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

As 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, there is a need to take stock. The unrest in the country raises question marks. What to make
of it all?
IHS, 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 June 15 and 16 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 epicenter of
protests, on June 15. 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 June 15 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 June 15 and 16.

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: June 3, 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
the protesters. Erdoğan's meetings with representatives of the Taksim
Solidarity movement, and announcement on June 14 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 destabilizing 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 June 14, 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 interventions. 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 stabilize 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 point, 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 realized by
mid-August at the earliest. The push of privatization 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.