mktdev,Markets Exchanges,

mktdev,Markets Exchanges,

What has happened? An attempted military coup was launched in Turkey on Friday evening. The coup failed and was quickly followed by the detention of several thousand members of the army and judiciary. The range of people detained – including some close to the President – suggest that support for the coup within the military was quite widespread. But there were widespread popular demonstrations against the coup and the four parties in the legislature have condemned it, as has the U.S. Secretary of State, John Kerry.

Why did it happen? The Turkish political system is under great stress. One key stress point is the new proposed draft constitution, which wants to create a more powerful executive presidency and possibly scale back the country's commitment to secularism. Other stress points include the ongoing fighting in the south-east of the country, linked to Kurdish demands for independence, and the Syrian refugee issue. The army, which sees itself has the ultimate guarantor of secularism in the political system, has intervened several times before to protect it.

What are the immediate implications? The crackdown on military and judicial dissent may strengthen President Erdogan's political grip on the country but may not fix any of the underlying fault lines. He has to work out a way of working with the military. Expect to see difficult diplomatic exchanges with the U.S: a prominent critic of the president, Fethullah Gulen, lives in Pennsylvania and the Turkish government wants his extradition. The U.S. seems unlikely to do this: it, like other developed democracies, may condemn the coup attempt, but may not want to encourage President Erdogan's authoritarian tendencies. The political situation – both internal and external – could therefore remain tense.

Economic and investment implications: Before the coup, Turkey's economic situation had appeared relatively good, with economic growth of 4.8% in Q2 and a scaling back of the country's large current account deficit, due in part to low energy prices (although it was still equivalent to 4.4% of GDP in 2015). Portfolio inflows reached their highest level in two years in March although foreign direct investment has been trending down from its recent high in 2011. 

In the short term, the failed coup should probably be seen as a shock to confidence – but with little immediate effect on the real economy. Over the
longer term, the size of effects on the real economy will depend on political developments and their impact on economic sentiment. If future political
developments are perceived as being likely to limit free market economic activity – either now or in the future – this would dampen the investment climate and overall economic activity. The Turkish government has moved to reassure investors, pledging bank liquidity and a non-interventionist approach to the lira, but investors will already be looking to longer-term issues.

As recently as 2011, Turkish GDP growth had been close to double-digit levels but had slowed to 4% in 2015. GDP growth then rose to 4.8% in Q1 2016, but this was largely due to one-off factors. The main driver in Q1 was domestic demand, with private consumption growth of 6.9%. But this was underpinned by a 30% rise in the minimum wage and 10.9% growth in government spending as he ruling AKP delivered on election promises. The underlying domestic economy is therefore less vibrant than the headline Q1 GDP number suggests. One problem has been structural inefficiencies in the economy. Progress on reforms has been slow and the labor market remains inflexible. Political intervention in the economy is seen as excessive and a cause of corruption and cronyism, as well as of making the economy less responsive to market trends. And while consumer confidence has been propped up recently by the minimum wage hike, a long-term depressing effect from political uncertainty and physical
insecurity (due to terrorism and internal conflict) remains.

Lack of progress on reforms has left Turkey vulnerable to its traditional Achilles heel: the external accounts. The current account deficit has fallen back recently, from a recent peak of 9.6% of GDP in 2011 to 4.5% in 2015, with a further decline evident in the first five months of 2016, but is still large in absolute terms and is accompanied by an even larger merchandise trade deficit. On the services side, tourism is also important but is under threat: net tourism receipts were worth $22.1bn in 2015, but were down by one-third in Q1 YoY. The number of tourist arrivals was down by -25% YoY in May, one problem being an economic falling-out with Russia, which has also affected other sectors of the economy. External debt has risen in recent years from 39.4% of GDP in 2011 to 55.5% in 2015. This underlines the fact that while Turkey’s savings rate of 14% might seem to be relatively solid, it is still not high enough to finance its current account deficit on its own. This means that Turkey is heavily dependent on foreign capital inflows. One other way of reducing the current account deficit is to reduce Turkey’s high dependency on energy imports. Turkey aims to achieve his via investment in renewable and atomic energy plants as well as through supporting export-orientated industry. The need to finance these external imbalances has left Turkey highly dependent on portfolio inflows, which will be affected by sentiment. 

The Turkish lira, which weakened on news of the coup attempt and is likely to remain volatile in coming weeks will not help matters. Aside from its impact on portfolio inflows, a weaker lira will push up the cost of imports, prejudicing the fight against inflation, which is already over target and spiked to 7.6% YoY in June. A weaker lira would also make it more difficult for Turkish firms to service their debt, much of which is USD-denominated. Any positive from a weaker currency on inbound tourism is likely to be more than offset by tourists' security concerns.

History suggests that any "knee-jerk" market reactions to individual events tend to reverse themselves quite quickly. But, given Turkey's underlying political stresses - particularly when seen in the context of recent terrorist attacks, for example on Istanbul's main airport - investors could well stay wary for some time. The event will also remind investors that emerging markets (EM) still face unpredictable economic and political challenges. Nevertheless this is a countryspecific and relatively isolated event with either no or very limited contagion effects on other emerging markets. For those investors with a more short-term approach this may be the time to take some profits after a very strong rally in the last weeks – but this would have been the case even without the attempted military coup. For longer-term investors this event doesn't change our view in emerging markets or on financial markets and the global economy in general. 

Re-disseminated by The Asian Banker