BABACAN SCENESETTER: TURKISH ECONOMY AT A WATERSHED

UNCLAS SECTION 01 OF 02 ANKARA 005502

SIPDIS

SENSITIVE

TREASURY FOR INTERNATIONAL AFFAIRS - U/S ADAMS, CPLANTIER
NSC FOR MCKIBBEN

E.O. 12958: N/A
TAGS: EFIN PGOV BEXP TU
SUBJECT: BABACAN SCENESETTER: TURKISH ECONOMY AT A WATERSHED



1. (SBU) Summary: Minister Babacan comes to Washington at
what may be a watershed moment for the Turkish economy. If
Turkey officially becomes an EU accession country October 3,
and recent privatization and FDI deals are consummated,
Turkey will have taken another important step away from its
boom-and-bust economic track record. On the other hand, a
disruptive scenario can still not be ruled out, and the GOT
needs to guard against complacency. Babacan has been a key
player in Turkey's continued economic progress, keeping the
reform program going whenever it was bogged down in domestic
opposition. As ever with Babacan, the challenge is to get
beyond his "everything's wonderful" spin and convey the need
to guard against complacency and push through IMF-sponsored
structural reforms. End Summary.

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Continued Progress on Economic Stabilization
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2. (SBU) As Minister Babacan comes to Washington the Turkish
economy's post-2001 crisis stabilization shows no sign of
being derailed. Though growth has slowed to around the 5%
target for 2005 from its torrid 2004 pace (GNP grew 9.9%),
last year's pace still reflected pent-up demand from the
immediate post-crisis period and the effect of
newly-affordable credit on autos and consumer durables.
There are encouraging signs the economy is moving from using
unutilized capacity dating from the crisis to new investment
to relieve capacity constraints. At the same time, even
though overall growth has slowed, signs of a long-awaited
revival in the construction sector raise hopes for faster
employment creation which could finally begin to bring down
Turkey's stubbornly-high unemployment rate (9.2% as of June,
2005).

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Exchange Rate Appreciation and Current Account Concerns
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3. (SBU) One factor in the slowdown is the Turkish lira's
continued real appreciation, particularly against the euro,
which raises concerns about Turkey's ability to maintain the
competitiveness of its exports. Coming at the same time as
higher oil prices, Turkey's trade deficit is worsening in
2005, exacerbating existing concerns about Turkey's current
account deficit. With global markets' yield-hungry
short-term portfolio investors betting on Turkey's
stabilization and EU-accession story, Turkey has had no
difficulty financing its current account deficit (which the
IMF forecasts will be 5.6% of GNP this year). However, this
leaves Turkey vulnerable to a shift in global sentiment on
emerging markets in general or Turkey in particular, which
could lead to a "rush to the exits" and a disruptive fall in
the exchange rate.

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FDI and Privatization Come to Life
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4. (SBU) While the risk of the above-described disruptive
scenario remains, 2005 brought major progress on both foreign
direct investment and privatization--areas of notable
weakness in recent years. There have been a series of major
FDI deals announced that are expected to provide a
significant source of longer-term stable financing to the
balance of payments. One of these deals (GE Capital's $1.56
billion purchase of a 25.5% stake in Garanti Bank) will be
the first large U.S. corporate investment in Turkey in years.
Combined with the resolution of Cargill's zoning problem,
and the seemingly close resolution of Motorola's protracted
effort to settle its $2 billion claim, the track record for
American companies has improved considerably. Nevertheless,
the opaque judicial and regulatory systems continue to need
reform. The AKP leadership, including Babacan, support
judicial reform, but face fierce resistance from the
powerful, entrenched state bureaucracy.


5. (SBU) Likewise, the AK Party Government, which tried but
mostly failed to privatize large state enterprises in 2003
and 2004, finally seems to have turned the corner with a
series of major privatization tenders that are likely to be
consummated. If the deals that have been tendered in 2005
are not overturned by the judiciary they will total about $14
billion. With a Saudi-led consortium winning the Turk
Telekom tender, and Shell's minority share in the Tupras oil
refinery, both transactions will lead to some increased FDI
as well, though spread over several years. As these deals
have raised nationalist and dirigiste hackles, Prime Minister
Erdogan and Babacan have shown political courage and publicly
stood up for the benefits of foreign investment and
privatization.

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Adding to Market Optimism
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6. (SBU)Good news on privatization and FDI has bolstered
already-optimistic Turkish financial markets, driven by
foreign investors who repeatedly bet the GOT will work things
out with the IMF, the EU, and the U.S. The Istanbul stock
exchange keeps breaking new records, while the lira stays
strong and interest rates slowly but surely move lower. If
Turkey, as seems likely, officially begins EU accession
negotiations October 3, it will only add to the flood of
short-term portfolio investment, exacerbating the risk of a
financial market bubble leading to a disruptive scenario if
investor sentiment suddenly shifts in the future.

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Continued Tight Fiscal and Monetary Policy
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7. (SBU) Consequently, despite the encouraging signs of more
long-term financing from FDI, the risk from the current
account deficit remains, linked as it is to Turkey's
continued (albeit gradually decreasing) need to continually
roll over large quantities of short-term debt in financial
markets. This concern reinforces the IMF's call for
continued tight monetary policy, with the GOT sticking to its
6.5% primary surplus target for 2006 and the independent
Central Bank sustaining its disinflation policy, which is on
track to meet this year's targeted 8% rate for CPI. At the
same time, both the IMF and business groups like TOBB,
Turkey's Chamber of Commerce, emphasize the need to keep
moving forward on structural reforms such as the social
security reform and tax reform. The social security reform
is closely-linked to Turkey's fiscal policy because the
longer the GOT waits to implement the reform the longer the
social security deficit (4.5% of GDP) exacerbates Turkey's
overall budget deficit. Though Babacan will insist the
reform will be implemented as soon as parliament returns
October 1, there are rumors the critical change in the
pension payment formulae will be postponed from the planned
January 1, 2006 start date.

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Hence the Need for Movement on the IMF Program:
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8. (SBU) All of which points to the importance of the GOT
avoiding complacency on economic policy, and moving forward
on its on-again off-again IMF program. After about four
months of inactivity on the IMF program at the beginning of
the year, the GOT worked hard from April through June:
finally securing board approval for the new $10 billion
Standby Arrangement in May and pressing parliament to pass
key legislation in June, only to be derailed by fierce
delaying tactics by the opposition and the long parliamentary
recess which ends October 1. Babacan will insist the GOT
fully owns the economic reform program and will quickly pass
the banking legislation (overriding the President's typically
unhelpful veto) and the social security reform, and quickly
wrapping up both the first and second reviews. But Babacan's
gloss masks the ambivalence of many GOT politicians,
particularly on the structural reforms, and USG officials are
well-advised to continually raise the IMF program, while
realizing Babacan is its principal proponent in the Council
of Ministers.

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Comment:
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9. (SBU) In this context of continued economic progress
coupled with continued--albeit lessening--risks, USG
officials' challenge in meetings with Babacan will be to get
beyond his ever-glowing spin, to have a substantive
discussion about how the GOT would deal with a run of bad
luck.
MCELDOWNEY