Turkey is set to hold a referendum next month that may change the entire political landscape, with knock-on effects for the economy and investors.

If the ‘Yes’ vote prevails in the upcoming popular vote, then the country will move to an executive presidential system, which critics claim will mean the “one-man rule” of President Recep Tayyip Erdogan without proper checks and balances. The continuing slide towards authoritarianism would deter foreign investors and stunt economic growth.

The government’s counter argument to all this is that once the executive presidency is established Turkey will never go back to those bad old days of weak coalition governments and feeble economic growth. The executive presidency will bring more stability, a stronger economy and more foreign investment, says the country’s ruling AKP party.

Turbulent years

Stability – strong one-party rule – was key to Turkey’s economic growth from 2002, when the AKP came to power, up until 2015.

A booming economy, strong one-party rule, good relations with the EU, and the favourable global economic/financial environment all boosted investor and consumer confidence in the first years of the AKP rule, helping Erdogan win consecutive elections with an ever increasing share in the votes. Turkey’s GDP growth averaged 6% between 2002 and 2012.

However, growth has been disappointing in recent years. The economy even shrank by 1.8% y/y in Q3, in the first contraction in seven years.

The IMF warned in February that “Turkish growth is projected to be below potential in 2016 and 2017”. The fund estimated that that the dramatic decline in foreign tourist arrivals took a percentage point of GDP from the country's economic growth last year. The fund expects Turkey’s economy to expand at just 2.9% this year and at 3.3% in 2018, after growth of 2.7% in 2016.

There are some promising signs. Confidence in the economy rose in February, recovering from a near-seven-year low in the previous month. Industrial output expanded for the fourth straight month in January. But they may be blighted by the political turbulence.

“The political focus on transitioning to a presidential system; renewed questions over the future of EU-Turkey relations; and the tense security situation in the southeast and conflicts in neighbouring countries are expected to prolong the uncertainty, keeping domestic demand subdued,” the IMF said.

Investors' darling

The stable political outlook and vibrant economy also made Turkey the darling of foreign investors in the noughties. FDI inflows surged to $22bn in 2007 from only $1bn in 2002.

But, last year's coup attempt, geopolitical tensions and domestic political noise have now scared foreign investors. Investors, especially international investors, anxiously watched as the government seized hundreds of companies for their alleged links to the coup plotters.

Foreign direct investments declined to $12.2bn last year, financing just 38% of the country’s current account deficit of $32.6bn.  Portfolio inflows rose to $38bn in 2012 from $1.5bn a decade ago, but they declined to $7.8bn last year.

Over the past five years M&A activity has also suffered. There were 331 deals in 2012 with a total value of €16.6bn, but last year there were only 183 transactions worth €12.5bn, according to data from the Emerging Europe M&A report published by law firm CMS and research company EMIS. However, Turkey still remained one of the most important M&A markets in the Central and Eastern Europe.

Reflecting investors’ worries, the currency lost 17% of its value last year against the dollar and it has fallen by another 6% since the start of the year. Inflation, propelled by the weaker currency, hit double digits in February for the first time in five years. The central bank believes inflation will start to fall in the second half of this year because of its tight monetary stance. But analysts do not appear to share the bank’s optimism: end-year inflation expectations rose 9.08% in March from 8.87% in February.

Wait and see

Investors are now firmly in a wait-and-see mode. The government is trying to convince them that the referendum will remove a major political uncertainty and then it will focus on long-delayed reforms to unleash the country’s economic potential and to address some of the chronic problems such as inflation and the current account deficit.

If the AKP emerges from the referendum even stronger, many investors will probably think this would mean “years of stability”, maybe for another 10 years.  “There is nobody within and outside the AKP who could challenge Erdogan given his popularity, charisma and grasp on power,” wrote Wolfgango Piccoli at Teneo Intelligence in an emailed note on March 12.

But investors may be more worried, at least in the short term, by the turbulent political environment and in particular the ongoing row with the European Union caused by the AKP’s referendum campaign among Turkish migrants there.

Ankara reacted angrily when Germany and the Netherlands barred Turkish ministers from attending pro-Erdogan rallies in their cities, triggering an unprecedented diplomatic spat. Turkey this week announced a series of sanctions against the Dutch government and again threatened to scrap a key migrant deal between Ankara and Brussels that has helped Europe reduce the number of illegal migrants trying to reach the continent.

Some analysts argue that the AKP is deliberately stoking this row to boost its support. Before the diplomatic crisis, some polls had suggested that the referendum would be a close call. According to most public opinion surveys, 20% of potential voters were still undecided. The tensions with European countries could now increase President Tayyip Erdogan’s popularity with Turkey’s nationalist voters and boost his image of a strong leader standing against the West.

“The still escalating political crisis between Turkey and the Netherlands has reinforced concerns that Erdogan and the ruling AKP are prepared to seek short-term domestic political gains at the cost of severe damage to the country’s long-term commercial, economic and political interests,” wrote Piccoli.

Upside, downside

If the AKP fails to win the referendum some observers think the ruling party would then call snap elections this year, which means more uncertainty, though they would likely win a crushing majority.

“A ‘No’ vote would represent a humiliating but not a fatal defeat for Erdogan’s standing. Nevertheless, it would trigger a phase with deeper uncertainty as a cabinet reshuffle and, most importantly, a snap parliamentary election would likely be on the agenda,” according to Piccoli.

If it wins the referendum – the most likely outcome – the AKP’s immediate task will be to convince investors that it will create a better investment climate and that respect for property rights and the rule of law will not be compromised. If the AKP manages to combine political stability with economic reforms then FDI may start to pour into the country again, the stock exchange could rally, and the currency would stabilise.

Defying the political uncertainties and the gloomy economic outlook, a stock exchange rally already started in December. The main index, BIST-100, hit a 25-month high of 91,045 in early March, though a mysterious single investor, known as “the Dude”, is reportedly responsible for some of the large moves in Turkish stocks. The index has surged more than 14% this year.

The M&A deals announced in Turkey over the past two months may also be signalling that foreign investors are betting on an AKP victory in the April 16 referendum and their confidence in the Turkish economy has not died away yet.

Spain’s second biggest lender BBVA on February 21 agreed to acquire an additional 9.95% of Turkish lender Garanti Bankasi from Dogus Group for TRY 3.32bn (€859mn). In March, VIP Turkey Enerji, a subsidiary of Swiss-based Vitol Investment Partnership, bought Austrian oil group OMV’s Petrol Ofisi, Turkey’s leading fuel retailer. And also in March, Qatar’s Mayhoola signed a deal to acquire an additional 12% stake in Boyner, a retail and textile company.

All in all, investors face a rocky ride until the referendum vote, and this uncertainty would persist if Erdogan then called an early election.

“Risks have increased markedly over the last 3–4 years. Turkey now faces a period of lacklustre growth and continued threats to its economic and political outlook”, SEB said in a February report. But, the bank’s analysts argue, the government will, over time, renew its focus on macroeconomic reforms designed to increase domestic savings and investment and improve the business climate. Nevertheless, “volatility will continue to define the economy and markets for the foreseeable future, presenting both upside and downside opportunities and risks”.