HIGH CURRENT ACCOUNT DEFICIT IN 2004; REVIVED

UNCLAS SECTION 01 OF 04 ANKARA 001318 SIPDIS SENSITIVE TREASURY FOR INTERNATIONAL AFFARIS - ASHAH AND CPLANTIER NSC FOR BRYZA AND MCKIBBEN E.O. 12958: N/A TAGS: EFIN ECON TU SUBJECT: HIGH CURRENT ACCOUNT DEFICIT IN 2004; REVIVED CONCERNS ABOUT 2005 This cable was coordinated with Congen Istanbul. ¶1. (SBU) Summary: Final 2004 data put Turkey,s current account deficit at $15.4 billion or 5.2% of GDP, Turkey's highest such deficit in memory. There are two views of the sustainability of deficits of this magnitude: optimists say that financing by private sector actors (roughly half of total financing) is long-term, mitigating the risks of a sharp outflow. Pessimists point to the continued large reliance on reversible, short-term portfolio investment. In any case, most analysts expect a slowdown in the rate of economic growth and a consequent slowing of import growth to shrink the size of the deficit in 2005. However, an appreciating lira and recent surge in portfolio inflows--apparently including from large international funds that are not savvy about Turkish risk--are reviving analysts' worries. End Summary. -------------- Imports Keep Growing Faster than Exports: -------------- ¶2. (SBU) Despite some signs that the torrid growth of the economy, especially in the durable goods sector, was beginning to moderate, December and January trade data continued a pattern whereby imports grew faster than exports, resulting in large monthly trade deficits. For December, imports totaled $9.6 billion and exports $6.6 billion, yielding a trade deficit of $3 billion--by far the largest monthly trade deficit of the year. For all of 2004, imports (on a FOB basis) were $90.7 billion, exports $66.9 billion and the trade deficit $23.8 billion. The year-on-year growth from 2003 dramatically demonstrates both strong growth in the economy and Turkey,s increasing integration into the global economy: exports grew 31% and imports grew 39% compared to 2003 data. Total exports plus imports totalled about 64% of GNP, versus about 49% in 2003. ¶3. (SBU) Central Bank data show that so-called "suitcase trade" registered a slight decrease in 2004, from $3.95 billion in 2003 to $3.88 billion. The suitcase trade consists of purchases by visitors (i.e. Turkish exports), many of them from the former Soviet Union, on short-term shopping trips. This seems to have been triggered by new policies of the CIS countries restricting the suitcase trade, although bombings in central Istanbul may have played a role. -------------- Tourism Boom partially offsets Trade Deficit: -------------- ¶4. (SBU) Turkey normally runs trade deficits and offsets these deficits in part with a positive services balance, largely deriving from tourism. Despite fears that the November 2003 Istanbul bombings or the war in Iraq would deter tourists in 2004, gross tourism receipts in the balance of payments rose 20% to $15.9 billion. Tourist arrivals increased from approximately 19.8 million in 2003 to about 24.6 million in 2004--a 25% increase. The remaining item in the current account--income--is typically a negative number because of Turkey's large external interest payments: about $4.6 billion in 2003 and $4.4 billion in 2004. The overall balance of the income account in 2004 was a negative $5.5 billion. ¶5. (SBU) Including tourism and remitted earnings, the 2004 balance of payments showed a current account deficit near the high end of what analysts had been predicting in recent months. For the year, the current account deficit reached $15.4 billion or about 5.2% of GDP. The deficit nearly doubled from 2003, when it was only $8.0 billion, and represents the highest deficit in memory, higher than in 2000, the year that produced the financial crisis, when the CA deficit was 4.8% of GDP. The increase in the current account can be attributed to the increase in the trade deficit which was roughly the same amount. -------------- Underwhelming Growth in FDI: -------------- ¶6. (SBU) Overall, the capital account provided more than ample financing of the current account deficit. The capital account, combined with positive errors and omissions, led to reserve accumulation of $4.3 billion. The increase in reserves brought gross Central Bank reserves to $ 37.6 billion as of December 31, 2004, or about 111% of short-term external debt. Several of the capital account line items, however, saw significant movements, not all of which are fully understood by local analysts. Most disappointing was the very modest growth in foreign direct investment, despite the low base and Turkey,s breakneck (estimated at 8.3%) economic growth rate in 2004. Net FDI rose only from about $900 million to $1.7 billion. A closer look suggests this is even less impressive: about half of the $2.6 billion of gross FDI was investment in real estate, following a 2003 change in local law to allow foreigners to buy property. -------------- Portfolio Inflows Soar: -------------- ¶7. (SBU) The most striking change in the capital account was the surge in portfolio inflows, which more than doubled from approximately $4 billion in 2003 to $9.2 billion in 2004. Most of this money went into debt securities, and most of this into government securities. This is the proverbial "hot money" that analysts worry could quickly reverse direction, disrupting Turkey,s thin financial markets. According to the Central Bank of Turkey, foreign holdings of TL and FX denominated Turkish debt increased $7 billion in 2004. So far in 2005, the money continues to flow in, at an even faster pace, as investors buy into Turkey as a quasi EU convergence story, following the December 17 EU Council decision to begin accession talks with Turkey. Analysts believe the inflows are increasingly coming from large international investment funds that have little specific knowledge about Turkey. High real returns on lira instruments, investors, belief that a new IMF program will be approved, and global liquidity all contribute to the continued strong flow. In January 2005 such flows totalled $4 billion versus only $672 million in November 2004. -------------- -------------- The debate over increased Private Sector Liabilities: -------------- -------------- ¶8. (SBU) The "Other Investment" category of the capital account has shown significant, and not fully understood, shifts from 2003 to 2004. Overall liabilities increased by $10 billion, contributing a significant source of financing to the BOP. Rising imports led to an increase in net trade credits, from $2.2 billion in 2003 to $4.1 billion in 2004. On the other hand, Turkey,s $3.5 billion in net repayments to the IMF weighed on the balance of payments in 2004, the first year in which Turkey was a substantial net payer to the Fund. More striking, and more commented upon, was the increase in bank and other private sector liabilities: bank liabilities shot up from $2.8 billion in 2003 to $6.2 billion, and "other sectors" liabilities soared from $3.1 billion in 2003 to $9.4 billion in 2004. This "other sector" liability increase began to be much discussed in late summer and early fall, with several analysts and government officials asserting that the increase was a positive development, since it was largely long-term corporate borrowing from abroad to be used to finance expanded capacity in Turkey. As such, these analysts made the argument that it was akin to FDI in being a more stable source of financing. -------------- Errors and Omissions Decline: -------------- ¶9. (SBU) Net errors and omissions, which had been very substantial in 2003 at $5 billion, fell to $2.9 billion in ¶2004. Though neither Central Bank officials nor private economists ever were completely sure what explained the large errors and omissions in 2003, the consensus view was that it represented some combination of reverse currency substitution (i.e. Turks moving foreign exchange-denominated assets into lira assets),flows of dollars from Iraq, and data capture problems in the methodology used by the Central Bank to track balance of payments data. Note: No local analyst that econoffs have met subscribed to the theory put forward by Michael Rubin in a recent article in Middle East Quarterly, that the large errors and omissions represents Islamist money arranged for by AK Party officials. End Note. -------------- Large CA Deficit Raises Eyebrows: -------------- ¶10. (SBU) With the 2004 current account deficit coming in at the high end of expectations, and indications that the flow of short-term portfolio investment continues to increase in 2005, analysts cannot discount the risk of a severe market disruption caused by a sudden reversal of these flows. In late 2003 and early 2004, a few analysts--notably the Economist Intelligence Unit and a Moody,s analyst--made dire predictions of that the increasing current account deficit would eventually lead to a reversal of portfolio flows and a crisis. As this did not transpire, analysts tended to move current account worries to the back burner during the second half of 2004, particularly as the improved fundamentals have gradually reduced most of Turkey,s indicators of financial vulnerability. Indeed, the formerly alarmist Moody,s upgraded Turkey,s outlook from stable to positive, despite the news of difficulties in concluding the IMF program. Analysts increasingly bought into Central Bank Governor Serdengecti,s mantra, that the floating exchange rate regime has built in automatic stabilizers, reducing the risk of a sharp market disruption. Moreover, analysts believed that the expected moderation of economic growth in 2005--with some analysts predicting growth below the 5% program target--will lead to a leveling off of import growth and a moderating current account deficit as a percentage of GDP. A gradual adjustment scenario seemed likely. -------------- Early 2005 data revive CA deficit concerns: -------------- ¶11. (SBU) However, recent data releases have revived worries about the current account deficit, and the possibility of a less gradual adjustment scenario. Though markets continue to be very bullish, there has been a notable shift in several analysts' views on the issue in the past few weeks, for a variety of reasons. First, though it's still too early in the year to be sure, there are signs the slowdown may not be as weak as expected. Recent releases on industrial production and capacity ulilization, for example, surprised analysts on the high side. At the same time, the January balance of payments showed continuing growth in imports such that the current account deficit continued to grow. ¶12. (SBU) Perhaps the most worrying trend, however, is the continuing appreciation of the lira, driven by stronger-than-ever short-term portfolio inflows. There are widespread indications that a portion of the increased flows derive from investment funds that are new to the Turkish market, that have not lived through Turkey's history of ups and downs, and therefore may not fully appreciate the downside. The January BOP data show portfolio investment inflows exceeding $4 billion, compared with $9.2 for all of ¶2004. With the lira now trading around 1.25 to the dollar, the nominal exchange rate is about where it was in September 2001, and the real exchange rate has appreciated roughly by half from its post-crisis trough. While the strong lira (and surprisingly favorable February inflation data) has reduced inflation concerns, it is reducing the probability of that import growth will slow. Consequently, analysts are lowering the probability of a gradual adjustment scenario. ¶13. (SBU) Finally, some analysts are beginning to think that even if growth slows, import growth may remain relatively high. Given that the composition of imports is heavily concentrated in intermediate goods, rather than capital or consumption goods, these analysts wonder whether imports will slow in a slower-growth scenario. Baturalp Candemir of HC Istanbul--who came close to the mark with a $14.5 billion CA deficit prediction at a period in 2004 when the consensus was $8-9 billion--predicts a CA deficit of $16 billion if GDP growth is 4%, and $18 billion if it is 6.5%. If he's right, this implies a continued widening of the CA deficit in all growth scenarios except those at the bottom of the range of analysts' expectations. ¶14. (U) 2004 BOP Highlights ($ billions): 2003 2004 -------------- -------------- Exports (fob) 51.2 66.9 Imports (fob) 65.2 90.7 Trade deficit (14.0) (23.8) Services 10.5 12.8 o/w Tourism (net) 11.1 13.4 Income (interest transfers) (4.5) (4.4) Current Account Deficit (8.0) (15.4) Net FDI 1.2 1.7 o/w inward FDI 1.7 2.6 Net Portfolio Investment 2.6 8.1 Other Investment 3.3 7.0 o/w non-bank liabilities 3.2 9.5 Net Errors and Omissions 5.0 3.0 Overall Balance (4.0) (4.3) EDELMAN