IMF CONCERNS: POPULIST MEASURES CLOUD FISCAL

C O N F I D E N T I A L SECTION 01 OF 04 ANKARA 000129

SIPDIS


STATE FOR E, EUR/SE, AND EB/IFD
TREASURY FOR OASIA - JLEICHTER AND MMILLS
NSC FOR MBRYZA AND TMCKIBBEN


E.O. 12958: DECL: 01/07/2009
TAGS: EFIN ECON PGOV TU
SUBJECT: IMF CONCERNS: POPULIST MEASURES CLOUD FISCAL
OUTLOOK

Classified by Economic Counselor Scot Marciel for reasons
1.5(b) and (d).





1. (C) Summary: According to IMF officials and market
analysts, GOT decisions to increase both minimum wage and
2004 pension payments well above projected inflation have
significantly complicated the outlook for achieving fiscal
targets, and possibly inflation targets as well. Fund staff
estimates the total effect in 2004 of these two measures and
revenue shortfalls as roughly 2 percent of GDP, requiring
difficult compensatory fiscal measures. It now appears
likely that the 6.5 percent primary surplus target for 2003
was missed by about half a percent of GDP, as revenues have
been lower than projected, a phenomenon that is likely to
continue into 2004. The populist measures were adopted with
little consultation with IMF staff and little regard for the
effect on the overall quality of fiscal adjustment. The IMF
is going ahead with its Seventh Review mission, but is
planning a two-stage process with no expectation of a Letter
of Intent during the first stage. Though markets dropped
Tuesday on concerns about these measures, they resumed their
optimistic tone by Wednesday afternoon after the IMF
announced its imminent mission. Fund staff is also concerned
about banking issues and the lack of progress on structural
reforms. End Summary.


Minimum Wage Increase:
--------------



2. (C) In mid-December, the Turkish press reported that Prime
Minister Erdogan supported a whopping 55 percent increase in
the minimum wage. Though senior GOT technocrats have told us
they recommended against a large increase in the minimum
wage, in the end the GOT approved a 34 percent increase--far
exceeding projected CPI inflation of 12 percent for 2004. To
ease employers' concerns about the cost of the increase, the
GOT agreed to absorb 20 percent of the employer's share of
the Social Security premium on minimum-wage employees. Many
market analysts cautioned that the 34 percent increase could
hamper disinflation efforts, as did the chief implementer of
those efforts--Central Bank Governor Serdengecti--who warned
publicly last week of the need for an incomes policy to
support disinflation.



3. (C) In a meeting with Econoffs January 7, IMF Resident
Representative Odd Per Brekk and deputy Christoph Klingen
said that Turkish Treasury's estimates are lower, but that
the IMF estimates the fiscal impact of the reduced Social
Security Premia to be around 1.3 or 1.4 Quadrillion TL (about
$1 billion USD or 0.3 percent of GDP). Brekk revealed that on
the evening before the IMF Board vote on the Sixth Review,
the Fund had threatened to postpone the vote unless the GOT
committed to hold the minimum wage increase to a reasonable
level and work with Fund staff on compensatory fiscal
measures. Despite high-level GOT commitments to do so--and
Deputy Managing Director Krueger calling Erdogan (at
Babacan's secret request) to press the issue--the Prime
Minister dug in his heels and went ahead with the large
minimum wage increase.


Pension Payment Increase:
--------------



4. (Sbu) Despite the Central Bank Governor's warning about
incomes policy, and GOT economic officials knowing that the
minimum wage agreement's fiscal impact exacerbated the fiscal
outlook for 2004, Prime Minister Erdogan announced January 6
that pension payments under the "SSK" (the pension system for
employees) and "Bag-Kur" (the pension system for the
self-employed) would be 21 percent for 2004, again exceeding
the 12 percent 2004 inflation target and raising fiscal and
inflationary concerns. As Erdogan pointed out, the estimated
cost of this measure is TL 2.6 Quadrillion (USD 1.9 billion
or about 0.6 percent of GDP).



5. (C) Brekk told econoffs that there had been only minimal,
last-minute consultation with the Fund on the pension hikes,
and that the earlier, IMF-blessed budget had assumed a much
lower increase in line with CPI projections.


Other Populist Measures:
--------------



6. (Sbu) Aside from the minimum wage and pension payment
increases, there are other signs of a re-emergence of
populist measures: the GOT has announced that it will remove
names of bad creditors from the banking system's common list,
arguing that the 2000-2001 crisis caused too many people to
have credit problems for which they should no longer be
denied new credit. According to press reports, state-owned
Halk and Ziraat Banks have announced reduced interest rates
on loans to small businesses and farmers, respectively.
Though some of the reduction can be justified by falling
market rates, these appear to be below-market (20 percent)
rates.


Markets React, Then Resume Rally:
--------------



7. (Sbu) On Monday, January 5, after the GOT announced
better-than-target inflation numbers for 2003, the market
resumed its 2003 rally: the IMKB 100 index rose sharply, the
benchmark interest rate fell and the lira continued to
strengthen. On Tuesday and Wednesday morning, however, after
the pension payments were announced, the market fell
back--the first time markets had dropped significantly on bad
news in several weeks. But by Wednesday afternoon, when the
IMF announced the Seventh Review mission was still coming,
the bulls--and moral hazard players--returned and the markets
resumed their forward march. In mid-day trading Thursday,
the IMKB 100 was at 19,724, the lira was at 1.367 to the
dollar, and the benchmark bond was back below 24 percent at
23.85. In the Eurobond market, the Turkish Treasury's
announcement of a new 30-year dollar-denominated issue this
week was greeted with enthusiasm and the issue was
oversubscribed.




Two-stage Seventh Review Process:
--------------



8. (C) In view of the GOT's introduction of budget-damaging
populist measures, with negligible consultation, Brekk said
the IMF staff is taking a cautious, two-stage approach to its
Seventh Review mission. Though the staff will still come as
planned this coming weekend, the first stage of the mission,
from January 10-20, is not expected to reach an agreement.
Brekk noted that in addition to some very difficult fiscal
issues (see below) the Seventh Review mission will need to
reach agreement with the GOT on structural benchmarks for

2004. Brekk said the Fund plans to send a second mission the
second week of February, after the Kurban Bayrami holiday.
Brekk pointed out that Erdogan would be meeting Koehler in
Washington, and that the much-postponed foreign investors'
council meeting, including IMF M.D. Koehler, and World Bank
President Wolfensohn, is to be held March 15 in Istanbul.
Brekk thought the GOT would surely want to conclude the
Seventh Review by then.




Difficult 2004 Fiscal Outlook:
--------------



9. (C) Though GOT commitment to fiscal discipline had
appeared to be its strong suit until the minimum wage
announcement, the wage and pension increases--combined with
worse-than-expected revenue collection--mean a much more
difficult fiscal outlook. Though final 2003 numbers are not
yet available, Brekk and Klingen said the latest information
suggests that the GOT fell short of the 6.5 percent primary
surplus target, probably by about 0.5 percent. According to
Klingen, revenue collections are lower than projected, a
phenomenon that neither the Fund staff nor the GOT fully
understand, but one that is likely to continue into 2004.
The IMF estimates that the shortfall in revenue projections,
combined with the fiscal costs of the minimum wage deal and
the pension payments increase will lead to a shortfall of
between 2 and 2.2 percent of GDP for 2004. In order to deal
with this projected shortfall, Brekk said that Economy
Minister Babacan and Finance Minister Unakitan presented a
package of compensatory measures to the Council of Ministers
on January 5, including a 10 percent across-the-board
reduction in discretionary spending and revenue-enhancements
such as increased taxes and higher electricity prices.
Though the Council balked (for now) at the revenue increases,
the GOT announced the 10 percent discretionary spending cut,
excluding personnel expenditures. Although Fund staff have
not yet studied the measures, Brekk noted that the
compensatory measures could well exacerbate pre-existing
problems with the quality of fiscal adjustment, and that the
10 percent spending cut might not be sufficient.


Banking Sector Issues:
--------------



10. (Sbu) Aside from the fiscal issues, Brekk said that in
2004 banking sector issues and other structural reforms will
be key areas for the IMF. Brekk admitted that the IMF staff
has yet to develop a good working relationship with the new
Chairman of the BRSA (Bank Regulatory Agency),Tevfik Bilgin.
Brekk said that BRSA has appealed the court decision
cancelling BRSA's takeover of Demir Bank. Though the
decision is not yet final, Brekk said he understands that the
GOT and BRSA want to merge intervened Pamuk Bank into
state-owned Halk Bank, a solution the Fund considers
acceptable. The Fund is still waiting for the GOT to announce
who will lead the high-profile inquiry into the Imar Bank
failure, an important IMF demand. Brekk said there will be a
benchmark for May for the inquiry to publish its findings.
The Fund's legal experts will also be doing a thorough review
of Turkey's 1999 Banking Act, for possible improvements.
Brekk deferred to the World Bank on the long-delayed
privatizations of state-owned Halk, Ziraat and Vakif Banks.
Though the GOT has announced, with IMF blessing, that it will
reduce the blanket guarantee on deposits, Fund staff will be
engaging with the GOT on the details, to be sure a balance is
struck between reducing moral hazard and creating systemic
risks. Continuing work on bankruptcy legislation will also
be part of the 2004 program.



11. (Sbu) Brekk shared econoff concerns about press reports
and rumors of Cukurova group trying to: a) re-negotiate its
repayments to the Deposit Guarantee Fund (SDIF) for Pamuk and
Yapi Kredi Bank; b) participate in one of the two consortia
bidding on the Tupras privatization; and c) regain control of
Yapi Kredi Bank. The IMF had not yet had a chance to check
out these reports. Brekk agreed that Cukurova regaining
control of Yapi Kredi would be a violation of the provision
in the Banking Act barring owners of failed banks from
regaining banking licences.


Other Structural Reforms:
--------------



12. (Sbu) Brekk said that very little happened in 2003 on
non-bank structural reforms, so there will need to be a
"catch-up" in the program. On privatization, Brekk said the
incentive structure may be part of the problem, since
Privatization Administration officials fear being blamed or
prosecuted if they sell state assets at prices below internal
valuations. Another possible flaw is the compensation
methodology used for outside advisors who do the evaluations.
If the advisors get higher fees based on a higher sales
price, they will tend to overvalue the companies slated for
privatizations. Brekk also passed on Privatization Authority
President Metin Kilci's lament that no one looks at the
hundreds of small parastatals he has sold.



13. (Sbu) Brekk said the World Bank will have the lead on
public sector reforms, though the Fund may require the
establishment of a Government Ethics Office. The Fund may
also draw on the work of its recent technical mission on the
unregistered economy to incorporate into the program new
measures for improved tax collection. The program will
continue its work on closure of special accounts and on the
SEE redundancy issue, though the GOT and the Fund continue to
diverge on which positions should be counted.



14. (Sbu) Econcouns noted the GOT's weak track record on
creating competitive markets, whether in telecoms or energy
or trade, an area in which the GOT has just announced it will
scrutinize imports at price levels that are deemed too low.
Brekk and Klingen, who had been on vacation, were not yet
aware of this announcement and said they would look into it
since IMF membership requires countries to commit not to try
to reduce imports by creating barriers. On the broader issue
that Econcouns had raised, Brekk said the Fund generally
tries to limit its structural requirements to those that have
a strong link to macro issues.


Lira Strength and the Current Account Deficit:
--------------



15. (Sbu) Brekk did not seem overly concerned about the 12
percent real appreciation of the Lira in 2003 and the outlook
for continued Lira strength and a growing current account
deficit. With a floating exchange rate, the vulnerability is
not what it was in the 2000-2001 crisis when Turkey had an
overvalued currency and a crawling peg. Nevertheless, he
agreed that the current account deficit was an indirect
vulnerability, because a sharp turnaround in the exchange
rate would greatly exacerbate Turkey's debt problem. If the
global appetite for emerging market debt declines and Turkey
has a large current account deficit, a political shock could
be a trigger for problems. Brekk ended by expressing hope
that top U.S. officials highlight this vulnerability, and the
consequent need to persist in economic reform, during Prime
Minister Erdogan's visit later this month.
DEUTSCH