Political Risk Analysis - Referendum Polarisation To Keep Political Risk High - JUNE 2017

BMI View: Turkey's April 16 referendum will move the country's system of governance in a more autocratic direction, with negative implications for EU relations and long-term growth. The close and contested nature of the result will keep political and societal tensions high, with the 2019 general elections already coming into focus.

On April 16, Turkey held a referendum on a new constitution that will abolish the post of prime minister, hand the president sweeping executive powers at the expense of checks and balances, and usher in a more autocratic system of governance ( for an overview of the changes see 'April Referendum To Consolidate Erdogan's Power', 19 January). President Recep Tayyip Erdogan's constitutional changes were voted through by a narrow margin of just over one million votes, with preliminary results showing 51.4% voting in favour and a turnout of 85%. The president will be handed major executive and legislative powers after the next general election in 2019, including considerable influence over the judiciary and state budgets, and could see Erdogan serve two five-year terms until 2029 if re-elected. This marks Erdogan's latest major step in consolidating political power following the failed military coup in July 2016, after which Turkey has been governed under a state of emergency and the ruling Justice and Development Party (AKP) has cracked down on opposition lawmakers, journalists, academics and the judiciary, including by means of detentions and job dismissals.

Contested Victory To Keep Tensions High

The narrow victory for the 'Yes' campaign is a reflection of a deeply polarised society and high levels of scepticism over the merits of an executive presidency, even from within segments of the AKP's core support base. For example, Turkey's three largest cities, Ankara, Izmir and Istanbul, voted against the new constitution, marking Erdogan's first defeat in the latter - his hometown - since 2002. More so than in previous elections, Erdogan's support was thus concentrated in the traditionally more religious and conservative central Anatolian heartland. The 'Yes' campaign also received significant support from Turkish immigrants across Europe with over 70% of voters in the Netherlands, Austria and Belgium supporting the changes.

Coasts And Big Cities Vote No
Turkey - Majority Voting 'Yes' or 'No' by Region
Source: L ocal media

Furthermore, the 'Yes' campaign - which was backed by the AKP and the Nationalist Movement Party (MHP) - fell well short of the two parties' combined vote shares in previous elections, suggesting that supporters of both strayed from the party line. Finally, the election result is being contested by the opposition Republican People's Party (CHP) and pro-Kurdish People's Democracy Party (HDP) amidst concerns over voting irregularities including a last-minute decision by the Supreme Electoral Council - contrary to Turkish law and prior custom - to count ballots as valid even if they did not carry an official seal. Foreign monitors including the OSCE and Council of Europe have expressed similar concerns over voting irregularities, concluding that the referendum fell short of international standards and citing that the election was not held on a level playing field in light of, among other factors, the AKP's firm grip over the media, the large number of displaced voters in Turkey's traditionally anti-AKP southeast, and the jailing of numerous opposition HDP members since last year.

AKP-MHP Bloc Fails To Convince All Followers
Turkey - Previous Election Results, % Of Total Vote Share
Source: Local media, Supreme Election Board, BMI

Erdogan and the AKP will nonetheless treat the result as a clear mandate, and this will only exacerbate current societal rifts. Lingering questions over the legitimacy of the referendum will prevent the government from pursuing a more conciliatory approach and encourage it to continue in its ongoing attempts at suppressing opposition voices. We do not believe the protestations of the CHP and HDP will lead to any formal review or recount, and supporters of both parties are thus highly unlikely to ever view the result as legitimate. In a sign that the government's hostile stance is unlikely to change in the near term, the state of emergency in place since the failed coup attempt in July 2016 was extended for another 90 days just two days after the referendum.

2019 Elections Already In Sight

We believe the victory for the 'Yes' campaign means the prospect of early elections is low. That said, Erdogan and the AKP will remain focused on ensuring a sizeable parliamentary majority in the 2019 general election, and preventing the referendum result from galvanising the opposition. This will help ensure that political tensions remain elevated, despite the referendum having gone in Erdogan's favour. In particular, Erdogan will want to ensure that the HDP falls below the 10% electoral threshold, the result of which would be to hand the majority of their 59 parliamentary seats over to the AKP. Combined with the need to continue courting nationalist voters, this suggests a low probability that the government will attempt to re-start peace talks with the separatist Kurdistan Workers' Party (PKK), given that the last attempt at doing so boosted the performance of the HDP in subsequent elections. Significant portions of southeastern Turkey remain in a state of low-level armed conflict, and the AKP has succeeded in affiliating the HDP with the PKK in the minds of voters by jailing many of its members on terrorism charges.

Despite the potential for the referendum to galvanise Erdogan's opponents, we do not see a credible opposition emerging between now and the 2019 elections. The MHP faces serious internal divisions over the decision of its leader Devlet Bahceli to support the 'Yes' campaign, while the HDP will face an uphill battle to enter parliament after winning just 13.1% of the vote in the November 2015 general election. The main opposition CHP, which has traditionally represented Turkey's secular elite, has not breached 26% of the vote in any general or local election even as Erdogan has become an increasingly divisive figure. This reflects in part the failure of its leadership to modernise and rally a younger generation.

Relations With Europe On Ice

One of our core pre-referendum views was that Turkey's relationship with the EU would deteriorate as a result ( see 'Referendum Pushes EU Membership Further Out Of Reach', 8 March), and early signs suggest that this will indeed be the case. The government has been quick to criticise OSCE and Council of Europe conclusions, which have been echoed by the European Commission, as biased and reflective of ongoing attempts by the West to undermine Erdogan's authority. Meanwhile, in post-referendum speeches Erdogan has brought up the possibility of holding a referendum on Turkey's EU accession process or on reinstating the death penalty, both common themes during the campaign. The latter would be grounds for immediately halting Turkey's already-stalled accession process in the eyes of the EU. That Erdogan decided to reiterate these themes even after victory in the referendum suggests that relations with the EU, which reached a low point after a diplomatic row erupted between Turkey and the Netherlands in March ( see 'Turkey With More To Lose From Spat With Netherlands', 13 March), are unlikely to improve soon.

Rule Of Law Erosion Dragging Down Score
Long-Term Political Risk Index, Out of 100
Note: 100 is the best score available, zero the worst. Source: BMI

The EU has come out strongly against Turkey's constitutional changes concentrating power in the hands of the presidency, as such a system is unlikely to meet the rule of law criteria required of any country hoping to join the bloc. We cannot rule out that the EU decides to unilaterally end Turkey's accession bid even if Erdogan and the AKP do not move to take such steps. That said, the EU has a delicate balancing act to play with Turkey in light of the migrant deal currently in place between the two sides, which has been partially responsible for significantly reducing the flow of migrants into Europe. Visa-free travel for Turkish citizens was a cornerstone of the original deal, although it has yet to be implemented and will face significant obstacles in many EU capitals. Any movement on the migrant deal will thus be an important indicator of future relations between the two sides, with a breakdown likely to presage a more formal split. Any such split would also carry negative implications for Cyprus' reunification prospects ( see ' Reunification Odds Diminishing Quickly ', 3 April).

US To Look Past Authoritarian Drift

Turkish-US relations are unlikely to deteriorate to a similar degree, however, with US President Donald Trump more willing to overlook Erdogan's autocratic tendencies and continue regarding him as a valuable ally against both Islamic State and Syrian President Bashar al-Assad. Trump has so far been the only Western leader to call Erdogan to congratulate him on the referendum victory, and this is despite the US State Department issuing a decidedly more cautious statement in which it acknowledged voting irregularities and urged Turkey to uphold human rights. While we note a significant potential for a long-term reorientation of Turkey away from its long-standing alliance with Western countries manifested by the country's NATO membership ( see 'Relations With West To Deteriorate Further', 24 March), Turkey's overwhelming geopolitical importance will continue acting as a key buffer against a breakdown in relations in the near term.

Deteriorating Macro Backdrop In Focus

We previously laid out the bullish economic scenario following a 'Yes' vote ( see 'Precarious Fundamentals No Matter Referendum Outcome', 29 March). This involved an easing of populist and nationalist rhetoric following the vote, and a re-focused effort on the structural reform agenda. The first criteria looks unlikely to be met in the near term, given the contested result and initial post-referendum rhetoric coming from Erdogan. It remains to be seen whether the structural reform agenda will gather pace, but it is clear that it is crucial to boost Turkey's growth prospects. Turkey's business environment has stagnated in recent years as the AKP government has had to devote much of its attention to consolidating power and pursuing constitutional change, as evidenced by the country falling well behind peers in the World Bank's Ease of Doing Business rankings.

A Reform Laggard
Ease of Doing Busines Index - Distance To Frontier
Note: An economy's distance to frontier is reflected on a scale from 0 to 100, where 0 represents the lowest performance and 100 represents the frontier. Source: World Bank, BMI

The referendum was held against an increasingly precarious macroeconomic backdrop. Despite Q416 GDP coming in much higher than consensus expectations ( see 'Quick View: Q416 Performance Poses Upside Risk', 31 March), the unemployment rate in January reached a seven-year high of 13%. Government stimulus efforts also played an important role in supporting growth, but this will not be sustainable over the coming quarters in light of a rapidly widening budget deficit ( see chart below). Prudent fiscal policy has been a key anchor of investor sentiment, underpinning continued capital inflows which are necessary to cover Turkey's large 'hot money'-financed current account deficit ( see 'Current Account Remains Primary Macro Vulnerability', 24 February). While the election victory is likely to diminish the urgency to kick start growth in the near term, we nonetheless believe that the government under an empowered Erdogan presidency will seek to expand its role in the economy over the coming years. This is highlighted by the creation of a sovereign wealth fund in 2016, which in our view will serve to increase state-directed spending and obscure the true state of the public finances ( see 'Wealth Fund To Obscure Rising Fiscal Risks', 15 February).

Focus Back On The Economy
Turkey - Unemployment Rate & Budget Balance
Source: Turkstat, Ministry of Finance, BMI

Alongside a more precarious fiscal policy outlook, it remains to be seen whether government interference in monetary policy will be reduced. In recent years, the government has pressured the Central Bank of the Republic of Turkey (CBRT) to keep borrowing costs low, even in the context of elevated inflation. This has eroded markets' confidence in the CBRT, weighing heavily on the lira. Moving forward, the key question is whether the government will continue to impinge on the independence of the CBRT. In turn, this depends on whether the government's hostile rhetoric towards the CBRT and the 'interest rate lobby' in recent years was simply an election ploy, or representative of a firm belief that lower interest rates in Turkey are needed and warranted. We lean towards the latter interpretation, and as such expect the interplay between government and the central bank to remain a source of weakness for the lira. Absent more significant monetary tightening and higher real interest rates, the CBRT will be constrained in its ability to materially bring down longer-term inflation expectations.