The markets hate uncertainty.
Turkish Prime Minister Ahmet Davutoglu’s departure has raised hard questions about the government’s ability to tackle slowing growth and pass the structural reforms that many investors are demanding.
Davutoglu said on Thursday he was stepping down as leader of the ruling AK Party at an extraordinary congress on May 22, ending weeks of speculation about his future amid tensions with President Tayyip Erdogan.
In an address, Davutoglu said that “investors should not worry about the continuity of stability” because a “strong” AK Party government would continue.
But his departure could mean an early election this year and, for investors, more uncertainty about the stewardship of the economy when private sector debt is high, savings are low, and Erdogan continues to champion lower interest rates to boost growth through consumption.
“The resurfacing of political risk on investors’ radar serves as a reminder that the longer-term outlook for the Turkish economy is not as rosy as some seem to think,” said William Jackson, an economist at Capital Economics in London.
“If we do get a stronger President Erdogan, the macroeconomic consequences might take longer to become visible, but it would probably result in a scenario of more volatile, and slower, growth.”
GDP growth is set to cool to 3.5% this year from 4% in 2015, the World Bank said last week, well below peaks of near double digits seen after the AKP first came to power in 2002. A sharp drop in tourism after a spate of bombings this year and unrest in the largely Kurdish southeast are also taking their toll.
Erdogan’s ambition for a new constitution centered on an executive presidency has not only raised the prospect of a third election in less than 18 months, but also of a shift to more authoritarian rule.
“The reform process will slow down as the whole energy of the new government will be spent on political issues such as the presidential system,” said BGC chief economist Ozgur Altug. “Investors have already started to ask whether Deputy Prime Minister Mehmet Simsek will be in the new government or not.”
Simsek, a reformist, is seen as an anchor of foreign investors’ confidence and UBS strategist Manik Narain said they would be hoping he stayed on.
Presidential adviser Cemil Ertem tried to reassure markets by saying there would be no changes in economic policy.
Turkey needs to lure foreign investment to plug a yawning current account deficit of around 4.5% of GDP and finance its heavily indebted companies. Investors are looking for measures to boost the savings rate, liberalize the labor market, and develop a higher-value manufacturing sector to reduce reliance on imports.
Turkey saw $15.5 billion flow out of investment portfolios last year, according to central bank data, due to worsening appetite towards emerging markets as well as domestic security worries.
Rate Cut Pressure
However, as the U.S. Federal Reserve signaled a slower pace of rate hikes this year, foreigners invested a net $4.0 billion in Turkish bonds and equities in the first four months of this year.
“The market wasn’t well positioned for this development; there has been a strong recovery in debt flows in recent weeks,” said UBS’s Narain.
The political rift, which sent the lira to a two-month low, is likely to delay further rate cuts by the central bank, analysts said.
The bank has already lowered the top end of its interest rate “corridor” by 75 basis points this year, even as inflation stands at 6.6 percent, well above the bank’s target of 5%.
Economists say newly appointed governor Murat Cetinkaya could cut further under pressure from Erdogan, who has repeatedly argued that high interest rates cause inflation, a stance at odds with orthodox economics.
“Rate cuts were imprudent even before the crisis erupted, given Turkey’s worryingly high inflation rate,” said Nicholas Spiro, partner at London-based Lauressa Advisory.
“The rift between Erdogan and Davutoglu undermines the credibility of Cetinkaya as it reinforces the perception among investors that the central bank’s independence is severely compromised.”