Turkey Economy: IMF Jitters Affect Lira

Buoyant business confidence in Turkey has been reflected over the past 12 months in the robust exchange rate and in the strong performance of the Istanbul Stock Exchange (ISE). Underpinning the positive sentiment has been the EU's decision to start accession talks with Turkey and, crucially, the prospect of a new stand-by credit agreement with the IMF. However, the atmosphere has changed in recent weeks as doubts have started to creep in about whether an IMF deal can be concluded as quickly as was initially assumed. Additional concerns for the markets are the frostiness in Turkey's relations with the US and the sharp rise in US bond yields, which make Turkish lira assets less attractive. The Turkish lira started to slide in mid March, and the ISE index has fallen sharply from its peak at the end of February.

The outline of a new US$10bn three-year stand-by credit agreement for 2005-07 was made public after talks between the government and the IMF in December. The IMF is to lend Turkey US$10bn, to be divided into five instalments in 2005, four in 2006 and three in 2007. This will in effect reduce Turkey's net repayments to the IMF over the three-year period from about US$20bn to some US$10bn. About US$3.7bn-worth of the repayments that the government was due to make in 2006 are to be put back to 2007. Without this extension, Turkey would have had particularly heavy repayments to make in the year 2006.

The previous three-year stand-by accord expired in February with no new deal in place, however. The delay reflects slow progress on legislation concerning the tax administration, financial institutions and the social security system, which had been set as core conditions for approving the new loan. In addition, IMF officials have criticised government plans to broaden the scope of investment incentives. They suggested that this step might endanger the fiscal targets that are central to the IMF-backed policy programme.

The tax administration bill, which will set up a semi-autonomous tax administration within the Ministry of Finance, was reportedly being signed by ministers in February for submission to parliament, after going through several drafts. The government has struggled to find a formula satisfactory both to the IMF and to various groups of tax officials. The financial sector bill is intended to improve the inspection system and to bring the banking environment into line with EU norms and standards. It has had to be negotiated with the banks, the inspectorates and the regulatory agency, the Banking Regulation and Supervisory Board (BRSA). The inspection system and the question of how to deal with weak banks are understood to have been among the sticking points. The proposed social security legislation will bring the three existing social security schemes under one roof and separate the administration of pensions from health services. It will increase some premiums and retirement qualifications and may be followed by reductions in pensions in real terms. A related law on the proposed new comprehensive health insurance system--providing a minimal level of insurance for all in return for premium payments and, implicitly, user fees--is already in parliament. The transfer of Social Security Board (SSK) hospitals into the hands of the Ministry of Health went ahead in February despite protests from many interested parties.

Government officials at the end of March sought to play down fears of a prolonged delay in reaching an accord with the IMF. A minister of state, Ali Babacan, told CNN Turk television on March 23rd that the government is considering inviting IMF officials to visit the country in early April for further discussions in light of new economic data released since the original outline of the stand-by deal was agreed at the end of 2004. He said that all the conditions regarding new legislation should be met by mid-April.

Lira correction

If these government reassurances prove to be misplaced, pressure is likely to mount on the Turkish lira, which is already being affected by expectations of higher US interest rates. As of the end of 2004, the Turkish lira was about 4% stronger against the US currency than at the beginning of the year, and 4% weaker against the euro. The new Turkish lira, which was introduced at the beginning of the year with one new lira (YTL) equivalent to 1m old lira (TL), appreciated against both the dollar and the euro to reach about YTL1.28:US$1 and YTL1.69:[euro]1 at the end of February (compared with YTL1.34:US$1 and YTL1.82:[euro]1 at the end of 2004), with the Central Bank intervening in the open market on January 27th to prevent the lira from rising even more sharply.

The strength of the lira at the end of 2004 and in early 2005 was attributed to strong inflows of capital through the banking system and the bond and stock markets, in response to positive sentiment about EU membership, IMF relations and the new lira. By March 8th the lira had firmed to YTL1.25:US$1 and YTL1.66:[euro]1. This prompted the Central Bank to intervene in the foreign exchange market again on March 9th--the same day as it cut interest rates. By March 23rd, in response both to the Central Bank's moves and the shift in sentiment, the lira had eased down to YTL1.36:US$1 and YTL1.78:[euro]1

The Central Bank's trade-weighted CPI-based real effective exchange rate index stood at 155.5 points at the end of February. This is the highest figure ever recorded. It indicates that the lira was stronger in real terms at the end of February even than it was in January 2001--on the eve of devaluation and financial crisis--or in September 2003 and March 2004, occasions when the currency was about to correct sharply.

ISE cools

The price movements on the Istanbul Stock Exchange (ISE) are highly volatile and are often closely linked to political developments and the returns on government securities, particularly Treasury bills. From December the main ISE National-100 share price index rose rapidly from December onwards, driven by rising capital inflows from abroad. On December 17th, the day the European Council agreed a date for the start of accession negotiations with Turkey, the index broke through the 24,000-point mark, and on the last day of trading in 2004 it closed at 24,972. This late surge brought the increase in the index during the course of 2004 up to 34% in lira terms-or 38% in US dollar terms.

The index continued to rise steeply in the first two months of 2005, notwithstanding some volatility in February owing to uncertainty in government-IMF relations and problems in the ruling Justice and Development Party (AKP). On February 28th, the index closed at a record 28,396 points. Thus during the first two months of 2004 share prices gained a further 14% in lira terms and even more in terms of major currencies. The average daily volume of trading in this period was also very high at US$937m, compared to US$593m for the whole of 2004. Likewise, the market capitalisation of the Istanbul bourse climbed to US$114bn at the end of February 2005 compared with US$98bn at the end of 2004 and US$69bn at the end of 2003. Only during the historic rally of late 1999 and early 2000 have the volumes of trading and market capitalisation ever been higher. The share of foreign investors in the free float reportedly rose to a record level of around 60% in February.

However in the first half of March the index fell sharply, and by March 23rd it had declined to about 24,311 as the doubts about the IMF accord started to mount and the effects of higher US yields made themselves felt.