Turkey: Meetings with Turkish Delegation in Singapore

UNCLAS SECTION 01 OF 02 ANKARA 005396

SIPDIS

TREASURY FOR U/S ADAMS
STATE FOR A/S SULLIVAN

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: EFIN TU

SUBJECT: Turkey: Meetings with Turkish Delegation in Singapore

REF: ANKARA 5092 and previous

Sensitive But Unclassified. Please handle accordingly.

1.(SBU) Summary: Your meeting with Minister Babacan occurs as Turkey
looks forward to an autumn of potentially rocky EU accession issues,
pre-election domestic politics and question marks about inflation --
any of which could roil financial markets, as they did in the
spring. Turkey weathered the spring financial volatility,
vindicating its overall policy framework. Public finances continue
to improve, the current account deficit, while large, can be
financed, and growth is expected to slow only slightly this year.
For now, inflation is the most significant macroeconomic issue. End
Summary.

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After a Quiet Summer, Autumn Challenges
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2. (SBU) This is a moment of transition for Babacan, Central Bank
Governor Yilmaz and the Turkish economic team. The spring emerging
market sell-off scared them, but the fact that the market correction
did not turn into a crisis also vindicated Turkey's overall policy
framework. After the Central Bank's missteps during the volatile
period, the Bank's ultimate ability to stabilize the markets and the
ensuing two months of relative calm have partially restored Governor
Yilmaz' credibility. Now Babacan and Yilmaz are focused on the
remainder of 2006: Babacan on avoiding a "train wreck" over Cyprus
in Turkey's EU accession process and Yilmaz on returning the Turkish
economy to its pre-correction disinflationary path.


3. (SBU) Babacan, normally a relatively technocratic,
under-the-political-radar minister, has run into a barrage of press
criticism in recent weeks over his perceived inactivity as EU
negotiator. This criticism, and the looming EU deadline for Turkey
to open its ports and airports to Greek Cypriot shipping and
aviation, is likely to make him focus more on his EU negotiator job
than on his macro policy responsibilities and the IMF program. The
current relatively benign macro environment and the absence of major
bones of contention with the IMF are likely to reinforce this
tendency. Turkey has recovered well from the May-June fall in the
exchange rate and spike in interest rates. To date, there is little
evidence that the correction has scarred either the banking system
or the corporate sector, despite initial fears to the contrary.

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Biggest Macro Issue is now Inflation
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4. (SBU) Public finances continue to benefit from a combination of
strong growth, a reduced interest bill, and cash receipts from
privatizations and asset sales from intervened banks. From January
through August, 2006 the central government actually ran a slight
overall surplus - not bad for a country which had a budget deficit
of 14% of GDP only four years ago. So far, there have been few
signs of political spending in the run-up to elections though this
remains a risk.


5. (SBU) Turkey's debt ratios are much improved from even two years
ago: net public sector debt of 56% at yearend 2005, versus 90% in

2001. After the spring volatility, however, interest rates never
returned to their pre-correction levels and rose again (surpassing
20%) during an early-September dip in the market. Higher nominal
rates reflect higher inflation expectations following the May-June
fall in the exchange rate. Nominal rates have also been nudged
upwards by the Turkish Treasury's need for large-scale redemptions
in September, as well as market concerns about the global outlook.
Higher rates are still manageable; Turkish Treasury has a strong
cash position and the declining trend in interest rates is likely to
resume soon.


6. (SBU) The resumption of nominal rates' declining trend will
depend on a return to disinflation. With the fall in the exchange
rate and higher fuel prices working to keep inflation high, the
annualized inflation rate returned to the low double digits in the
summer months. Markets are now hoping inflation will start coming
down again in the fall, given the Central Bank's cautious stance.


7. (SBU) In July, in the immediate aftermath of the fall in the
exchange rate and the increase in interest rates, there was a
consensus among economists that there would be a significant
slowdown in economic growth in the second half of the year. Private
investment and interest-rate sensitive consumption -- autos,
housing, consumer durables -- have been major drivers of Turkey's

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strong growth from 2002 through the first half of 2006. The most
recent data releases, however, suggest that the slowdown may not be
as pronounced as previously thought and that growth is likely to
surpass the 5% program target for the full year.


8. (SBU) The balance of payments outlook for 2006 is mixed, with a
current deficit probably surpassing 7% of GDP. On top of a still
weak trade account, tourism receipts now look slightly down this
year, particularly following the recent spate of terrorist bombings.
Still, the current account deficit does not seem a serious concern
in the near-term, as Turkey has ample financing for it: strong FDI
flows are set to surpass last year's record $9.6 billion by $10
billion or more and portfolio investors have returned.

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Political and EU Wrangling Likely
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9. (SBU) Even as the macro picture looks more comfortable, the same
contentious domestic political atmosphere that helped drive
investors away in May will continue to be a risk in the run-up to
May 2007 presidential elections and parliamentary elections, which
must be held by November 2007. A sign of the underlying political
seething was the bitter debate over Turkey's participation in UNIFIL
that pitted the Kemalist secular establishment - led by President
Sezer and the vocal leading opposition party -- against the AK Party
Government.


10. (SBU) Turkish participation in UNIFIL, along with the Rice-Gul
announcement in July of the Shared Vision and Structured Strategic
Dialogue, have helped U.S.-Turkish bilateral relations, despite the
exceedingly poor USG image in Turkey, as reflected in the German
Marshall Fund's Transatlantic Trends and other recent surveys.
Ongoing PKK terrorist violence continues to roil bilateral
relations, and is topic number one domestically. The recent naming
of General (ret) Ralston as the U.S. special envoy to combat PKK
terrorism has helped, but Turkey is still looking for concrete
action against the PKK in Iraq.

Wilson