Turkish stocks fell and the lira dropped against the dollar on the departure of Prime Minister Ahmet Davutoglu. All this means one thing: politics is back to the fore for Turkish market watchers.

Davutoglu, who served as prime minister for 20 months, announced on May 5 that he is stepping down after losing a power struggle with Turkish President Recep Tayyip Erdogan. The ruling Justice and Development Party (AKP) will hold an extraordinary congress on May 22 to elect a new leader and Turkey’s next prime minister.

The main stock exchange, BIST-100, had risen 19% in the year to date until the end of April. But as political tensions rose, culminating in Davutoglu’s resignation, the BIST-100 fell more than 8%, while the lira lost nearly 5% of its value against the dollar between April 29 and May 5.

Davutoglu’s exit raises some uncomfortable questions: what the new economic management team will look like, in particular whether the new cabinet includes reform-minded, market-friendly deputy premier Mehmet Simsek. For investors, the other key concern is the central bank’s independence.

Davutoglu leaves offices at a time when Turkey’s $720bn economy is facing difficult challenges. Exports are falling, inflation is easing but still remains well above the central bank’s 5% target, GDP growth, at 4% last year, is expected to slow this year and unemployment runs at a stubbornly high 11%; meanwhile the tide in risk appetite towards emerging markets is turning.

A key migrant deal the EU struck with Turkey back in March has also been thrown into doubt with the resignation of Davutoglu.

"100% yes man"

Erdogan is likely to pick up a “100% yes man” as his next prime minister. Among those tipped as successors 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.

Critics fear that as Erdogan consolidates his powers Turkey’s already wobbly democracy will probably decay further and his authoritarian rule may become even more arbitrary. However, there is no sense of political crisis.

Nobody expects Davutoglu’s dramatic departure to trigger mutiny among AKP ranks; simply because there is no one to lead such a rebellion against Erdogan. Even his critics do not think that the AKP will fall apart or disintegrate in the near future: Erdogan has once again proved that he controls everything: the party, the government, the media, the military, and the judiciary. And the president has made it completely clear to everybody that he will never hesitate to crush anyone in his way to absolute power. Even Davutoglu vowed to remain loyal to Erdogan at the press conference he announced his decision.

Some analysts think snap polls could now be on the cards. But two top aides of Erdogan have ruled out such a possibility. Parliamentary elections will be held in 2019 as planned, they said. Yet, Erdogan is still pushing for constitutional amendments that would pave the way for the executive presidential system he envisions for Turkey. A referendum on constitutional changes should be held as quickly as possible, Erdogan said on May 6, only a day after Davutoglu announced his resignation.

Though it regained its parliamentary majority in the November elections with 317 seats, Erdogan’s AKP failed to secure enough seats – 330 in the 550-seat parliament – to allow it to hold a referendum on a new constitution that would give more executive powers to Erdogan. If it had won 367 seats it would have been able to re-write the constitution by itself without a referendum.

The AKP’s attempts to secure the opposition parties’ support for a new constitution have so far failed. But the Nationalist Movement Party (MHP) may be willing to form a coalition government with the AKP, Ahmet Hakan, a columnist for Hurriyet, wrote on May 9. The MHP has 40 seats in parliament while the AKP has 317. Under such a scenario, the AKP will be able to put a new constitution to a referendum.

The MHP lost ground to the AKP in the November elections, as Erdogan sharpened his nationalist rhetoric ahead of the poll, helping the ruling party steal votes from the country’s main nationalist party. The MHP’s share of the vote fell to 11.9% in November from 16.3% in the June elections. The MHP is currently struggling with its own internal problems. Its leader, Devlet Bahceli, may think that a coalition government with the AKP could prevent the disintegration of his party. The threat of new elections may also help persuade him to co-operate.

Davutoglu’s resignation has stoked fears in European capitals that the migrant deal could be one of the casualties of the power struggle in Turkey. Erdogan, who has a less positive view of the EU than Davutoglu, has threatened that Ankara will not implement the migrant deal if the EU fails to keep its promises. But after Davutoglu’s resignation he seems to have taken a tougher line.

Erdogan on May 6 rejected the EU’s demands for an overhaul of Turkey’s anti-terror law in exchange for visa liberalisation. “While Turkey is under attack from all quarters by terror organisations, the EU asks Turkey to change its terrorism law … We go our way, you go yours”, he said.

Actually it is difficult to see how a new government headed by a pliant PM would pass the required anti-terrorism law and legislation ensuring civil liberties, given Erdogan’s growing intolerance for dissent and the Kurdistan Workers’ Party (PKK). Erdogan rules out any negotiations with the outlawed Kurdish group that has intensified attacks on security forces since last summer when a two-year ceasefire collapsed.

Muted reaction

Investors have been on the edge of their seats since Davutoglu’s resignation but they are rather in a “wait-and-see” mood. The main stock exchange was up 0.96% in early Monday trading, the lira gained some ground against the greenback, rising 0.1% to trade at 2.9239 per dollar.

“The muted reaction from investors to Davutoglu’s departure is best explained by two main factors. Annual consumer price inflation continued to decelerate in April, falling to 6.6%, and business confidence indices improved from March. Second, is the cordial nature of Davutoglu’s departure, or at least the public manifestations thereof,” Ege Seckin from IHS in London told bne IntelliNews.

Michael Harris at Rencap agrees: “As Davutoglu is going quietly there is no reason his departure in itself should cause market volatility as there will be a smooth transition to a new PM and cabinet”.

But all Turkey analysts warn that the future is far from being certain. “We need to see the new PM and if there are any faces in the new cabinet that are market friendly,” Harris told bne IntelliNews. The risk of volatility in the coming months, however, is high, according to Seckin. The IHS analyst thinks that with Davutoglu’s departure it is now even less likely that the government will push forward with the far-reaching reforms necessary to address fundamental problems in the economy, such as its low domestic savings rate and corresponding dependence on external financing.

Financial markets could establish a floor around current levels in the coming days, but it is hard to claim that a bottom has been reached, according to Atilla Yesildada, GlobalSource Partners Turkey analyst. “Once the cabinet is announced, attention will shift to the biggest question in Turkish politics, namely the issue of executive presidency,” Yesilada told bne IntelliNews.

Harris stresses the same point, adding that the latest political developments crystalize to a broad audience the fact that Turkey has yet to achieve post-election political equilibrium. “Until Erdogan achieves his executive presidency, which will likely require both an election and a referendum, expect policy to be driven by populism and stimulus with no serious structural reforms".

Seckin at IHS warns that Erdogan’s push for the presidential system may have wider ramifications. Erdogan’s ambitious plans not only will deepen societal polarisation and raise the risk of unrest, “but might be accompanied by renewed pressure on the central bank to lower interest rates…this would be likely particularly if a snap election is called,” Seckin said.

According to Yesilada, the currency recovered somewhat, as major brokerage houses began arguing that in its May Monetary Policy Committee (MPC) meeting the central bank would forego the impending rate cut. At its last meeting on April 20, the MPC reduced the overnight lending rate by 50bps from 10.5% to 10%. It left its main policy rate (one-week repo) on hold at 7.50% and kept the overnight borrowing rate unchanged at 7.25%.

Yesilaada sees more troubles ahead for investors and the Turkish economy. Investors refuse to believe that terror has devastated the tourism season, which might mean that the Turkish current account deficit could begin to expand at a time when Fed governors are talking up a second rate hike, Yesilada said.

His base-case scenario entails the central bank caving in to political pressure to cut rates through summer months, until Fed fears and a bad tourism season undermine exchange rate stability with volatility spilling over to other asset classes. Markets will discount these eventualities only step by step, according to Yesilada. “In any case unless economic growth soars suddenly, or risk appetite in EM recovers once again, it is hard to find the catalysts to propel Turkish markets higher.”