A/S SULLIVAN MEETINGS WITH TURKISH ECONOMY

C O N F I D E N T I A L ANKARA 004304 SIPDIS SIPDIS TREASURY FOR INTERNATIONAL AFFAIRS - JROSE AND MNUGENT E.O. 12958: DECL: 07/25/2016 TAGS: ECON EFIN EINV TU IZ SUBJECT: A/S SULLIVAN MEETINGS WITH TURKISH ECONOMY MINISTER, CENTRAL BANK GOVERNOR REF: A. ANKARA 4133(NOTAL) ¶B. ANKARA 4132(NOTAL) ¶C. ANKARA 4131(NOTAL) ¶D. ANKARA 4301(NOTAL) Classified By: Ambassador Ross Wilson for reasons 1.4(b) and (d). ¶1. (C) SUMMARY: In meetings with Economy Minister Ali Babacan and Central Bank Governor July 14, Assistant Secretary Sullivan explored recent financial market volatility, Turkey,s macroeconomic progress and Iraq,s bilateral debt. Babacan and the Central Bank Governor both admitted there were Turkey-specific factors in the sell-off, but emphasized how much stronger Turkey,s economy had become in recent years. Both downplayed current account concerns, citing large capital goods imports. Babacan pointed to strong FDI inflows and said the GOT was creating an investment promotion agency. The Central Bank Governor insisted the Bank had only intervened to provide liquidity to the foreign exchange market on a temporary basis and was not targeting a particular exchange rate level. Both Babacan and MFA Under Secretary Tuygan were resistant to the idea of Turkey SIPDIS forgiving Iraqi debt. A/S Sullivan,s meetings with other officials are covered septel. END SUMMARY. -------------- Bullish Babacan -------------- ¶2. (SBU) In a July 14 meeting with Minister of Economy Ali Babacan and Treasury Under Secretary Ibrahim Canakci, A/S Sullivan congratulated Turkey on the BTC pipeline inauguration, and for the World Bank board,s selection of Istanbul to host the 2009 Bank/Fund annual meetings. Babacan said that Istanbul hosting the Bank/Fund meetings had symbolic importance, particularly since the last two hosts were Singapore and Dubai. He thanked Sullivan for the U.S. support and said the GOT was looking at ways to bolster Istanbul as a regional financial center, including by moving state banks, headquarters there without waiting for privatization. Sullivan told Babacan that U.S. companies had told him Turkey could do a better job promoting the importance of the country,s strategic location between Europe and Asia. ¶3. (SBU) Babacan described the recent GOT decision to create an investment promotion agency of 25 to 30 people reporting to the prime minister which will both promote Turkey as a Foreign Direct Investment destination and help investors who run into problems. The GOT is considering hiring the staff from the private sector. Babacan said he expects 2006 FDI to reach between $12 and $24 billion. ¶4. (SBU) Sullivan brought up the Economic Partnership Commission (EPC) and floated the idea of greater involvement by the economic ministries and by the private sector. Babacan, who did not seem familiar with the EPC, said he and Turkish Treasury officials could discuss this with the Foreign Ministry. ¶5. (SBU) Babacan gave an overview of Turkey,s macroeconomic progress in recent years, referring to the program as "our program," not the IMF,s. He said he expects the GOT to seek some sort of follow-on arrangement with the IMF though they may need "another format." He said Turkey benefits from its relations with the IMF. "We don,t complain." In 2006, for the first time in memory, the public sector borrowing requirement is expected to be zero. Last year,s budget deficit was 2% of GDP, down from 17% in 2001. This improvement was possible through a combination of fiscal austerity and lower inflation which led to lower interest rates and reduced state borrowing. Babacan said no other developing country has been able to achieve a 6.5% of GDP primary surplus for four years in a row. He said in Turkey,s case there has not been the usual tradeoff between inflation and growth. The reason is that lower inflation has meant lower real interest rates which have encouraged private sector borrowing and helped stimulate growth. ¶6. (SBU) Babacan said that unlike in 2001, the economy can withstand the kind of market volatility and exchange rate depreciation Turkey has reently experienced. Bank balance sheets are protected against both exchange rate and interest rate shifts, net public sector debt to GDP has fallen to 55% of GDP as of year end 2005 and Turkey has experienced reverse currency substitution with foreign exchange deposits declining from around 60% of total deposits in 2002 to around 30% now. Canakci told us that in their modeling, Treasury could still service its debt even with a combination of a 2-3% growth shock, a 2-3% interest rate shock, and a 20% exchange rate shock. ¶7. (SBU) In response to a question by Sullivan about current account deficit levels of over 6 percent of GDP, Babacan downplayed concerns about the current account deficit, saying much of it was for capital goods imports for the private sector and was financed by long-term borrowing or FDI. He said Turkish industry invested $60 billion last year and imported $20 billion in machinery imports. The current account deficit is being created by the private sector. Babacan also said "we don,t say the currency is overvalued or undervalued," since the markets decide the level. In an important difference from his public statements, Babacan admitted there were Turkey-specific factors in the recent market turbulence. -------------- Iraq Debt -------------- ¶8. (C) Sullivan raised the issue of Iraq,s bilateral debt to Turkey and mentioned the importance of debt forgiveness. Babacan said Turkey is an indebted country and if Turkey were wealthier, it could view the issue differently. He compared the situation to Turkey,s experience as a creditor to Russia when Russia received a Paris Club restructuring, noting that Russia and Turkey eventually came to terms. Sullivan and the Ambassador expressed skepticism that the Russian example was relevant, pointing out the much weaker repayment prospects and the desirability of getting something rather than nothing. The Ambassador also stressed Turkey,s interest in a stabilized Iraq. 9.(C) In an earlier meeting with MFA Under Secretary Ali Tuygan, Sullivan also asked for Turkish action to reduce Iraqi bilateral debt. To which Tuygan replied, "With oil at 74 dollars a barrel?" -------------- Central Bank Governor -------------- ¶10. (SBU) In a meeting with Central Bank Governor Durmus Yilmaz, Sullivan congratulated the Governor on his appointment and Yilmaz noted Turkey,s longstanding friendship with the U.S., recalling U.S. food aid he saw as a child in a small town in Anatolia. Yilmaz said the Central Bank has excellent relations with the Federal Reserve through which the Central Bank settles any transactions relating to its foreign exchange reserves. ¶11. (SBU) Echoing Babacan, Yilmaz said Turkey,s recent growth is related to the return of price stability. In Yilmaz, view, the turning point in Turkey,s economic stabilization was the granting of independence to the Central Bank in 2001. Since that time the Government has been unable to finance itself from the Central Bank: even the Bank,s open market operations are now only taken in the secondary market. ¶12. (C) In response to Sullivan,s inquiries about inflationary pressures due to recent market turbulence, Yilmaz acknowledged that the decline in the exchange rate had made it impossible to achieve the quarterly indicative inflation targets under the Bank,s inflation targeting regime introduced at the beginning of the year. The Bank was required to write the Government and IMF a letter explaining why inflation has surpassed the upper limit of the targeted range. Yilmaz said the Bank expected higher inflation in July and August but easing inflationary pressures thereafter, allowing 2006 inflation to come in under 10% and convergence towards the 4% target in 2007. He said the letter would be made public and admitted that neither the Bank nor the markets had expected the uptick in inflation. ¶13. (C) The Governor admitted Turkey had been hit harder than other emerging markets because of the higher-than-expected inflation and the high current account deficit. "Some people also say it was because of the Central Bank Governor selection process," but he chuckled when he said that was beyond his control. Looking ahead, he recognized that political and regional factors, and the EU accession process could roil markets, but that the Bank had to focus on what it could control. Like Babacan, Yilmaz downplayed the current account concerns when pressed by Sullivan about the high level, saying only 10% of imports were consumer goods and 45% were capital goods. Moreover, with the lower exchange rate expected to impact domestic demand he expected the current account deficit to moderate in the coming months. ¶14. (C) Yilmaz praised the recent structural reforms in Turkey, especially the social security reform. He said the reforms had begun before the current government but that the current government had done more than its predecessors. He believes that the reform process is institutionalized in Turkey, in part due to the EU process. On Turkey,s intractable unemployment problem, Yilmaz said that 1.3 million jobs had been created over the past two years but that job-creation cannot keep up with rural-urban migration. In rural areas, the employment data disguise the number of underemployed people. He also attributed high unemployment to the difficulty of firing employees and other frictions in the labor market. ¶15. (C) When Sullivan introduced Jonathan Rose from the U.S. Treasury, Yilmaz recalled that Treasury DAS Ahmed Saeed had raised the Bank,s communication policy with the Governor in New York. Yilmaz said he is discussing the issue with his Vice-Governors. He also outlined the Bank,s package of actions -- foreign exchange intervention, raising interest rates, foreign exchange deposit auctions and lira repo auctions -- that have succeeded for now in calming Turkish markets. He said the bank decided to intervene, rather than just raise rates, because there was a class of foreign investors that were very short-term and were insensitive to interest rate increases. By providing foreign exchange liquidity, the Bank allowed these investors to get out of lira assets. Since June 25, however, the Bank has not had to intervene since other foreign investors have responded to the interest rate increases and stayed in the market. The bank was not, however, committed to a level of the exchange rate. Yilmaz reiterated the Bank mantra that it only intervenes to counter excessive volatility or (in the other direction) to buy foreign exchange reserves. Sullivan concluded by saying the U.S. Government respects the Governor,s actions, having come in at a difficult time. In a subsequent TV interview, Sullivan emphasized confidence in Turkey,s economic team and their continued commitment to sound economic fundamentals. A/S Sullivan cleared this message. Visit Ankara's Classified Web Site at http://www.state.sgov.gov/p/eur/ankara/ WILSON