TRENDS FOR TURKISH ECONOMY IN 2008

C O N F I D E N T I A L ANKARA 000198 SIPDIS SIPDIS ANKARA PASS TO ADANA E.O. 12958: DECL: 01/31/2018 TAGS: ECON ENRG EFIN TU SUBJECT: TRENDS FOR TURKISH ECONOMY IN 2008 Classified By: Ambassador Ross Wilson for reasons 1.4 b and d. ¶1. (C) Summary: 2008 will be a challenging year for the Turkish economy and the government's economic policies. Turkey already has felt effects from the global credit crisis and investor risk re-assessment and it remains vulnerable because of its external financing needs. Economic growth is slowing, commodity prices remain very high, and the overvalued Lira is adding to the country's financial vulnerabilities. Anchors that have served Turkey well for the past six years -- the IMF program, EU accession process, structural reforms, fiscal discipline, and strong anti-inflation policies -- came loose to some degree in 2007. The government may be too focused on domestic political events to see the need to re-attach these anchors or it may underestimate how skittish investors have become. On the bright side, a statistical revision due out soon will increase Turkey's GDP by an estimated 30% (septel). End summary. Global Trends Are Negative For Turkey -------------- ¶2. (C) Turkey largely avoided any negative fallout from the sub-prime mortgage crisis last year, but will face greater difficulties in 2008 as investors re-assess and re-price risk. For all its economic success over the past six years, Turkey remains one of the most exposed countries in the world to a global credit crunch and risk re-assessment. It remains highly dependent on foreign financing. Its external financing needs this year will be about $83 billion, $41 billion for debt service and $42 billion for the current account deficit. Turkey has been and remains a very attractive place for foreign investment, but will have more difficulty attracting investment in this uncertain, slower growth, global environment. ¶3. (C) Turkey's economic growth is directly correlated with world and, in particular, European growth. With growth slowing both in Europe and at a global level, Turkey's economy also will slow. The 2008 budget estimates GDP growth of 5.5%. Private economists already have lowered their 2008 estimates to between 4 and 5%. ¶4. (C) Turkey depends on imported food, energy and metals, all of which are at record price levels. Oil prices soared 80% in 2007; food prices globally increased 50%. Turkey imports 85-90% of its energy ($28 billion in 2007) and a large amount of its food ($3 billion in 2007). It is one of the world's largest gold importers (around 200 tons, worth $3 billion last year). Even with the high Lira, Turkey is importing inflationary pressures at these prices, and expanding its current account deficit. The pricetag for its energy bill is particularly large and important. Every $1 increase in the price of oil increases Turkey's current account deficit by $350 million. During the recent Iranian gas supply cutoff, Turkey was paying an additional $600,000 per day to purchase high-priced liquefied natural gas. Emerging market analysts say that high current account deficit countries are the most exposed to investor re-pricing of risk. ¶5. (C) The Turkish Lira gained 19% against the dollar in 2007 and private analysts estimate it is anywhere from 10 to 40% overvalued. The high Lira has both positive and negative effects. It reduces inflation and the cost of imports. The high Lira and very high real interest rates have made Turkey one of the most attractive markets for the carry trade and drawn in significant foreign investment, albeit short-term. On the negative side, the high Lira reduces exports, and encourages imports and borrowing in foreign currency (the Turkish private sector borrowed $51 billion in foreign currency last year, most of which is unhedged). The high foreign investor interest in Turkish instruments and high private sector borrowing make exchange rate volatility much more likely, and reduce the Central Bank's (CBRT's) ability to control the exchange rate in the event of a crisis. Turkey's Loose Economic Anchors -------------- ¶6. (C) Since 2002, Turkey's economy has been anchored by its IMF program, its EU accession program, privatization, structural reforms, the CBRT's anti-inflation program, and the government's strict fiscal discipline. The privatization anchor remains firmly in place, but all the other anchors were loosened in 2007. The value of these anchors increases as the global credit crunch deepens, but it is not yet clear what the government plans to do on other fronts. ¶7. (C) The IMF program's seventh review is now in its 17th week, with continuing expectations that it will be closed "soon." Neither the GOT nor the IMF Mission seem to have a firm idea what Turkey's relations with the IMF will look like after the current program expires in May. The Prime Minister has publicly rejected cutting off relations with the IMF, but has not indicated what kind of program he wants. Treasury Minister Simsek told us that the government wanted a continuing relationship with the IMF, but "not if they ask too much." The IMF has been important to Turkey not because it provides low-cost funding, as Prime Minister Erdogan recently suggested, but because its stamp of approval mattered to investors looking for assurance that the reform process would continue. It is not clear if an "IMF-Lite" follow-on program later this year will offer investors the same assurance. ¶8. (C) Turkey's EU accession process continues at a technical level (septel),but both Turks and Europeans have grown pessimistic about Turkey's prospects for actually entering the EU. The boom in foreign investment in Turkey began just as Turkey's accession negotiations started. Two-thirds of the foreign investment in Turkey has come from the EU. A sustained, negative perception of its EU accession chances could reduce Turkey's attractiveness to EU investors, particularly for the greenfield investment that Turkey most wants. ¶9. (C) The CBRT's credibility was damaged last year when it began cutting interest rates (from 17.50% to 15.75%) even though inflation was 8.4%, double its 4% target. This year, the financial sector expects inflation of around 6.5%, again well above the 4% target. The government's recent announcement that the CBRT will move to Istanbul, apparently over the objections of the independent central bank, has further undermined the CBRT's credibility and called its independence into question. ¶10. (C) After five years of exceptional fiscal control, the AKP loosened spending substantially before the July 2007 elections. Non-interest expenditures soared 25% in the first half. Agricultural support payments in the first half of 2007 were over 50% higher than in 2006, and capital expenditures were 40% higher. The government introduced sectoral VAT cuts despite committing to the IMF not to do so. It re-imposed fiscal discipline right after the elections, but the damage was done. The government missed its 2007 primary fiscal surplus (PFS) target by nearly 2.5% of GDP (4.1% versus a 6.5% target). This year, even with its usual austerity, the government will struggle to meet its lower, 5.5% PFS target due to the slowdown in growth. Investors and the IMF wrote off last year's relatively poor fiscal performance to election spending. If the government has problems again this year, they may conclude that the government is willing to subordinate fiscal discipline to achieving its political objectives. The Structural Reform Agenda is on Slow Track -------------- -- ¶11. (C) There were high expectations that the AKP government would use its post-election honeymoon period to move forward on structural reforms, particularly the long-delayed Social Security reform and a package on labor markets. But the government took no action on its economic agenda during its first 90 days. It delayed introducing the revised Social Security reform package (already drafted before the elections and the highest priority on the structural reform agenda) until the 95th day, and then failed to impose party discipline to pass it. (In contrast, the government rammed through the Nuclear Power law in just two days over vociferous opposition on a party-line vote.) Five months into the new government, the Social Security packet still has not been voted out of committee, and the government has not submitted any other structural reform legislation to the Parliament. ¶12. (C) There are several reasons why the new Erdogan government is moving slowly on the structural reform agenda. The new economic "team" is not working together yet. Its economic policies are fragmented and decision-making appears to be very stove-piped up to the Prime Minister, who seems focused on political, rather than economic, priorities, in particular the 2009 municipal elections. The structural reform agenda includes the most difficult, unpopular, expensive and complex reforms: social security, health, labor markets, the unregistered economy and tax administration. Seeing little political gain in rushing forward with any of these, the government is slow-rolling these packages forward, and engaging with labor and business groups about the details before passing them. Comment: A Danger of Complacency -------------- ¶13. (C) Twice in the past ten days, CBRT President Yilmaz indicated that his major fear was a foreign investor exodus from Turkish markets. No one knows for sure what might trigger investors to head for the door. They might decide to pull out of emerging markets generally, or just out of countries with high current account deficits, or just out of Turkey. The dangers this year include that a GOT very focused on domestic politics will get complacent about the tattered state of Turkey's economic anchors, and/or underestimate how skittish investors have become. It will be too late to do anything if and when an exodus starts. End comment. Visit Ankara's Classified Web Site at http://www.intelink.sgov.gov/wiki/Portal:Turk ey WILSON