Justin Vela in Istanbul -

As expected, the incumbent AKP won the Turkish election on June 12. Although Prime Minister Recep Tayyip Erdogan failed to secure the overall majority he sought, he's still likely to push ahead with constitutional reform. Some worry this will take his eye off the economy.

Taking 49.9% of the vote, Erdogan's ruling Justice and Development Party (AKP) won 326 of the 550 seats in Turkey's parliament, enough to allow it to form a single party government. The PM had hoped to push the party's seat count to 367, which would have given him a two-thirds majority and allowed him to write a new constitution without having to go through a referendum.

AKP fell short though, with the main opposition party - the Republican People's Party (CHP) taking 26% of the vote, and the far-right Nationalist Movement Party (MHP) clinching 13%. However, the result still leaves the constitutional change very much on the cards, with AKP needing no more than 330 votes in parliament to put a rewritten constitution to a referendum. "We will embrace everyone, whether they voted for the AKP or not," Erdogan said in a victory speech on the night of the election. However, only time will tell how inclusive the writing of the new constitution will be, with Erdogan unlikely to struggle to find four additional MPs to support him.

The current constitution was written following a 1980 military coup and, as a referendum in September illustrated, the majority of Turks believe it needs to be amended. However, the need for a complete rewrite is questioned by some. Now the election is over, the coming months are likely to be dominated by that debate, with Erdogan's apparent wish to turn Turkey towards a presidential system front and centre.

"Even within the AKP there are quite a few who are opposed to the idea," says Sahin Alpay, a columnist at the pro-government Zaman newspaper. "Then if you ask commentators and intellectuals, an overwhelming majority is against. I have seen some surveys that show maybe there is some 50% support among the public - there's a lot of support for whatever Erdogan thinks. Myself and many others would raise hell over it."

Such opposition is only likely to be encouraged by Erdogan's failure to secure the overall majority in the parliament. Whilst the government may still try to push its will through the house, the country's numerous competing groups - ranging from secularists to Islamists to Kurds - will all insist on having their say in the process.

"In our view," says Citigroup analyst Ilker Domac, "the AKP remains resolute in pressing ahead with its ambition to rewrite the Constitution. The fact that AKP fell short of gaining 330 seats doesn't necessarily imply that the party will pursue a more inclusive approach in the constitutional reform process, as gaining the support of an additional 4 deputies may not prove to be too difficult. Consequently, whether the AKP will pursue a more conciliatory approach in this process will have important implications for political stability. "

However, whilst expectation around the country is for political reform to dominate the agenda in the coming months, analysts worry that the economy needs more attention. Whilst the markets are generally happy to see the AKP - which is credited with ushering in a period of political stability and economic growth - remain in power, there is also concern.

Turkey's story has changed this year. Until 2010 the country celebrated growth of around 9% of GDP per year under the AKP - second only to China among the G20; today analysts worry that a messy post-election period will distract the government from focusing on an economy showing alarming signs of overheating.

Economic challenge

In the face of poorly performing assets this year, the markets are keen to see attention paid in particular to fiscal and monetary policy in order to deal with signs of overheating. Inflation is on the rise and analysts at Danske Bank worry the current account deficit could hit double figures this year.

In May, headline inflation rose the most since January 2002, coming in at 7.17% year-on-year, up from 4.26% in April, according to TurkStat, but the Central Bank of the Republic of Turkey's is still forecasting full year inflation will come in at 5.5%. The current account deficit, which is forecast by the government to widen this year to $39.3bn, or 5.4% of gross domestic product due to domestic demand for energy and imported consumer goods is pointed to by rating agencies such as Moody's as a factor keeping the country below investment grade status.

For months investors have wanted the central bank to change its policy of keeping interest rates low while hiking bank reserve requirements, which is largely seen as ineffective. Critics say the policy does not take into account the expected year-end rise in inflation, nor sufficiently curb lending for credit happy Turks.

Danske Bank suggests loan growth is still running at a stunning annual pace of around 35%. Once the election dust has settled then, attention will move to the central bank's June 23 meeting to see if the policy is adjusted. In a recent release, Domac suggests it's likely "to take certain measures to alleviate these concerns," which most likely means policy rate hikes in the second half of the year.

With Turkey's growth model overly reliant on the central bank's stockpile of foreign reserves, Domac says, any new policy should focus on permanently raising the savings rate to help finance growth. Structural reforms are also necessary to increase the country's productivity and competitiveness.

"Looking ahead," the Citigroup analyst frets, "we believe that the jury is still out on the political will of the new AKP government to press ahead with a comprehensive reform package aimed at bolstering macroeconomic stability and addressing Turkey's structural weaknesses. In our view, this will be crucial for improving the secular outlook for Turkish assets, as the country needs a new credible story to reach investment-grade status and beyond."