A global geo-political intelligence firm gives its take on what to make of Turkey’s political turmoil.

Further unrest continues in Turkey, a country that has been seen in recent years as one of the most promising emerging market nations – and a potential wealth management growth story. Last autumn, this publication went to Turkey to explore the potential for a wealth management market in the country. Clearly, however, the unrest in the country raises question marks. What to make of it all? HIS, a global provider of geo-political intelligence for firms, gives its assessment on what is going on. The views expressed here are those of the company.

Mass rallies were held in Ankara and Istanbul on 15 and 16 June in support of Turkish Prime Minister Recep Tayyip Erdoğan. It has been reported by local media news outlets that the over 100,000 supporters attended both rallies. In preparation for the Istanbul rally, municipal authorities cleared Gezi Park, the epicentre of protests, on 15 June. Taksim Square, adjacent to the park, has also been cleared by police and then blocked off to prevent further infiltration by protesters. The Bosphorus bridge was blocked by police on 15 June to prevent protesters from gathering near Taksim Square. Despite these measures, protests continued in nearby areas of Istanbul, accompanied by fighting with the police, on 15 and 16 June.

A split environment

Turkey has witnessed 18 days of anti-government protests, initially sparked by plans to redevelop Gezi Park into a shopping mall (see Turkey: 3 June 2013: Anti-authoritarian protests proliferate across Turkey). However, Gezi Park has served as a catalyst for growing anti-government sentiment as secularists, ultra-nationalists, trade-unionists, environmentalists, and religious and ethnic minorities have all joined to demonstrate against what they perceive as Erdoğan's authoritarianism.

Erdoğan’s continued defiance and hostile attitude towards the protesters, combined with a heavy-handed approach by police, has served to exacerbate the situation. Conciliatory remarks by deputy prime minister Bulent Arinc and president Abdullah Gul have proved unsuccessful in assuaging the concerns of the protesters. Erdoğan's meetings with representatives of the Taksim Solidarity movement, and announcement on 14 June that the Gezi Park redevelopment has been suspended pending a court ruling, were also insufficient. The rhetoric used by Erdoğan at the rallies over the weekend highlights the growing social divide and hostility of the discourse that is preventing the political engagement needed to bring an end to the protests.

One of the main drivers of the protests has been the increasingly conservative Islamic social policies being passed by parliament. However, Erdoğan's handling of the protests has increasingly made him the primary target of the protesters. This has opened divisions with the ruling Justice and Development Party (Adalet ve Kalkınma Partisi: AKP), raising the risk of a split. If a breakaway party was to form, it would be most likely headed by serving President Gul. However, this scenario remains unlikely as long as Erdoğan's approval ratings are high; current polls show that he retains approval of about 60 per cent countrywide.

Another potential political implication of the country-wide protests is the risk of a breakdown in the ongoing peace process with the militant Kurdistan Workers Party (Partiya Karkerên Kurdistan: PKK), as the political capital Erdoğan had accrued prior to the outbreak of protests may have been lost. If support for Erdoğan drops in the next six months, as a result of his handling of the protests, he may not make the concessions to the Kurds that are mandated by the peace process, fearing he will lose the key nationalist vote ahead of a busy election schedule in 2014-2015.

Economic implications

The economic implications will also have a bearing on Erdoğan's popularity since economic stability has been one of the foundations of his electoral success. On the economic front, the greatest immediate concern is what the political troubles will do to the net flow of foreign portfolio investment.

Central Bank of the Republic of Turkey governor Erdem Başçı last week estimated that from the beginning of May through to mid-June, $7.9 to $8.0 billion has flowed out of Turkish markets. Only about one-third of this total, he estimated, was due to the rise in political instability. The rest was primarily a result of shifting global sentiment, itself triggered by the actions of the US Federal Bank.

Although Başçı claims it has not yet caused a major problem, continued political instability will no doubt exacerbate this net outflow of portfolio investment as long as it continues. This possibility is a primary reason why IHS Global Insight has disagreed with Fitch's and Moody's recent elevation of Turkey's sovereign risk ratings to investment grade and remains fairly bearish on banking sector risks. The fact that the country relies so heavily upon "hot" portfolio investment inflows to finance its still dangerously large current account deficit leaves the country extremely vulnerable to the kinds of shocks it is experiencing right now.

Turkish banks have become particularly vulnerable to changing investor sentiment through their increasing reliance on non-deposit foreign funding which, in spite of a recent increase in bond placements, remains dominated by short-term syndicated loans. At the end of March foreign liabilities in the banking sector stood at $142 billion, or approximately 16 per cent of total funding – an elevated level. With a loan-to-deposit ratio above 100 per cent currently, such a funding profile creates significant roll-over risk for the local banking sector.

On the asset side, Turkish banks carry significant indirect foreign exchange risk emanating from the large outstanding stock of foreign exchange-denominated lending to Turkish corporations, which themselves have built up a significant negative net open foreign exchange position over the last several years. While foreign currency lending in Turkey is low by emerging Europe standards more broadly it is still significant at roughly 25 per cent of total loans. Around 40 per cent of loans to the corporate sector are denominated in foreign exchange.

However, assuming that the worst of the protests dissipate by the end of July, the short-term outflow of portfolio investment should not cause a destabilising current account or banking crisis. Though yields have risen over the past week, the country's investment-grade ratings by Fitch and Moody's does allow the country to take on new debts to meet short-term financing obligations. Its external debt levels are low enough so that it can undertake significant new borrowing without undue stress on its sovereign position. Additionally, the country has built up ample reserves – nearly $114 billion as of the end of April – with which it can finance shortages for limited periods.

Local banks' access to international financing meanwhile has shown resilience to recent external shocks with banks continuing to roll-over syndicated loans and obtain relatively low borrowing rates throughout the eurozone crisis. Furthermore, the IMF has recently noted that Turkish banks largely require corporations borrowing in foreign currency to have recourse to foreign exchange income, which should cushion these borrowers' resilience to foreign exchange movements and prevent a significant increase in non-performing loans.

The country’s strong reserve level also affords the CBRT room to defend against the fall of the lira. After pursuing an expansionary policy throughout the first part of 2013, the CBRT had already become more cautious in May with the shift of international investor sentiment. Given the onset of the political turbulence, the CBRT is actually becoming defensive. Already, the CBRT has taken steps to support the lira, meeting with success. As of 14 June, the lira/dollar rate was back to where it had been at the end of May.

Whatever it takes

The CBRT has promised further action as needed. Although he suggested it was an option that would be discussed, Başçı suggested that raising interest rates was not likely in the immediate future, instead preferring the Bank's other tools, such as the Reserve Options Mechanism, foreign-exchange offerings, and direct inverventions. However, should the protests continue, the CBRT may eventually be forced to operate in a more traditional way and actually raise rates to try to calm the markets and stabilise the lira. Such a development would in fact be welcomed from the standpoint of banking sector stability as it could serve to rein in the robust lending pace that has contributed to rising vulnerabilities in the system.

With a loss of investment inflows and a more defensive monetary policy, IHS Global Insight will be trimming its short-term economic growth forecast in our July revisions. From our current 2013 GDP growth rate of 3.8 per cent, the new outlook will likely be down by between 0.5 and 1.0 percentage points, depending on the events over the remainder of June. The second quarter growth rate will not be significantly altered given the events only began in June, but our second-half growth rates will be trimmed even though we assume the political protests die down by the middle of the third quarter, as it will take some time for investment and domestic demand to actually return.

Outlook

Erdoğan's reactions to events are largely driven by poll ratings, which partly explain his stance towards the protesters. There appears to be no indication that Erdoğan is willing to forge an agreement with representatives of the protesters. Parliamentary speaker Cemil Çiçek mooted the possibility of talks on the drafting of a new constitution, but again there has been no sign from Erdoğan that he is willing to negotiate on anything other than redevelopment of Gezi Park. The court ruling, for which no date has yet been given, may act to reignite the protests. The potential for a split in the ruling party has increased as a result of the protests, but the potential for a split will largely depend on Erdoğan's poll ratings in the coming months.

IHS Global Insight anticipates that the economic implications of continued large-scale protests are likely to be realised by mid-August at the earliest. The push of privatisation will once again be undermined by political uncertainty. With capital inflows growing somewhat slower than we have previously projected, available financing for stronger domestic demand gains will be lower, thus dampening growth rates throughout the medium term. With more limited domestic demand gains, the upward pressure on the current account deficit will be lessened, though we do not expect that the gap will actually fall to comfortable levels in any scenario. While the current account deficit would be slightly lower given the new medium-term political assumptions, the fiscal deficit will be larger. In the short term, government social spending and infrastructure development will be likely to increase as the AKP attempts to soothe popular opinion. In the longer term, with the AKP likely to dissolve into greater factionalism, the ability to restrict spending will be compromised.