1
percent on the five-month bill and 59.6 percent on the
nine-month bill. The Treasury raised only TL 1.5 quadrillion
from the market in the two auctions.


Structural Reforms - No Progress
--------------



11. (SBU) World Bank lead economist in Turkey Jim Parks told
us January 7 that he saw "no progress" on the structural
reform agenda. Furthermore, discussion of the World Bank's
main loan to Turkey, the Programmatic Public and Financial
Sector Adjustment Loan, has been delayed to end March to give
the GOT time to draft a new letter of intent.


-- On privatization, Deputy PM Sener (in charge of
privatization) has not approved the Privatization
Administration's 2003 plan, nor has he authorized the PA to
announce the winning bids on about $200 million in assets
that were auctioned in October. The PA is keeping the
auction bids sealed until it receives instructions. Sener
did task the PA with a list of board members of the state
enterprises (257 positions which the new GOT could fill with
their own people).


-- On the Public Procurement Law, the GOT came under
pressure from the IMF, World Bank and EU when it announced
plans to delay the scheduled January 1 implementation date.
Instead, the GOT allowed the law to come into force, but then
proposed to parliament a series of amendments to limit the
scope of the law (e.g., excluding procurement by
municipalities and state economic enterprises). These
amendments also proved controversial, and they remain in
parliamentary committee. The British Embassy told us that
the EU member countries are organizing a joint demarche to
the GOT against the proposed amendments, which would be
contrary to EU codes.


-- On banking sector reform, resolution of Pamukbank and the
ownership of Yapi Kredi bank remains a critical condition for
completing the Fourth Review, per IMF resrep. Talks between
owner Cukurova Holding and the Banking Board (BRSA) are
"deadlocked," per BRSA Vice Chairman Pazarbasioglu. BRSA has
agreed to a restructuring of Cukurova's $2 billion in loans
from Yapi Kredi, and this news cheered the markets and lead
to a 18 percent rise in Yapi's stock. But this restructuring
is conditioned on an overall agreement with Cukurova on
ownership issues by January 31. In the meantime, the
mainstream Turkish press (owned by Cukurova Holding rival
Dogan Holding) has been accusing the GOT and BRSA of bailing
out Cukurova owner Karamehmet with public money.


Comment on Market Reaction
--------------



12. (SBU) The local financial markets have continued to
weaken since their December 3 height: T-bills rates are up 9
percentage points; the Istanbul Stock Exchange index has lost
about one third; the lira has depreciated about 10 percent.
Market sources are citing worries about the fiscal shortfalls
as a major factor in today's weak demand in the T-bill
auctions. Behind the fiscal problem lies a political concern
heard in the markets that the AK government is disunited and
unable to reach agreement on key economic policies.



13. (SBU) The GOT leadership is attempting to counter these
concerns by hinting to its public that budget shortfalls will
be covered by the USG through the Iraq scenario - see for
example PM Gul's December 30 briefing to the press (ref b).
This GOT spinning of recent discussions with the U.S. is
helping inculcate a moral hazard in the markets. IF this
calculation is part of the GOT's thinking as well, it will be
increasingly hard to sell it on the reforms still needed.
But any possible future assistance can only serve to delay
the GOT's market reckoning, if it doesn't adopt appropriate
economic reform policies.
DEUTSCH