Turkey. Country Report. Turkey at a glance: June Key changes from last month

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1 Country Report Turkey Turkey at a glance: OVERVIEW The Economist Intelligence Unit believes that the Justice and Development Party (AKP) government, led by the prime minister, Recep Tayyip Erdogan, will win enough seats in the general election on July 22nd to form a single-party government. There is a possibility, however, that the AKP will have to enter a coalition if more than two other parties exceed the 10% vote threshold. Tensions with the military over the choice of the next president may come to the fore again. Turkey!s EU accession talks will make slow progress this year, but some of the required reforms are likely to be adopted after the election. We expect Turkey to continue the economic reform process after the three-year IMF stand-by agreement expires in early If a coalition government emerges from the election, it might have a negative impact on economic policy. Higher inflation and a sharp tightening of monetary policy have led to a slowdown in GDP growth, but it will still be robust at just over 5% in 2007, before picking up slightly in A softer lira and weaker domestic demand should help to reduce the current-account deficit in , but it will still be large. Key changes from last month Political outlook The collapse of the merger between the Democrat Party (DP, formerly True Path Party, or DYP) and the centre-right Motherland Party (Anap) has damaged the DP!s chances of exceeding the 10% vote threshold for representation in parliament. This provides support to our central forecast that the AKP will have enough seats to form a single-party government Economic policy outlook In May the Central Bank of Turkey left official interest rates unchanged for the tenth consecutive month since the sharp increases in June-July Rates are expected to remain at their current high levels during most of 2007, given the political uncertainty and stickiness of inflation expectations. Economic forecast Tight monetary policy, weakening domestic demand and a strengthening of the lira in the first half of 2007 has helped to slow consumer price inflation to 9.2% in May. Our forecast remains that it will continue to ease to an annual rate of 7-7.5% at the end of 2007, still above the IMF-agreed rate of 4%. June 2007 The Economist Intelligence Unit 26 Red Lion Square London WC1R 4HQ United Kingdom

2 Turkey 1 Outlook for Political outlook Domestic politics Turkey s politics throughout the outlook period will be fundamentally affected by the outcome of the general election, which will be held on July 22nd. The election was unexpectedly brought forward to try to diffuse growing tensions following the standoff between the Justice and Development Party (AKP) government led by Recep Tayyip Erdogan and secularist forces, including the military, over the ruling party!s choice of presidential candidate. Under the electoral law, parties scoring less than 10% of the total vote are excluded from the Assembly. The main question is how many parties manage to break through the 10% threshold. As the parties stand currently, the Economist Intelligence Unit!s baseline forecast is that the AKP will emerge as the biggest party, but with a smaller majority than at present. We expect two opposition parties to exceed the 10% threshold compared with only one in There is a possibility that more than three parties will exceed the 10% barrier, which would probably require the AKP to enter a coalition with another party to be able to form a government. A coalition would provide less stability and certainty than Turkey has enjoyed over the last four years and a half years. However, the AKP would be the lead partner, ensuring a continuation of most of the present government s policies, particularly Turkey!s EU membership bid and economic reforms aimed at maintaining macroeconomic stability and attracting further foreign direct investment (FDI). We expect the Constitutional Court to uphold appeals by the main opposition party, the Republican People!s Party (CHP), and the current president, Ahmet Necdet Sezer, to annul the constitutional amendments approved by parliament in May. In that case, Mr Erdogan would have to accept the election of the next president by parliament, following the present rules, rather than by direct election. An earlier Court ruling on May 1st set the parliamentary quorum at 367, two-thirds of the 550-seat Assembly, effectively annulling the constitutional provision that has allowed a president to be elected by a simple majority if needed (this has been the case for the last three presidents). Assuming that the opposition parties will have just over one-third of the seats in parliament, they would be able to block the election of the AKP!s candidate president by just not turning up for the vote, as happened in April/May. Therefore, unless the AKP has a two-thirds majority after the July general election, Mr Erdogan will have to agree on a compromise candidate with the staunchly secularist, nationalist CHP, which we expect to be still the largest opposition party after the election. However, the choice of a moderate AKP member acceptable to the opposition and the military might cause tensions within the AKP. The Turkish army s strong opposition to what they see as the risk to secularism posed by the AKP will probably continue to reverberate. However an outright military coup seems unlikely. Instead, the AKP will probably continue its outward show of co-operation with the army on other issues, especially the resurgent campaign of terrorist attacks by the militant Kurdistan Workers Party (PKK), which has caused serious civilian as well as military casualties.

3 2 Turkey In focus Parliamentary election forecast Public opinion polls in Turkey are generally unreliable, but they all suggest that the ruling Justice and Development Party (AKP), under prime minister Recep Tayyip Erdogan, will emerge as the biggest party. The main arguments in the AKP!s election campaign are likely to be the success of its economic policies compared with the mainly disastrous performance of previous governments; the fact that the AKP is the only party likely to be able to form a stable single-party government; and attacks on the main opposition Republican People!s Party (CHP), which it has characterised as "elitist" (for example for opposing the AKP!s proposal to allow the direct election of the president). The nominally centre-left CHP, led by Deniz Baykal, has formed an electoral alliance with the Democratic Left Party (DSP), which is currently not represented in parliament. The CHP-DSP alliance will probably be some way behind the AKP, but is likely to exceed the threshold of 10%. Mr Baykal is expected to continue his hardline nationalist stance during the campaign, arguing that Mr Erdogan is soft on the Kurdish militant group, the Kurdistan Workers! Party (PKK), because his government is not prepared to invade Iraq, and that the AKP poses a threat to the secularist state. He is also likely to adopt a strongly anti-us rhetoric. For the first time the pro-kurdish Democratic Society Party (DTP) is likely to win de facto representation, by running its candidates as independents, to whom the 10% requirement does not apply, and may win some seats. The main uncertainty is whether either or both of two other parties"the centre-right Democrat Party (DP, formerly True Path Party, or DYP, which was to have merged with the centre-right Motherland Party, Anap, but the merger collapsed less than a month after it was launched), and/or the ultra-nationalist Nationalist Action Party (MHP)"will also break through the 10% barrier. If neither do so, as some polls have suggested, then the AKP will stay in government, with a substantial majority. If only one of these parties exceeds 10% (MHP appears to be the more likely of the two to succeed, according to opinion polls) then the AKP will probably be able to carry on in government by itself, albeit with a reduced majority, and this seems a likely result. If both of them break through the 10% barrier, then Mr Erdogan will probably have to form a coalition to stay in power. At first glance, his most likely partner would be the DP, since the two parties are close on most issues, but the DP leader, Mehmet Agar, has stated that he does not want to form a coalition with the AKP (whether his party would stick to this line after the election is far from certain). What line the DP will take in the electoral campaign is not clear. There is not much difference between the policies of the DP and AKP, just personal rivalry between the two party leaders. For the MHP Devlet Bahceli will be more outspokenly nationalist, attacking the EU and the IMF as well as the US, although he has some foreign-policy advisers who are trying to tell him not to do this. Asked about coalition possibilities, Mr Erdogan has cautiously hinted that he might reach an agreement with the DTP "independents" (assuming they have enough seats) or with the CHP. An AKP-CHP coalition would almost certainly have a comfortable majority, but the two parties would find it hard to work together, given the fierce personal rivalry between Mr Erdogan and Mr Baykal, as well as differences of ideology and policy. If the CHP and MHP together had more than 50% of the seats and formed a coalition, their fiercely nationalist rhetoric could have serious effects on Turkey s relations with the EU, the US and the IMF, but this outcome seems unlikely.

4 Turkey 3 International relations On the reasonable assumption that the AKP will stay in office after the election, even if in coalition with another party, it is not likely that Turkey s foreign policy will alter drastically during the forecast period. A post-election coalition between the AKP and CHP could present problems, even though such a combination currently seems unlikely. In the election campaign, the CHP leader, Deniz Baykal, has been attacking the government for allegedly being too soft in its approach to the PKK presence in Iraq, and has been critical of the EU. However, if he were to join a coalition with the AKP, he would probably soften his approach. The CHP supports Turkish accession to the EU in principle and in practice Mr Baykal is likely to accept that a full-scale Turkish military intervention in northern Iraq would cause serious damage to Turkey s relations with the EU as well as the US and could lead the country into a quagmire. On the EU side, two obstacles to rapid progress in Turkey s accession process are likely to remain. First, the EU s demand that Turkey ratify an additional protocol to its customs union agreement with the Union, so as to open its airports and harbours to Greek-Cypriot aircraft and shipping, is likely to be resisted by Turkey unless and until the EU makes good its longstanding promise to end the ban on direct trade between the EU and the self-proclaimed Turkish Republic of Northern Cyprus (TRNC). Currently, little progress seems to have been made on the last score. More critically, the election of Nicolas Sarkozy as the new president of France could threaten the whole process, given that Mr Sarkozy has repeatedly stated that he opposes the prospect of eventual Turkish accession. For the time being he appears ready to put this issue on the back burner, preferring to concentrate on the achievement of reforms within the EU. However, he may well return to the charge later in the year. In response, both the Commission and the big majority of EU member governments" including Germany, Italy, Spain, UK and Greece"are likely to stick to the position that the EU must abide by its commitments to proceed with the accession process. Hence the most probable result would be slow progress in the negotiations, rather than a total halt. In these conditions, the Turkish government is unlikely to abandon its bid. The continued presence of PKK bases in northern Iraq will almost certainly be the main stumbling-block in Turkish-US relations. The US forces in Iraq are still reluctant to take effective action against the PKK, even though the US government classifies it as a terrorist organisation. In response to PKK attacks within Turkey, the Turkish army has substantially reinforced its forces along the Turkey-Iraq border. However, a full-scale military incursion into Iraq seems unlikely, given the risk of a head-on collision between Turkish and US forces that this would pose, as well as the damaging political fallout. There have been hints that the US government might be prepared to turn a blind eye to a short and limited operation by Turkey"by, for example, special airborne troops attacking PKK base in Iraq, and then withdrawing rapidly"but this cannot be assumed. Since the PKK is based in areas controlled by the Kurdistan Regional Government, headed by Massoud Barzani, the Iraqi Kurds effectively hold the key to a solution. So far Mr Barzani has refused to take any effective action against the PKK, but he might change his mind if the US puts sufficient pressure on him over this issue. In the meantime, Turkish diplomacy is likely to concentrate its efforts on strengthening

5 4 Turkey its relations with the Iraqi government, which apparently wants to maintain good relations with Turkey, and opposes the PKK. Economic policy outlook Policy trends Fiscal policy Monetary policy Although still vulnerable to shifts in investor sentiment, the Turkish economy is more robust as a result of the wide-ranging IMF-backed reforms introduced in the last seven years. Fiscal and monetary policies have been kept tight, helping to reduce inflation from historically high levels (it averaged almost 70% in ), and wide-ranging structural reforms have strengthened the banking sector, enhanced competitiveness and begun to attract substantial inflows of FDI. Ahead of the general election, which is scheduled to take place on July 22nd, the government!s privatisation plans and the implementation of the social security reforms already approved by parliament have been delayed. However, we do not expect the government to loosen fiscal policy too much or to undermine the independence of the Central Bank of Turkey, as the AKP!s sound management of the economy will be a crucial factor in securing the party a second term in office. It is unclear whether the government that emerges after the general election will sign a new IMF stand-by agreement after the current one expires in early Nevertheless, even in the absence of a new accord there will be a post-stand-by monitoring process, which should help to keep the economic reform process on track. The main risk to our forecast that present policies will be maintained is if the new government formed after the election allows the budget to slip into serious deficit and starts to backtrack on existing reforms, as might happen if there were to be an unstable coalition for example between AKP and CHP, or CHP and the ultranationalist Nationalist Action Party (MHP). Under the three-year IMF stand-by accord signed in May 2005, the government committed itself to producing large primary surpluses of 6.5% of GNP for the consolidated government sector (CGS). The target was only narrowly missed in 2005, but met in The same target will probably be set for 2008, requiring the government to keep fiscal policy tight next year too. As a result of weaker economic growth and political pressure on the budget ahead of the general election, we expect a smaller primary surplus in Interest payments will also be higher as a result of the interest rate increases in mid-2006, causing the budget deficit to widen. However, we expect the budget deficit to remain below 3% of GDP in 2007 and We believe that the government will be able to continue to service its still large debt (62% of GDP at end-2006), despite a likely moderate fall in the value of the lira and continued high interest rates during much of If the next government is a coalition, it will make tightening fiscal policy in 2008 difficult. In an attempt to halt the fall in the value of the lira and dampen rising inflationary pressures, the Central Bank of Turkey increased its overnight borrowing rate by a total of 425 basis points to 17.5% in June-July 2006 and its lending rate by 625 basis points to 22.5%. The rate increases were far larger than the markets had been expecting, and the Central Bank has since kept rates on

6 Turkey 5 hold, helping to dispel some of the doubts that emerged in early 2006 about the continued independence of the Central Bank from political influence. Consumer price inflation was almost double the end-2006 inflation target of 5% agreed with the IMF, but the Central Bank is tailoring its monetary policy with a view to putting inflation on a downward path towards the target of 4% (±2 percentage points) at the end of 2007 and Given the possibility of more financial market and exchange-rate volatility and wage increases above the inflation target, we do not expect the Central Bank to start to cut interest rates significantly until later in It has also warned that it would be prepared to raise rates further, if inflation were to rise sharply again. Economic forecast International assumptions International assumptions summary (% unless otherwise indicated) Real GDP growth World OECD EU Exchange rates 100:US$ US$: SDR: Financial indicators 3-month interbank rate US$ 3-month Libor Commodity prices Oil (Brent; US$/b) Gold (US$/troy oz) Food, feedstuffs & beverages (% change in US$ terms) Industrial raw materials (% change in US$ terms) Note. Regional GDP growth rates weighted using purchasing power parity exchange rates. Despite an uncertain geopolitical backdrop, the world economy has remained buoyant. World GDP measured at purchasing power parity (PPP) exchange rates is estimated to have grown by 5.3% in With monetary policy being tightened around the world, the period of easy money that has underpinned the recent global boom has come to an end. Nevertheless, we only expect a modest slowdown in , when world GDP is forecast to grow by 4.8% and 4.6% on a PPP basis. Growth in the euro area, Turkey!s main export market, will slow only marginally as a result of a slightly weaker international environment, fiscal tightening and less expansionary financial conditions. A key risk to this forecast stems from the possibility of a sharper than expected downturn in the US, if the current high house prices were to fall significantly. Given the large capital inflows needed to finance the US current-account deficit, a loss of confidence in the US could also lead to a sharp fall in the US dollar. Either development (or both occurring together) would have major negative repercussions for global growth. Other risks that are most relevant to Turkey are that rises in interest rates in the developed world might lead to a renewed

7 6 Turkey increase in risk aversion in global financial markets and a withdrawal of funds from emerging markets; and higher oil prices, which would add to Turkey!s large current-account deficit. Economic growth Gross domestic product by expenditure (YTL m at constant 1987 prices where series are indicated; otherwise % change year on year) 2005a 2006 a 2007b 2008b Private consumption Public consumption Gross fixed investment Final domestic demand Stockbuilding c -2.1 c -0.5c 0.2C Total domestic demand Exports of goods & services Imports of goods & services Foreign balance c 0.3 c 1.8c -0.4C GDPd a Actual. b Economist Intelligence Unit forecasts. c Contribution to real GDP growth (as a percentage of real GDP in previous year). d Non seasonally adjusted. In 2006 GDP growth averaged 7.5% year on year in the first half of the year, but slowed in the second half to a still robust 4.8% in the third quarter and 5.2% in the fourth, reflecting the impact on domestic demand of the fall in the value of the lira in May-June, rising inflation and higher interest rates. As a result of the continuing impact of high interest rates, final domestic demand growth will slow from an average of 8% in 2006 to around 3.5-4% in Weaker domestic demand growth will be partly offset by a deceleration in imports and continued robust export growth, resulting in a marked improvement in the foreign balance and GDP growth of just over 5%. In 2008 economic growth is forecast to pick up moderately to 5.5%, as domestic demand accelerates again. However, import growth will also rise sharply, so that the foreign balance will produce a moderate reduction in overall GDP growth. There is a risk of a more prolonged and deeper slowdown in 2007 and 2008, if inflation were to rise sharply again, as a result of another prolonged slide in the value of the lira, and if the Central Bank were to return to a tightening monetary policy stance. Inflation Higher inflation expectations as a result of the fall in the value of the lira in May-June 2006 meant that the IMF-agreed target of 5% for the end of 2006 was missed. Tight monetary policy, weakening domestic demand and a strengthening of the lira in the first half of 2007 has helped to slow consumer price inflation, but at 9.2% in May it remained well above the IMF agreed yearend target. Assuming that commodity prices stabilise, that fiscal policy has not

8 Turkey 7 been relaxed too much in the run-up to the general election, and that the lira does not fall further than we currently predict, we expect the rate of inflation to ease to an annual rate of 7-7.5% at the end of The decline should continue in 2008, to a rate of about 4.5% at the end of the year. Exchange rates External sector Our baseline forecast is that during the remainder of 2007 the lira will depreciate moderately against a weakening US dollar, from YTL1.30:US$1 in mid-june 2007 to about YTL1.46:US$1 by the end of 2007, before stabilising in The depreciation will be more marked against the euro, which has appreciated against the US dollar, but this will have a positive impact on Turkey!s external sector. The main risk to this forecast is that domestic political tensions surrounding the parliamentary and presidential elections could trigger a sharp loss of confidence in the lira, causing a much more severe depreciation than in our baseline forecast; or that the lira could appreciate sharply, driven by large short-term capital inflows attracted by high domestic interest rates, resulting in a further deterioration in the current-account deficit and a larger currency adjustment at a later stage. The current-account deficit continued to increase in 2006, rising to almost 8% of GDP, from 6.4% in In 2007 we expect it to stabilise in US dollar terms and decline slightly in GDP terms as a result of weaker domestic demand growth, especially in the first half of the year. A softer lira, especially against the euro, and robust demand in the euro area, Turkey!s main export market, should help to sustain Turkish exports of goods and services. However, the current-account deficit will remain large, at 6.5-7%% of GDP in 2007 and Forecast summary (% unless otherwise indicated) 2005 a 2006 a 2007b 2008b Real GDP growth Industrial production growth Gross fixed investment growth Unemployment rate (av) Consumer price inflation (av) Consumer price inflation (year-end) Short-term interbank rate Government balance (% of GDP) -1.7 c -0.7 c Exports of goods fob (US$ bn) d Imports of goods fob (US$ bn) d Current-account balance (US$ bn) d Current-account balance (% of GDP) d External debt (year-end; US$ bn) e Exchange rate YTL:US$ (av) Exchange rate YTL: 100 (av) Exchange rate YTL: (av) Exchange rate YTL:SDR (year-end) a Actual. b Economist Intelligence Unit forecasts. c Based on official government figures. d Based on full-year data published by the Central Bank of Turkey. e Based on full-year data published by the Treasury. Editors: Robert O'Daly (editor); Charles Jenkins (consulting editor) Editorial closing date: June 19th 2007 All queries: Tel: (44.20) london@eiu.com Next report: Full schedule on

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