Turkey is surrounded by conflict and crisis-ridden countries, but the biggest element of risk comes from within. Sofia Lotto Persio looks at the challenges ahead of the parliamentary election.

Greek economic crisis, Syria conflict and, just across the Black Sea, unrest in Ukraine: Turkey’s borders are surrounded by high-risk situations. But with the June 7 parliamentary elections looming, what worries investors and analysts is not so much what happens outside of the country’s borders, but within them.

In the past few months, tensions between the central bank and government representatives, including President Recep Tayyip Erdogan, have raised concerns in the markets over the bank’s independence. In particular, Erdogan lashed out at the central bank for not lowering the interest rate enough which, he believes, would ease inflation – a strategy analysts consider to be unorthodox to say the least.

A country at risk?

The Turkish president is supposed to hold a largely ceremonial role, but his frequent interjections in policy-making have prompted members of his own AK Party to warn him over meddling with the government’s work. Erdogan’s long-term goal is to change the constitution to move from a parliamentary to a presidential system of government. His party would need a two-third majority in parliament to amend the constitution without calling a referendum.

“My understanding is that there are a number of members within the AK Party who are not hugely enthusiastic about the prospect of a potential shift towards the presidential system. The parliament has always had the most say in Turkish policy so in a way they might be taking a stand that they would want to maintain that role,” explains Maya Senussi, senior economist for Turkey, Middle East and Africa at Roubini Global Economics.

Analysts’ evaluation of the country’s political risk is negatively affected by these tensions. Asked to give it a value, Senussi tells GTR: “Moderate to high. Two years ago I would have probably said more moderate than high.”

Phoenix Kalen, analyst at Société Générale, adds: “Political risk is likely to remain quite elevated until after the elections, when we may have more clarity on the shape of governance and direction of political leadership.

“It is deeply troubling that there appear to be elements within the country attempting to alter the course of orthodox economic policy by shifting its direction toward unorthodoxy, while undermining the credibility and independence of the central bank.”
Despite the AK Party being tipped for winning the election, the chances of it getting an absolute two-third majority of votes are quite slim. “Forecasts need to be taken with a grain of salt, but I don’t think the party can muster 330 deputies. That would imply that they won’t be able to unilaterally make the constitutional changes they would like. At the same time, it suggests some risks of splintering down the line, and fragmentation,” Senussi says.

Impact on the economy

Despite the concern shown by analysts, banks seem relaxed as to how the political situation will affect the country’s economy. Muzaffer Aksoy, country manager and chief representative at Arab Banking Corporation, brushes off the political tension: “I don’t see the elections affecting the banking system because it seems like the current government will stay in power and this will show stability to us.”

“Political stability is important,” agrees Ahmet Suayb Gundogdu, Turkey representative at the International Islamic Trade Finance Corporation (ITFC), Islamic Development Bank Group, who also seems unperturbed about the upcoming elections: “We will wait for a result and to see what policy a new government will come up with. Compared to its neighbours, Turkey is very stable. In my opinion, this shows the resilience of the Turkish economy.”

Despite a dramatic drop in GDP growth from the previous year, Turkish GDP still rose by 2.9% in 2014. The World Bank forecasts a slight increase to 3.5% in 2015, though this is still below the 4% government target.

Earlier in the year, speculation over the US Federal Reserve raising interest rates strengthened the dollar, pushing down the value of the Turkish lira, increasing the cost of imports and the inflation rate. The central bank had to decide whether to stabilise the currency by raising interest rates or boosting growth by lowering them. After the central bank eventually cut short-term interest rates by a quarter percentage point at the end of February, a still dissatisfied Erdogan suggested that central bank governor Erdem Basci was “selling out the homeland” by keeping interest rates high. Following Erdogan’s remarks, the Turkish lira hit an all-time-low below 2.57 to the dollar. As GTR went to press, the lira had further tumbled to 2.68.

Since Erdogan’s clash with the central bank, foreigners’ net selling of Turkish equities and government debt has increased. According to central bank data reported by Reuters, since late January, foreign investors have pulled a net US$1.2bn from Turkish equities with overall holdings down US$9.8bn. Non-resident holdings of government domestic debt securities have had a net outflow of US$366bn with overall holdings dropping by US$5.7bn.

According to Kalen, the possibility of a shift towards more autocratic tendencies and exacerbating political tensions in the lead up to the elections will keep undermining investor confidence and weakening Turkish assets.

Turkish debt is one of the assets concerned. “The short-term nature of the FX debt is a concern because in any event of exchange rate volatility, that pushes up the value of the debt,” says Senussi.

“So far the whole figure is manageable, but if we were to see a domestic political or confidence crisis at a time when global risk sentiment and appetite for risk was low, that would trigger new movement in the lira and necessitate much tighter financing conditions within Turkey.”

This could lead to a fall in demand, potentially triggering a recession, followed by a rise in non-performing loans in the banking system.

Bankers like Aksoy are not worried: “The depreciation of the lira will not affect the Turkish banking system, because the Turkish banks are already hedged,” he says. Yet, according to Senussi, even if the banking system does not have an open FX position, the corporate sector to which it lends does, implying indirect risk to the banking sector in the event of further currency depreciation.
“Turkey has not had problems with attracting short-term finance, due to relatively high interest rates that compensate for some of the risk, but equally, investors are not prepared to lock in money for the long term,” says Senussi.

In an effort to help those corporates looking to export out of the country, the Multilateral Investment Guarantee Agency (MIGA), the political risk insurance and credit enhancement arm of the World Bank Group, announced on April 7 that it will help Turkish Eximbank provide medium and long-term funds to Turkish exporters, particularly SMEs.

“MIGA is providing guarantees of US$333mn to a syndicate of banks jointly led by Citibank and Norddeutsche Landesbank Girozentrale of Germany, against the risk of non-honoring of financial obligations by a state-owned enterprise on their 10-year loan facility to Turkey’s official export credit agency,” a MIGA statement says.

The guarantee is expected to support an export-led growth that has performed below the target set by the government and registered a year-on-year decline in the first months of 2015.

Only the election will tell

While the tensions between the government and central bank have recently relaxed, how long this period of grace will last remains unclear: “Overall, political tensions are still elevated. There will likely be continued pressure on the Turkish central bank to reduce interest rates before June to bolster economic growth and support popular sentiment,” says Kalen.

The composition of the economic team in the new government will be crucial to understand which direction the country will take in the coming year. “Many reformists will drop out of government due to the three terms limit and I’ll be watching for who will enter the new team. Whether that is going to be a pro-reform team or a pro-growth team, that would obviously raise the risk of an institutional crisis and the over-reach of the executive in monetary policy,” says Senussi.

According to Kalen, there are reasons to believe Turkey will show resilience throughout this potentially turbulent period. “Turkey has several key fundamental strengths, including its demographics, well-diversified trade linkages, and the robust macro-economic measures adopted over the past decade, which have boosted economic growth and improved living standards for the population,” she says, adding: “It is unfortunate that progress in economic development has slowed due to rising political risks. Without such political tensions, Turkey could be on a much higher growth trajectory.”

Islamic banking on the rise

As analysts look to the Turkish election to see what economic changes will derive from it, one certainty is that Islamic banking will keep rising: the government is providing the necessary support for the sector to expand from its current 6% market share to at least 10%. A bigger Islamic banking sector would better fit with President Erdogan’s desire to decrease interest rates, since the shariah-compliant system forbids the loaning of money, allowing the buying and selling of assets instead.

Explaining the recent wave of government support for Islamic finance, Muzaffer Aksoy, country manager and chief representative at Arab Banking Corporation says: “The government is conservative, so they’d like to see more Islamic banking in Turkey. It is also a commercially good decision, as there are possibilities for Islamic banking in our neighbouring market like the GCC.”

Ahmet Suayb Gundogdu, Turkey representative at the International Islamic Trade Finance Corporation (ITFC), Islamic Development Bank Group agrees: “From a commercial perspective, promoting Islamic banking is a good move. Turkey is very close to the GCC and the Mena region. Turkey, and Istanbul especially, is trying to become a financial hub, which is why it targets certain fragments of the financial markets and the closest one – the best one – is Islamic banking.”

According to Gundogdu, Islamic banking services can be very popular in Turkey: “Islamic finance is relatively safer [than traditional banking]. Many people do not want to use financial services because of the interest rates. Proper Islamic banking can be of great help to finance the real economy like trade and projects.”

Neither bankers are concerned with competition with the traditional banking sectors, agreeing the two can co-exist. “There is enough space for everybody. The banking system is growing,” says Aksoy.