IMF BOARD VOTE UNLIKELY BEFORE EU DECISION

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