The imminent departure of Turkish Prime Minister Ahmet Davutoglu, together potentially with key cabinet economic reformers, has rattled Turkish markets. Stocks fell, the lira lost value, and bond yields rose as wary foreign investors await the formation of the new cabinet for clues on future economic policy direction.
Their questions are unlikely to be fully answered when President Recep Tayyip Erdogan’s ruling Justice and Development Party (AKP) holds an extraordinary congress on May 22 to pick a new leader who will also become the new prime minister.
Nobody expects turmoil within the AKP or rebellion against Erdogan who controls the entire party apparatus. Even the humiliated Davutoglu vowed to remain loyal to Erdogan.
It is widely believed that “Erdogan the absolutist” has already hand-picked a name to succeed Davutoglu and delegates will only rubber stamp his plans at the showcase congress. The name of the candidate that will replace outgoing Davutoglu may be announced at a press conference on May 19 ahead of the congress.
But investors will probably have to wait a bit longer to find out whether market-friendly ex-investment banker deputy premier Mehmet Simsek will keep his post as economy tsar.
A pliant prime minister
Among those tipped as potential candidates to replace the outgoing premier are Transport Minister Binali Yildirim, who is Erdogan’s right-hand man, Energy Minister Berat Albayrak, who is the president's 38-year old son in law, deputy premier Numan Kurtulmus and Justice Minister Bekir Bozdag.
Yildirim’s name has surfaced as the most likely replacement for Davutoglu. “The name and skill set of the next PM matters little, for he will act as ‘chief of staff’ for Erdogan who by firing Davutoglu demoted the cabinet to a secretariat”, Atilla Yesilada, GlobalSource Partners Turkey analyst, tells bneIntelliNews.
The immediate task of the new prime minister will be to push for constitutional amendments that will give more executive powers to Erdogan. He argues - and he is right – that Turkey is already operating under a de facto presidential system, and constitutional reforms would only formalise the change.
But it is difficult for the AKP to pass the required amendments at the national assembly, given the parliamentary arithmetic, so Erdogan may find early elections too tempting, according to Yesilada.
Though it regained the parliamentary majority in the November elections with 317 seats, the AKP failed to secure enough seats – 330 in the 550-seat parliament – to allow it to hold a referendum on the new constitution. If it had won 367 seats it would have been able to re-write the constitution by itself without a referendum. The ruling party therefore needs support from the opposition party but this backing will not probably come.
Erdogan’s top aides have repeatedly dismissed speculations of an early poll, saying general elections will be held in 2019 as planned, but events within the HDP and MHP parties may change the electoral arithmetic.
“With MHP in turmoil and HDP possibly weakened by the upcoming arrest of key deputies, AKP strategists believe a two-party parliament with AKP holding a constitutional majority is a strong possibility,” says Yesilada.
On May 17, parliament approved a government-sponsored bill that would lift the immunity of lawmakers. The bill, believed to target some members of the pro-Kurdish party HDP, including its co-chair Selahattin Demirtas, could pave the way for the trial of several HDP lawmakers on terror-related charges.
In a preliminary vote, the controversial bill was backed by 348 lawmakers in the 550-seat parliament. That opens the way for a second and final vote on May 20, when 330 will be needed to refer the issue to a referendum. In case the bill is supported by 367 lawmakers, the bill will be passed without holding a referendum.
Here, the key player is the nationalist opposition party MHP. There were speculations that MHP’s leader Devlet Bahceli could seek to form a coalition government with the AKP to avoid the threat of new elections and the potential disintegration of his party, which is in turmoil over whether to replace him as leader. But, last week Bahceli came out to put an end to all this speculations, rejecting any support for Erdogan’s presidential ambitions.
Given the impasse at parliament, the only solution left for Erdogan to achieve his goal seems to call early elections that may lead to another round of political uncertainty.
EU-Turkey migrant deal falters
Yesilada is rather pessimistic about the future. According to him, the government will tighten the screws on opponents, it will refuse to make peace with the Kurds and relations with the EU and US will deteriorate.
In recent weeks, concerns have been rising in European capitals that the EU’s key migrant deal with Turkey might collapse because of the departure of Davutoglu and Ankara’s resistance to calls from the EU to change its anti-terror laws, one of the key conditions Turkey must meet for the EU to relax visa requirements for Turkish nationals. Visa-free travel is one of the incentives Ankara received when signing the migrant deal in March.
Erdogan says Turkey needs these laws to counter the threats posed by the Kurdistan Workers’ Party (PKK), Islamic State and other radical groups. But his critics claim that Erdogan and the government use the draconian anti-terror measures to silence opponents and to repress the media.
European Commission President Jean-Claude Juncker’s warning was clear: The migrant deal will collapse if Ankara fails to fulfil its commitments. “We fixed criteria for visa liberalisation, there are 72 of them and number 65 says that the Turkish government must review the anti-terror law,” Juncker said on May 12.
Under the deal, Ankara had agreed to take back all illegal asylum seekers from Greece. In return, the EU promised fast-track membership talks and easing of visa rules for Turkish citizens by June. Brussels also pledged €6bn in financial aid until 2018.
But nothing moves Erdogan. In the face of pressure from the EU, Turkey’s most powerful man defiantly told Europe that: “We'll go our way, you go yours…Go make your agreement with whoever you can”.
Given Erdogan’s tough approach, apparently the EU is now just doing that: looking for an alternative. German newspaper Bild reported that the European Union is working on a plan B to stem the influx of refugees in case the deal with Turkey fails. Brussels may consider cutting off the planned €6bn of aid, and instead allocate the money to Greece, according to the daily.
The German newspaper cited an unnamed EU minister as saying that if the arrangement fails, arrangements would be put in place to keep asylum-seekers on the Greek islands, suspend ferry traffic to the mainland and deport failed asylum-seekers directly from the islands back to their home countries.
Turkey’s markets have had a bumpy ride since the resignation of Davutoglu. The lira lost 2% of its value against the dollar between May 5, when Davutoglu announced he is stepping down, and May 18. Local investors that had been accumulating FX took profit when the lira started to depreciate, preventing the lira from further losing its value.
Turkish stocks fell 2.1% over the same period. The uncertainties triggered by Davutoglu’s exit led to an outflow of $298mn from the equity market and another $161mn from the bond market last week. Yield on the two-year benchmark bond increased from 9.51% on May 5 to 9.61% on May 18. The Treasury’s borrowing cost has increased: The authority on May 17 sold five-year bonds at an annual compound yield of 10.02%, up from 9.56% at the auction the Treasury held for securities with a similar maturity in April.
Commerzbank, which expects early elections over the coming year, raised its near-term USD-TRY forecast from 2.90 to 3, and its end-2016 forecast from 3.00 to 3.25.
“The uncertainty which this transition [Davutoglu’s departure] will induce will likely squash investment intentions in the business sector. We had been relatively bullish about investment prospects when AKP won a clear majority in November – but this outlook has now been reversed,” Commerzbank said.
For investors, the crucial questions are whether Simsek will keep his post in the new cabinet and whether the central bank will be able to retain its independence when it is watched over by a government filled with Erdogan’s close allies. Investors are concerned that the quality of economic policy making could deteriorate and the central bank may come under further pressure to cut its interest rates to boost economic growth, something Erdogan has long called for. It is speculated that Energy Minister Berat Albayrak, the president’s son-in-law, may become the new economy tsar.
“In an environment where policy is geared to winning ballots, populism will run rampant” Yesilada told bneIntelliNews. He expects the budget deficit to reach 2.5% of GDP, compared to a target of 1.3%, while “tremendous pressure” will be exerted on the central bank to reduce rates to stimulate the economy. Proving Yesilada’s concerns, Erdogan's chief economic adviser Bulent Gedikli said on May 18 that the bank should implement significant rate cuts instead of the tiny 25bps steps.
Morgan Stanley sees three main risks: Rising early elections and/or referendum risk – possibly in 4Q16 or 1Q17, deteriorating relations with the West, and change in the current economy management.
“Following these changes, Turkey has entered a period of rising political risk again, at least for the next 6-8 months, in our view. This is also likely to have some implications for the macro and financial variable,” the investment bank wrote in a note on May 6, adding that the most imminent one is likely to be a change in the central bank’s monetary policy stance. Morgan Stanley expects another 50bps cut in the upper bound of the interest rate corridor at the bank’s next Monetary Committee Meeting on May 24.
The timing of Davutoglu’s departure and a possible cabinet reshuffle couldn’t have been worse: Turkey’s $720mn economy is facing serious challenges: Geopolitical and domestic political risks are hurting the country’s tourism industry that provides hard-currency, financing the country’s declining but still large current account deficit. Inflation is falling but remains well above the government target of 5%. Unemployment has been stuck above 10%.
All this is happening at a time when officials from the US Fed are suggesting another rate hike as soon as next quarter, which could mean elevated volatility for emerging markets.
Despite local and international challenges, Turkey’s new economic management team may choose to focus only on economic growth just to please Erdogan and may ignore the headwinds.
“The markets and economy at large are yet to grasp the severity of the political crisis Turkey is about to enter. The ramifications will therefore be shocking,” Yesilada says.