2015 has been a difficult year for Turkey: two elections in six months, the flare-up of ethnic violence after two years of a truce, a slowing economy, stubbornly high inflation, high and sticky unemployment, and on top of all these came the blow-up with Russia towards the end of the year.

The November snap election may have ended the political deadlock, but more political noise should be expected in the new year. The debate around a new constitution and executive presidential system will dominate the political agenda in 2016 and continue to polarise the nation. The violence in the country’s southeastern provinces is also unlikely to end any time soon, given the hardened positions of the government and the Kurdistan Workers’ Party (PKK). Russian President Vladimir Putin says he sees no reconciliation with the current Turkish leadership, signalling that tensions between Ankara and Moscow are here to stay for some time.

On the economic front, the pick-up in GDP growth in the third quarter was encouraging, but was probably temporary and growth in 2016 should be slower. The main challenges for the Turkish economy in 2016 are the post-Federal Reserve rate hike environment with higher borrowing costs and the strained geopolitics. Inflation will continue to trouble Turkey’s central bank, while the budget performance will be less impressive given the populist measures the government is set to implement. The central bank’s credibility will also be tested next year in the face of the Fed’s policy normalisation.

To summarize, Turkey will struggle with challenging political, geopolitical and economic problems in 2016.

Challenges ahead for the Turkish economy

Turkey’s economy grew by 4% on year (y/y) in the third quarter versus 3.8% y/y in the second, driven by public and private consumption. This growth rate was much higher than what the markets had been expecting (2.8%), leading analysts to revise up their forecasts.

JP Morgan lifted its growth estimate for 2015 to 3.9% from 3.3%, and it revised the 2016 GDP forecast to 3.3% from the previous 2.8%, noting the strong momentum in the third quarter and the minimum wage hike scheduled for next year. Similarly, Citigroup now expects the Turkish economy to expand by 3.5% in 2015, up from its previous projection of 2.8%. The US bank also upgraded next year’s GDP forecast to 2.5% from 2.3%.

The bottom line is that Turkish growth will be slower in 2016 as the global economic environment becomes more challenging, especially for emerging economies. “We stress that the risk of a forced external adjustment in 2016 should be taken more seriously than before not only because of the likely tighter external financing environment, but also the sharp surge in Turkish debt levels,” Citi said in a note on Turkish GDP dynamics.

Private consumption, which accounted for 65% of GDP in the third quarter, increased by 3.4% y/y and public consumption was up 7.8% in the quarter. But worryingly, activity at major industries, such as heavy industry, manufacturing and construction, were weak, raising concerns about the sustainability of economic growth. Industrial output rose by 1.5% y/y, slowing from 4.0% in the previous quarter. Manufacturing expanded only 1.3% y/y in the third quarter versus 4.9% in the second, while construction registered growth of 1.9% y/y, unchanged from the previous quarter.

“Looking ahead, we expect the favourable temporary factors – ie. accommodative policy stance, stronger-than-expected private consumption and the large size of unidentified inflows – to fade away, thereby leading to softer economic activity in 2016,” says Citi, adding that: “We look for more challenging external financing conditions next year, which, coupled with domestic and geopolitical risks, should thwart economic growth.”

Lack of reforms

Turkey needs reforms to reignite the engine of economic growth and to attract much-needed foreign capital, but the new Justice and Development Party (AKP) government has failed to deliver them so far. Instead of unveiling wide-ranging reforms, Prime Minister Ahmet Davutoglu announced a so-called “action plan” in December, which the markets see as populist measures mainly designed to secure public support for a new constitution and executive presidential system that the AKP hopes to put to a referendum.

“For emerging markets, the issue is not whether the Fed raises by 25bp or not, but whether in countries as wide ranging as Argentina, Russia, South Africa, Turkey, Ukraine, Ghana, Nigeria and Venezuela, policymakers get serious about real economic reforms,” said Tim Ash of Nomura International in an emailed comment on December 17.

Investors fear that the AKP’s election promises and measures announced by the government will be costly and damage the public finances next year. The government pledged to hike the minimum wage by 30% to TRY1,300 (€409mn), promised higher pensions, and said it would remove the VAT on fertilisers for farmers. Owners of small businesses will be exempt from income tax for up to TRY8,000 (€2,500) of their annual revenue.

The government has pledged to share the burden of the wage hike on small and medium-sized enterprises, but did not say how and where the financing would come from. Election promises are expected to cost some TRY20bn (€6.3bn) or around 1% of GDP next year.

These measures are clearly aimed at stimulating domestic consumption. But as the latest GDP figures show, investment activity has remained anaemic. Gross fixed capital formation declined by 0.5% y/y in the third quarter after rising by 9.7% in the second, with private sector investments contracting 0.7% y/y in the third quarter versus a 11.3% increase in the previous quarter. The minimum wage hike and other consumption-led policies combined with the supply side problems could constitute a toxic conbination for inflation.

Inflation was running at 8.1% in November. Central Bank Governor Erdem Basci, however, believes inflation will fall to 6.5% by the end of the next year. This forecast reflects an estimated 1.5 percentage point (pp) impact of the planned minimum wage hike, Basci said.  Cheaper oil prices, now below $40 per barrel, will help Turkey reduce inflation if they remain there.

The food import ban imposed by the Kremlin over Turkey’s downing of a Russian bomber near the Syrian border in November could be beneficial for Turkish consumers, as local companies have now turned to domestic markets to sell products that they cannot export to Russia. This may have a positive impact on Turkey’s inflation, as the prices of some fresh fruits and vegetables could decline. But, on balance, the adverse impacts of the Russian sanctions will be more damaging than their possible positive impact on inflation.

The sanctions will hit the Turkish economy through trade and tourism, which looks even more troubling because tourism revenues are one of the main sources of hard currency, helping Turkey to finance its current account deficit. In 2014, some 4.5mn Russian tourists visited Turkey, representing a 12% share of total foreign tourist visits to the country, second only to Germany. The number of Russian tourists declined by 19% y/y to 3.5mn in the first ten months of the year.

EBRD economists calculate that persistent sanctions could reduce Turkey’s GDP growth in 2016 by 0.3-0.7pp. Capital Economics estimates that the maximum losses from Russian sanctions to the Turkish economy would be around 0.5% of GDP a year.

If Russia extends the scope of its sanctions, Turkey’s losses could amount to as much as $7.3bn over the next 12 months, and the current account deficit/GDP ratio would increase around 0.6-1.0pp in 2016, said a report published in December by the local Is Bank’s economic research department.

Turkey’s current account deficit is still large, but declining on the back of the depressed energy prices. The 10-month current account deficit declined by 25% y/y to $25.4bn, while the annualised deficit declined to $38.1bn in October, from $40.3bn in September. According to a latest survey by the central bank, Turkey’s current account shortfall is expected to be $41bn next year, up from the projected $37.4bn at the end of 2015.

The normalization of US monetary policy will make competition for foreign capital fiercer among developing countries, putting more pressure on the Turkish economy, whose foreign funding needs, according to the OECD, are projected to reach 25% of GDP in 2016, including the refinancing of external debt. Turkey’s equity market has already seen an outflow of $2.2bn this year, while the outflow from the bond market amounted to $6.5bn.

The Central Bank of the Republic of Turkey’s credibility will be on the line next year. Investors want to see a central bank free of political pressure. But if the growth outlook deteriorates, the CBRT could come under pressure to cut rates to stimulate economic activity, as the ruling party plans a referendum on a new constitution to give President Recep Tayyip Erdogan more executive powers. If the CBRT caves in to the political pressure, its credibility will be undermined.

“Downward pressure on the rating would arise from sustained further delays in implementing the structural reforms needed to reduce external imbalances and sustain economic, fiscal and institutional strength; and/or an increase in investor risk aversion which intensifies pressures on the country's external finances, thereby heightening the risk of a sudden and sustained halt in foreign capital flows,” said Moody’s in December. The rating agency affirmed Turkey's ‘Baa3’ government debt and issuer ratings, but maintained a negative outlook.

Erdogan centre stage

Tensions with Russia, the fight over a new constitution and presidential system, the violence in the country’s southeastern provinces, and relations with the EU will dominate the political agenda in 2016, with President Recep Erdogan, the most powerful man in Turkey, taking the centre stage in all of this.

Relations with Moscow hit a low in November when Turkey downed a Russian bomber near the Syrian border on November 24 for violating its airspace, prompting economic sanctions from Russia. Since then, Ankara and Moscow have traded angry barbs, but the situation did not escalate into a military confrontation.

Russian strongman Vladimir Putin described the downing of the plane as a hostile rather than an unfriendly act, thus any reconciliation with the current Turkish leadership is impossible.

Erdogan said Turkey does not want to escalate the tensions, but the president still refuses to apologise. He is aware that controlled tensions with Russia, which Turkey’s nationalists see as the country’s historical enemy, could increase his chances in a possible referendum on the executive presidential system.

In the run-up to November’s snap poll, Erdogan saw that strong nationalist rhetoric pays off handsomely. His AKP managed to steal votes from the main nationalist party MHP, whose share of the vote declined 11.9% from 16.3% in the June election.

The president’s job approval rating rose to 47.7% in November, the highest since December 2013, and this was even before the plane incident. Moreover, a survey by polling company Gezici found that more than 90% think Turkey did the right thing by downing the Russian jet. Erdogan, a very skilful politician, can easily capitalise on this.

The problem is that the AKP needs to get support from other parties in parliament to rewrite the constitution to give Erdogan more executive powers. The AKP regained a majority in the November poll, but it failed to secure a super-majority that would allow the party to rewrite the constitution alone. Moreover, the AKP is 13 seats short of the 330 required to call a referendum on any constitutional change.

Opposition leaders have repeatedly said they would contribute to the writing of a more democratic constitution, but they are against the executive presidential system. It is difficult to see how the AKP and Erdogan can break this impasse in their favour. But Erdogan will continue to push for the system change, probably causing further social and political polarisation in 2016.

The government’s tough stance on the Kurdish issue could also be related to its new constitutional agenda. Military operations against PKK militants no doubt please the nationalists, who might consider voting in favour of moving to a presidential system in any referendum.

Hundreds of security personnel, PKK militants and civilians have died in the renewed clashes amid the collapse of the peace talks in July. But the flare-up of violence did not alienate the voters from the AKP; on the contrary, more nationalists and Kurds voted for the AKP in the November election. Erdogan vows to continue carrying out operations against the PKK. The government, which has imposed days-long curfews in a number of Kurdish towns, says it will return to the negotiating table only if the PKK lays down arms or its militants leave the country.

The main Kurdish party HDP has been ineffective, with the PKK saying the HDP has no power to decide what it should do, whether it should cease its attacks on security forces. The key figure in the conflict, the PKK’s jailed leader Abdullah Ocalan, has been silent and isolated. It is not known if state officials and Ocalan are still talking behind closed doors and whether he might come out soon with a proposal to end the conflict.

The Kurdish problem will remain one of the key political issues in 2016. But, given the uncompromising position the sides are taking, it is difficult to predict how this will play out.

The EU decided in November to breath new life into Ankara’s long-stalled accession process, in return for Turkey’s help in stemming the flow of migrants to Europe. Brussels promised to liberalise the visa regime for Turkish citizens and pledged €3bn to help Turkey host more than 2mn refugees. In December, in a sign of a warming relations, the EU and Ankara opened negotiations on Chapter 17 focusing on economic and monetary policy as part of the refugee deal.

A candidate for EU membership since 1999, Turkey began formal accession talks in 2005. Ankara has opened 15 out of 35 chapters since then, but managed to close only one.  Ankara hopes to open more chapters and expects visa liberalisation to be completed sometime in 2016.

The EU needs Turkey to stop the influx of refugees, but how long will it keep compromising with Turkey over democratic rights? Brussels delayed the release of its annual progress report on Turkey until after the November snap election. In the delayed report, the EU emphasised an overall negative trend in the respect for the rule of law and fundamental rights. After several years of progress on freedom of expression, serious backsliding was seen over the past two years, said the report.

It is unclear how Ankara can reduce tensions with Russia or whether it is willing to do so any time soon. Erdogan, an unpredictable yet at the same time a very pragmatic figure, could take the initiative to end the row, just as he has recently done with Israel. After years of tense relations, Ankara and Tel Aviv agreed to normalise relations on December 17.

Erdogan will wait until he thinks the time is right to make this move. This could also be the case with the Kurdish question. Apparently, his priority is the presidential system and he will coordinate all his efforts to achieve this goal.

“We would want to see a big push forward in EU accession-related political/economic reforms, peace deal with Cyprus, normalisation in relations with Israel (looking to diversify way from dependence on Russian gas to the Eastern Med) and a resumption of the Kurdish peace process. In that scenario, Turkish markets would rally hard,” said Nomura’s Ash.