Kivanc Dundar in Istanbul -

The Turkish economy is feeling the effects of the country’s escalating violence and political instability at a time when it should be benefiting from tumbling oil prices. The Turkish lira has already lost more than 20% of its value against the dollar this year, consumer confidence has hit rock bottom, unemployment hovers around 10%, exports are falling, the current account deficit – though declining – is still large, and inflation is stubbornly high at 7%.

Amid the current emerging market turbulence, Turkey is now seen as one of the most vulnerable to a mooted rate hike by the US Federal Reserve (now probably delayed until the new year) and the reversal of capital flows that would bring.

Rocked by increasing domestic civil unrest and under pressure from the Islamic State terrorist threat just over its border, Turkey desperately needs some political stability to reignite growth of the $800bn economy. But surveys suggest that the snap elections in November will produce yet another hung parliament, raising doubts about a return to high economic growth any time soon.

Reflecting investors’ perception of risks weighing on the economy, Turkey's five-year credit default swaps (CDS) by September 23 had almost doubled to 293bp from 184 basis points (bp) on January 1.

Amid the current political deadlock, the flare-up in violence in the Kurdish regions and the economic weakness, Turkey now heads toward elections in November, maybe the most important test for the Justice and Development Party (AKP) and President Recep Tayyip Erdogan since his party came to power in 2002.

Erdogan has clearly set his heart on regaining the parliamentary majority he lost in a surprise result in elections in July, which is part of his drive to transfer more executive power from the government to the presidency. However, that is impossible unless he controls parliament and he has pulled out all the stops to regain his majority in the snap elections to be held in November. Playing nationalist cards and liberally applying the anti-terrorist laws for political purposes against his opponents, the president has been pouring more oil on the flames.

And it is not working. Most polls suggest that under fair elections the AKP would not be able to secure enough votes to form a single party government. Only one survey commissioned by the AKP itself showed that support for Erdogan’s party had risen to 44.2% from 40% in June to regain the parliamentary majority it lost in June.

Structural problems

The ruling party AKP owes much of its past electoral victories to unprecedented economic growth, which averaged an impressive 5.5% between 2002 and 2011. The economy grew 9.4% in 2004, 8.4% in the following year, 9.2% in 2010 and 8.8% in 2011. But it now seems that Erdogan is paying the political cost of not delivering on the promise of more prosperity. In 2012 the economy grew by a mere 2.1%, picking up to 4.2% in 2013, but then it expanded by only 2.9% last year. The International Monetary Fund (IMF) forecasts GDP growth of 3.1% for 2015, but the central bank’s latest expectations survey puts the figure at just 2.9%.

A combination of domestic and international factors had contributed to the Turkish boom; the country had a stable, market-friendly and EU-oriented government. The international economic environment was also very favourable, supporting growth in emerging markets.

But the tide turned after the 2008 global financial crisis, while the political landscape changed in Turkey after June 2013 when the Gezi Park anti-government protests rocked the nation. This has been a toxic combination for Turkey, scaring away foreign investors that had once put so much trust in this rising economy.

Erdogan’s increasingly authoritarian tendencies, his tight grip over state institutions and media, politicisation of the judiciary, the corruption allegations in 2013 that targeted Erdogan’s inner circle, and the lack of reforms which should address the country’s chronic saving and current account deficit problems have all eroded investor confidence in Turkey, which has become a socially/politically deeply polarised nation over the past couple of years as a result.

For example, as an indicator of investors’ confidence in the economy, net portfolio inflows declined from $41bn in 2012 to $24bn in 2013, and further down to $20bn in 2014. It is this “hot money” that meets Turkey’s need for some $200mn a year to close the declining but still large current account deficit, which is hovering above 5% of GDP.

The falling amount of foreign investment is partly due ot the global economic woes that are affecting everyone, but the country’s failure to attract long-term investment is a failure that can be laid at Erdogan’s door for failing to put in place the policies and reforms that underpin this kind of investment.

Moreover, as a major importer of energy Turkey should be one of the few countries in the region that benefits from the collapse of oil prices, but the reform failure means the reverse is true.

The current account deficit widened 32% on year in July to $3.15bn (market consensus: $3.5bn) as exports fell by 16%. The 12-month rolling deficit increased to $45bn in July from $44.3bn in the previous month. Energy-dependent Turkey definitely benefits from low oil prices, but the weak export performance and weak currency has off set any gains made from paying less for fuel. Energy Minister Taner Yildiz admitted in late August that the depreciation of the lira cost Turkey a $4bn increase in the energy import bill since the beginning of this year.

In its medium-term programme, the government had predicted that the current account deficit would be 5.4% of GDP or $46bn, based on the assumption that average exchange rate would be TRY2.29 to the dollar this year. But the actual average rate was already TRY2.6523 as of September 21, with the lira trading above TRY3.0 to the dollar since early September. Moreover, a recent central bank survey showed that local economists see the rate at TRY3.0414 at the end of 2015.

There are no indications of a structural improvement in the current account deficit or in the availability of non-debt creating financing sources, said Fitch on September 18 when it affirmed Turkey’s investment grade at 'BBB-' with stable outlook.

Foreign investors spooked by the political uncertainty, surge in violence with Kurdish militants and a possible Fed hike are dumping Turkish equities and Turkish debt. The central bank reported an outflow of $474mn from Turkish equities and another $1.1bn outflow from government debt securities in July. The debt securities outflow amounted to $4.88bn in the first eight months of the year versus an inflow of $1.2bn a year ago, while outflows from the equities market was $368mn in the same period against an inflow of $2.1bn in January-July 2014. The result is a badly battered currency.

The Turkish lira is one of the worst performing among all emerging market currencies this year and the central bank's failure to respond effectively to the lira’s sharp depreciation has added to investors’ unease.

A weaker currency is supposed to lift the country’s exports and thus support local economic activity. But this is not happening because of weak demand from Turkey’s trading partners. Net exports’ contribution to GDP growth in the second quarter was -1.1 percentage points.

The weaker currency has also kept inflation stubbornly high. Despite falling oil prices, the annual inflation rate remains at 7.0%, eroding wages. The other culprit is food prices that rose by 1.3% on month in August, bringing the annual food inflation to 9.71%. The polling agency Gezi found out in August that 68.4% of the surveyed experience economic hardship. 

“Core inflation, currently at 7.7%, is also likely to trend higher for the remainder of the year, carrying the impact of the exchange rate pass-through,” said Deniz Invest, a local brokerage, in an emailed note in September.

Weaker growth expected in second half

Turkey's GDP grew by 3.8% y/y in the second quarter (market consensus: 3.45%), up from 2.5% on year in the first quarter, driven by consumption. The economy expanded 3.1% on year in the first half versus 6.3% in the year-earlier period. Households’ final consumption that accounted for more than 65% of GDP rose by 5.6% on year in the second quarter, up from 4.6% in the first, and private investments increased 2.1% in the first quarter rose by 11.4% in the second. Domestic demand was strong in the quarter, probably because consumers brought forward their purchases, for example car purchases, with the anticipation of the depreciation of currency and higher interest rates in the post-Fed rate hike environment.

In the second quarter, both consumer sentiment and business confident were relatively strong because the political uncertainty that emerged after the June elections was not in sight yet then. Leading indicators for July and August, however, suggest that industrial production might moderate in the second half of the year, while the overall economic activity is expected to slow in the coming months because of the political uncertainty that has pulled down consumer and business confidence. Moreover, exports are likely to remain weak in the remainder of the year, creating further downside risks to growth.

Full-blown economic crisis not expected

This year’s growth rate will be moderate at around 3%, not enough to reduce unemployment, inflation will remain high and above the official target of 5%, and the financial markets will stay volatile until and after the expected Fed hike. Debt rollover ratio has been over 100%, but the post-Fed hike world will be different for households, companies and banks. However, despite this unfavourable outlook, a full-blown economic crisis is not expected this year.

It's no surprise that there is a correlation between economic growth and AKP’s electoral success. Yet it's intriguing that even if the economy contracted in 2009 or expanded by a relatively mild 3.1% in the first half of 2015, the AKP’s share of the vote never fell below 38% and the gap with its closest rival Peoples’ Republican Party (CHP) remained wide. The CHP has received less than 30% of the votes since 2002.

The question is whether the economy really matters to voters, especially to AKP supporters. It could be argued that people in Turkey have been living with high unemployment and high inflation for years and have got used to that. But this only partially explains AKP supporters’ commitment to the party. Even the corruption allegations and Erdogan’s authoritarian attitude do not seem to have much effect on core AKP supporters who are mostly poor, conservative and nationalist. The charismatic Erdogan always finds ways to appeal to AKP’s core supporters and keep them together even if his tactics deeply polarise the country. He has dismissed the corruption investigations as a coup attempt to topple him and an international plot against Turkey, he blames the secularist elites (CHP, Western-minded bourgeoisie and Istanbul-based big business) for the problems the country’s poor have suffered since the foundation of the Republic and apparently AKP supporters are ready to buy these arguments.

The June elections, however, showed that some AKP supporters could switch sides if something very dramatic happens. The Kurdish voters who had previously supported for the AKP turned to the Kurdish party HDP as Erdogan sharpened his nationalist rhetoric before the June polls. Turkey’s disenchanted liberals long ago distanced themselves from the AKP and the country’s leftists never supported Erdogan’s Islamist party.

What could possibly then further alienate AKP supporters - an economic crisis, perhaps? What fuelled Turkey’s economic growth under the AKP was the consumer credit boom. Consumer loans rose more than 2,000% from 2004 to 2014, reaching TRY284bn (€85bn). Data from the Banks Association of Turkey show that 53% of consumer credit users are people with less than monthly income of TRY2,000 (€600); that’s an AKP supporter’s profile. Low-income people have been able to buy houses (built by the public housing administration TOKI), cars, furniture, LCD TVs with consumer loans; they feel prosperous and give the AKP credit for this. Banks' non-performling loan/total loan ratio is around 3%, meaning people are still able to repay their credit debts. But a full-blown economic crisis could yet change AKP supporters’ minds if they start to fail to repay their debts and more people lose their jobs. Given the Kurdish voters; reaction in the June elections, the question is whether AKP supporters’ commitment to and adoration of Erdogan is limitless. A political party with a convincing economic and political programme, led by a charismatic leader, could steal votes from the AKP, but this looks like a remote possibility, at least in the short term.

It is difficult to predict how Erdogan would react if the upcoming elections produced yet another hung parliament. The current political deadlock must be broken before the Fed hikes rates and consumer and business confidence must be restored to bring about stronger growth or at least to prevent economic turmoil. A stable government with a clear reform agenda is needed to restore confidence in Turkey and unleash the growth potential of the world’s 17^th largest economy.

Reforms must aim at increasing domestic savings through better private pension schemes in order to reduce the country’s current account deficit and restructure the economy in a way that GDP growth no longer causes large external imbalances. Domestic production must reduce its dependence on imported intermediate and capital goods, and exporters must produce higher value-added products.

A stable political environment and a government that respects the rule of law will improve business climate, attract more foreign direct investments and unleash the $800bn economy’s potentials. “Although the state, corporates, banks and households have some buffers, it may not be easy to cope with adverse effects if Fed lift-off couples with ongoing political uncertainty after November 1 elections, a rating cut from Fitch or Moody’s or complacent central bank,” said Morgan Stanley in a report on September 17.