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