TURKEY: LIMITED IMPACT OF INTEREST RATE HIKES

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SIPDIS

TREASURY FOR JROSE

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SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN TU
SUBJECT: TURKEY: LIMITED IMPACT OF INTEREST RATE HIKES

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1. (SBU) Summary. In its August 24 meeting, Turkey's interest
rate setting Monetary Policy Committee (MPC) decided to keep Central
Bank interest rates on hold at 17.5%. Since the global emerging
market turmoil in May, however, the MPC has increased interest rates
by a total of 4.25%, reversing the post 2001 financial crisis trend
that had seen rates decline from 62% in February 2002. The MPC's
firm response played a key role in staunching the outflow of foreign
portfolio investment, stabilizing the exchange rate, and restoring
some of the policy credibility that had had been lost since Central
Bank Governor Durmus Yilmaz took over as chairman in April. Yet,
observers have argued that the rate hikes and will have a depressing
effect on real economic activity and growth at a time of increasing
political sensitivity as 2007 presidential and parliamentary
elections approach. While it does seem that GDP growth will slow
this year and next from the torrid pace of recent years, most local
economists see a relatively limited impact of the 4.25% increase on
growth and employment, trimming a percentage point or so off their
forecasts. Instead of 5-7% growth this year, growth will probably
be in the 4-6% range. Growth will stay positive next year. End
Summary.

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Large Rate Hikes Part of Firm Response to Turmoil
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2. (SBU) After a bumbling its initial response to May's and June's
market turmoil, the MPC made the decisive decision beginning June 8
to reverse the downward trend in the Central Bank's policy rates. A
cumulative rate increase of 425 basis points and a resumption of the
Central Bank's daily liraauction intended to extract "excess
liquidity" from foreign exchange markets seems to have a positive
impact on markets' inflation expectations and to have stabilized the
level of the currency, which had hit a low of 1.76 TL to the dollar.
The government's commitment to further tighten its fiscal surplus
under the IMF program also helped reassure that Turkey had not lost
its inflation-fighting zeal in the run-up to 2007 presidential and
parliamentary elections.


3. (SBU) At the same time, local and foreign economists began to
worry that the aggressive response to market turmoil would lead to a
slow-down in the economy through curbed demand and delays in planned
investment decisions as the cost of money increased. Indeed, the
increase in market interest rates charged in the fast-expanding
consumer loan sector had an immediate impact on consumer demand.
Banks saw a booming credit card and housing loan growth come to an
abrupt stop that was also reflected in a drop in domestic automobile
sales (which was a big part of consumer demand growth). They
worried that a spending slowdown could encourage populist political
responses that would further stir markets.

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Economists Relaxed, Seeing Continued Strong Growth
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4. (SBU) Yet, most economists who observe the Turkish economy up
close are sanguine about the impact of the rate hike, even in the
short-term. For instance, Hakan Kara, Deputy Director of the
Central Bank's Research Department, told us that the Bank did not
see rate hikes having a large negative impact on growth, although he
agreed that there would be a relative slow-down in consumer and
business spending. He noted that part of the real interest rate
increase would be offset by the increase in inflation expectations.
Also, he thought that banks were likely to trim their interest rate
margins and cut rates to spur lending as they accumulated new
deposits. He pointed out that changes in banking regulations have
decreased banks' ability to stash surplus funds in government
securities, essentially obliging them to absorb increased interest
costs instead of passing them on to customers.


5. (SBU) Another element offsetting a decrease in domestic demand
would be a spur to external demand coming from the exchange rate
depreciation. Most observers, including the Central Bank
economists, expect this to be seen more in slower import growth than
an increased rate of export growth. As noted to us by Central Bank
Advisor Ercan Turkan, this could lead to industrial cost increases
and a consequent slow-down in production since Turkey's domestic and
export industries are heavily dependent on imported inputs.
However, this has not yet been observed in the industrial production
or corporate profitability statistics. Indeed, industrial
production has surprised many economists with its continued
strength, surpassing expectations in both June and July. At the
same time, a reduction in Turkey's large current account deficit
should have a positive impact on markets' perceptions of Turkey's
financial vulnerabilities, theoretically leading to a lower risk
premium and lower borrowing costs.

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GDP Growth Forecasts Trimmed Only Slightly
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6. (SBU) There seems to be a consensus that the impact of the rate
hikes will be felt most in the second half of 2006, when real GDP
growth rates should fall below the 6.4% annual pace recorded in the
first half. As a result, local forecasters seem to have trimmed on
average about one percentage point off their 2006 outlooks. So,
instead of 5-7% growth this year, economists are betting on a 4-6%
range. At the low end, Fitch rating agency's local director told us
her forecast was for 4.5% growth this year, similar to Global
Securities' Murat Ucer's 4.4% prediction. Meanwhile, Baturalp
Candemir, a widely quoted analyst for EFG Securities in Istanbul
said he is expecting 5.5%. The Central Bank's Turkan expects growth
to exceed five percent. This is a slowdown only when compared to
last year's 7.4% pace. All of these economists expect the slowdown
to continue to be felt in 2007, but with rate hike impact gradually
diminishing.

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Comment: Markets More Sophisticated About Turkey?
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7. (SBU) In this troubled region and neighborhood, only the very
brave forecast economic growth beyond the very short-term. Still,
there appears to be a strong consensus that economic growth will
remain strongly positive in 2006 and 2007 and that the impact of the
recent rate hikes will be passing. Indeed, several of the
economists we spoke to said that risks were "on the upside."
Nevertheless, Turkey's economic and financial vulnerabilities
remain including its large current account deficit and still
substantial foreign-currency linked government debt that leave the
country especially exposed to swings in global markets.
Interestingly, however, a senior London-based Goldman Sachs Turkey
watcher told us he saw markets growing more sophisticated in their
approach to political risk in Turkey. He did not see major market
fluctuations resulting from the inevitable political uncertainties
in a pre-election period. He thought this was due both to greater
sophistication by investors as well as greater sensitivity of
policymakers to the impact their comments have on markets. The
recent smooth transition in the military command structure was, he
thought, evidence of this.
Wilson