EU DECISION PROMPTS MARKET RALLY AND INTEREST RATE

UNCLAS SECTION 01 OF 02 ANKARA 007105 SIPDIS SENSITIVE TREASURY FOR INTERNATIONAL AFFAIRS - RADKINS AND MMILLS NSC FOR BRYZA AND MCKIBBEN E.O. 12958: N/A TAGS: EFIN ECON TU SUBJECT: EU DECISION PROMPTS MARKET RALLY AND INTEREST RATE CUT REF: A. ANKARA 7000 ¶B. ANKARA 6947 ¶C. ANKARA 6700 ¶1. (SBU) Summary: The EU decision to give Turkey a date for accession negotiations, underpinned by the news earlier in the week of a new IMF program, sparked a rally in Turkish financial markets. Though the markets ended up on Friday, confusion over what was really happening in Brussels created uncertainty, and the big rally for the lira and government securities, came Monday. The Central Bank accommodated and encouraged the market with a 2 percentage point cut in short-term rates early Monday and announced it would resume its foreign exchange purchase auctions this week, without waiting for the new year. The Central Bank also publicly confirmed that it would move to formal inflation targeting as of January 1, 2006, as agreed in the IMF program. The confluence of good news leaves the market in a bullish mood heading into 2005. End Summary. Market confusion over EU decision Friday: -------------- ¶2. (SBU) After hesitating earlier in the week over the confusing EU news flow, markets moved up Thursday and Friday, betting on a positive outcome in Brussels. On Friday, markets had a rough time figuring out what was really happening in Brussels. Markets opened lower on fears the discussions were going badly, then worked their way back up to close up on increasingly positive hints--but no confirmation by the close--that Turkey had reached an understanding with the EU Council. The uncertainty during the day, and the importance of the decision, resulted in a huge (TL 2.1 Quadrillion or $1.5 billion) trading volume. In the end, the IMKB 100 stock price index hit a new record, at 24,503. The increase from Thursday's close was only 0.58% increase, following the 1.78% surge on Thursday. The lira, despite falling at the opening Friday ended up pretty much where it started at 1.403 million to the dollar and 1.891 to the Euro. Though Thursday's optimism had caused the interest rate on the benchmark July 5, 2006 bond to come down 91 basis points, from 23.27% to 22.36%, Friday's uncertainty caused the bond to give up half of this gain, as the rate rose 44 basis points to 22.80%. EU decision and Interest Rate Cut Cause a Rally in Lira and Bonds Monday: ; -------------- ¶3. (SBU) Having digested the confirmation of the EU decision, the markets opened with a bang Monday. They were quickly given an assist by Central Bank Governor Serdengecti, who announced an interest rate cut early in the trading day (see below). The lira broke out of what had been its trading range, strengthening on the day against both dollar and euro, ending up at 1.386 million to the dollar and 1.855 million to the euro. The Central Bank interest cut helped the benchmark bond interest rate to fall 150 basis points on the day. Though this was less than the 200 basis point cut on the Central Bank's overnight rate, it represents a 206 basis point fall since the close on December 14. Though the rate cut is for the shortest maturities, it tends to bring down the entire yield curve, as banks fund their purchases of longer-dated paper with short-term deposits (ref a). The stock market, on the other hand, though it started to move up in the morning, ended the day Monday almost flat with a loss of 0.08% at 24,341. ¶4. (SBU) The rally was both accommodated and given impetus by a Central Bank announcement early Monday that it was cutting its simple overnight borrowing rate from 20% to 18%. For months analysts had been predicting a further rate cut by yearend, ranging between 100 and 200 basis points. The Central Bank, however, has a track record of waiting until positive reform-linked events are confirmed (such as IMF reviews, or the EU decision) before cutting rates as a way of maintaining pressure on the GOT to stay on the reform track. True to form, the Bank waited for the IMF and EU announcements before moving to cut rates. The markets wait was rewarded both by the cut being at the top of the expected range. By one analyst's calculation, ex ante real interest rates are now only 10.3%, the lowest level since the introduction of implicit inflation targeting after the 2001 financial crisis. Resumption of Foreign Exchange Purchase Auctions: -------------- --- ¶5. (SBU) The market was also pleased with the Central Bank's announcements about resuming foreign exchange purchases. Taking advantage of favorable market conditions (i.e. strong inflows of foreign exchange),the Central Bank announced it would resume its foreign exchange purchase auctions on Wednesday, December 22. The Bank had agreed with the IMF on the desirability of resuming these auctions, which will allow the Central Bank to build up reserves in anticipation of large external debt payments coming in 2005. But it only made a public announcement on Monday, and moved up the start date to this week because of the rally. The Central Bank and IMF have worked out a change in approach, in the hope of avoiding of the problem the Bank ran into in April, when the unlucky timing of a change in the amount purchased left market participants angry at the Central Bank for exacerbating a sell-off. ¶6. (SBU) The new plan is to make smaller but more frequent purchase, that will be known in advance to the market. The Central Bank announced it would buy $15 million of foreign exchange each trading day, with the Bank having the option of buying up to $30 million more from the winner of the auction. Analysts considered the auction resumption to be market-positive--some thought it was even more important than the rate cut--because it will inject needed liquidity into the lira market. Some analysts attributed the relatively slow fall in interest rates to the recent decline in lira liquidity. As it has before, the Bank stressed that its goal was to build up reserves rather than to try to influence the exchange rate. The IMF and the Bank hope that announcing in advance a modest sum of daily purchases, the Central Bank's needed reserve build-up will have less of a market-distorting impact. Formal Inflation Targeting in 2006: -------------- ¶7. (SBU) The Bank also publicly announced its decision to move to formal inflation targeting (as opposed to informal, or implicit inflation targeting) as of January 1, 2006, and to institutionalize the monetary policy decision-making process and make it more transparent. Whereas the volatility of money supply in Turkey's volatile, high-inflation, environment had made it difficult for the Bank to set formal inflation targets, it will begin to do so on January 1, 2006. The IMF had long been urging the Central Bank to move to formal inflation-targeting, but, as he had told us privately, Central Bank Governor Serdengecti worried that the Bank needed to be very cautious before making this move. If it went badly, he argued, the Bank had no other policy options left. ¶8. (SBU) The moves to a more transparent and institutionalized decision-making process bring Turkish monetary policy in line with international practice. The Bank announced that, beginning in 2005, it will make monetary policy decisions at a monetary policy committee meeting to be held the eighth of each month. The monetary policy commmittee will continue to be merely advisory in 2005, with the Governor making the decisions. In 2006, however, the committee will gain formal decision-making powers. Bullish Mood Heading into 2005: -------------- ¶9. (SBU) Comment: The markets perceive the EU decision as a huge positive, as it it is viewed as ensuring greater stability and continuity of economic reform. Indeed, the size of the rally understates the importance to market participants, since they had priced in a high probability of a successful outcome. Coupled with the IMF announcement and encouraging macro data releases in recent weeks, the markets end 2004 on a very positive note. DEUTSCH