Old concerns are returning

Been there, done that. Political tensions have been rising over the past week in Turkey after a top prosecutor was arrested last week and a number of present and former officers were arrested this week on a charge of plotting to overthrow the Turkish government. The  arrests are the outcome of ongoing investigations in the so-called ‘Sledgehammer’ and ‘Ergenekon’ cases, both involving alleged plots to overthrow the government. In the Ergenekon case, numerous arrests have already been made over the past year, but the most recent developments have led to a stepping-up of tensions between the Turkish government and the country’s secular elite – the military and the judiciary.

It should be noted that the earlier round of arrests in the Ergenekon case was viewed by many in Turkey as a clean-up exercise of the Turkish armed forces while the arrests made this week are seen as being much more controversial. Following a meeting of top generals yesterday, the armed forces voiced concerns about the ‘serious situation’, but the wording of the generals’ comments was not as strong as during the so-called e-coup in April 2007 when the armed forces indirectly threatened to overthrow the AKP government.

Our overall assessment is that the situation is highly uncertain and that the conflict between the military and the government is likely to escalate further in the coming days and weeks. However, it should also be noted that both parties in the conflict have a relatively strong incentive to ensure that the situation does not get totally out of control. That said, investors should not just assume that everything will be fine and that a calm political situation will be restored anytime soon. The problem is that there is a near ‘structural conflict’ between the Islamist-oriented government and the secular elite in Turkey over the role of religion in Turkish society and this is likely to flare up again and again as it has done over the past week. One can only hope that the outcome will be the same as it has been in the earlier conflicts in 2007 and 2008 and that cooler and calmer heads will prevail in the end.

How much should political uncertainty move the markets?

The Turkish lira has been under some pressure over the past week and has clearly underperformed its Emerging Markets peers. That said, for now, the markets have not reacted in ‘panic’ and the move in the lira looks more like a bit of profit-taking rather than a ‘run for the exit’.

There is no doubt that investors are nervous about the political developments in Turkey, but many are probably also betting that the situation will calm down soon while limiting the sell-off in the lira.

How big will the market impact of the Turkish political events be? We have two other recent cases to compare with. The so-called e-coup in April 2007 and the closure case against the governing AKParty in 2008.

The e-coup had a quite strong impact initially, but the fears in the markets were very short-lived and the crisis is hardly visible on a graph of the lira in April-May 2007. The impact of the closure case against AKP was much greater. From the start of the crisis in March 2008 to the peak of tensions in late April 2008, the lira lost around 10% against a basket of the euro and the dollar and tensions remained in Turkish markets until the final ruling in the case in July 2008.

Overall, the developments during the political tensions in 2007 and 2008 give us reason to expect that the impact on the Turkish financial markets of the current uncertainty will be short-lived and will be contained. That said, given the increased uncertainties in the global markets, the negative political development in Turkey is hardly helpful and we would recommend investors stay sidelined in the Turkish markets for now. We have not changed our forecast for the Turkish lira, but might do if the crisis escalates.