SHARP SELL-OFF IN TURKISH MARKETS

UNCLAS SECTION 01 OF 02 ANKARA 002742

SIPDIS

TREASURY FOR INT'L AFFAIRS - CPLANTIER AND MNUGENT
NSC FOR MCKIBBEN

SENSITIVE

E.O. 12958: N/A
TAGS: EFIN TU
SUBJECT: SHARP SELL-OFF IN TURKISH MARKETS


THIS CABLE HAS BEEN COORDINATED WITH CONGEN ISTANBUL.

1.(SBU) Summary: A decline in Turkey's financial markets
turned into a rout Friday, May 12 and continued May 15.
Driven by a combination of global and local factors,
investors -- especially foreign investors -- reached a
tipping point and reduced their Turkish positions.
Neither the Government nor the Central Bank has any easy
tools with which to stop the slide, but at this stage a
2001-style crisis seems only a remote possibility. End
Summary.

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Market Decline Turns into a Rout
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2. (U) During the first four months of 2006, Turkish
financial markets continued to go their bullish way, with
equities continuing to rise as the lira accompanied the
dollar's gradual fall against the euro. In May, however,
sentiment cooled due for a variety of global and local
reasons. On Friday, May 12, the gradual decline turned
into a rout given increasingly unfavorable global market
conditions and more and more market-unfriendly local and
regional news flow. Though there was no single event
that triggered the sell-off, a series of concerns finally
reached a tipping point.


3. (U) On Friday, the IMKB 100 stock market index fell
3.99%, the exchange rate dropped 4.5% against a Euro-
dollar basket and the yield on the benchmark bond rose to
14.51%, the highest rate so far in 2006. For the week
the IMKB was off 6.13%, the exchange rate had fallen 6.6%
and the yield rose from 14.13% to 14.51%. The lira
closed at 1.3976 to the dollar -- an eighteen month low -
- and 1.8032 to the euro. New Central Bank Governor
Durmus Yilmaz, attempted Friday to reassure markets by
reaffirming the Bank'scommitted to the floating exchange
rate regime. He also said the higher-than-expected April
inflation numbers had not altered the Bank's medium-term
inflation projections. The Governor said the Bank was
watching market developments closely. This statement was
sufficient to cause markets to pause in their fall and
even pull back a bit.


4. (U) On Monday, however, following an overnight sell-
off in Asian markets, the free fall continued with the
IMKB 100 down an additional 3.45% to 40,519.89 at 2:35
local time, the exchange rate down to 1.46 to the dollar
and 1.86 to the Euro. The benchmark yield rose to
14.82%.

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Causes Local and Global
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5. (U) First among the global factors were signs of the
long-expected weakness in Emerging Markets as a result of
tightening monetary policy in the U.S., Europe and Japan.
This tightness particularly affects Turkey, since many
international investors in Turkish markets do so by means
of "carry trades," i.e. borrowing in low-interest
currencies like the yen and investing in high-yielding
Turkish assets. An HSBC trader told May 13 that
investors were not renewing the normally-popular yen-lira
carry trades.


6. (SBU) Over the previous days and weeks, a variety of
local and regional factors combined to make market
participants increasingly anxious. Among the
longstanding worries were high oil prices that exacerbate
Turkey's widening current account deficit; concerns about
regional tension (especially vis-a-vis Iran); and
increasingly acrimonious domestic political wrangling
with more and more talk of early elections. Early
elections are considered a negative for markets since
they bring with them the possibility that the market-
unfriendly Nationalist Party (MHP) would enter parliament
and possibly even form a coalition government with the AK
Party.


7. (SBU) On more purely economic issues, markets were
surprised by unexpectedly high April inflation numbers,
which wrong footed the Central Bank: Only days beforehand
the Monetary Policy Committee, chaired for the first time
by newly-appointed Governor Yilmaz, cut rates a quarter
point. With the prospect of the Bank facing greater-than-
foreseen difficulties getting close to the 5% year-end
target, inflation expectations and interest rates blipped
upwards.


8. (SBU) President Sezer's May 10 veto of Social
Security Reform legislation further rattled markets.
Although the President's veto is likely to be overridden
by parliament, it created new uncertainties that the
reform would not be implemented in a way as to bring the
social security system's red ink under control. The
reform is also crucial for the IMF program.
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Uncertain Outlook
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9. (SBU) Some observers welcome a limited market slide
as a healthy corrective to what they see as excessive
investor enthusiasm. They also believe a weaker lira
will give exporters a competitiveness boost, particularly
for exports to Europe. On the other hand, if the
downturn marks the beginning of a sustained fall in
Turkish markets, neither the government nor the Central
Bank have easy access to tools that can stop the slide.


10. (SBU) Though the Central Bank could intervene to
support the lira, this would run counter to the Bank's
longstanding claims that its interventions are primarily
intended to build up foreign exchange reserves. The Bank
had long warned investors it would not facilitate their
exit from the market (i.e. buy lira in a correction).
The Bank could, however, raise interest rates, which
could send a signal of renewed inflation-fighting zeal
and would help Turkish yields become attractive again.


11. (SBU) Quickly wrapping-up an agreement with the
visiting IMF mission on a new Letter of Intent without
the customary drama could also give markets a shot in the
arm. The more the Government can do in the way of strong
fiscal and structural measures in this IMF review to show
a renewed commitment to the reform track the more it is
likely to help markets. Likewise, the sooner parliament
overrides Sezer's veto of the social security legislation
the better.

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Crisis Unlikely
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12. (SBU) The sharp fall with seemingly no buyers of
lira assets is the worst correction since at least the
spring of 2004. Though worrisome, it has some way to go
before it gets into crisis territory. Even if it does,
Turkey's much-improved fundamentals, including a
strengthened fiscal situation a better-capitalized
banking sector and improved public sector debt ratios
suggest the likelihood of a full-blown financial crisis a
la 2001 is remote.

Wilson