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Turkey faces strong headwinds in the coming year both on the political and economic front. The corruption probe that began yesterday is the latest in a series of political battles for power. Next year is an important election year for Turkey with local and legislative positions up for grabs. In August, Turkish voters will decide on the next prime minister. Thus, the stakes both politically and economically are huge with the future direction of the country in the balance.

I want to emphasize that the corruption probe that began yesterday is a significant event. The Wall Street Journal article today details the extent of the corruption probe with the sons of the Economic and Interior Minister being detained. In addition, a very wealthy construction magnate and the chief executive of Halk Bank (police found $4.5 million in shoe boxes inside his house) were detained. In Istanbul a local municipal politician was arrested.

First, I will provide you with long-term investor implications. Then, I will provide the reader with the necessary background or context on the current political situation in Turkey to fully comprehend these developments surrounding the corruption probe. Finally, I will give you further insights as to what this all means for future political developments in Turkey.

For long-term investors in Turkey, this has significant implications. How the corruption probe is handled will go a long way in determining confidence in the rule of law in Turkey. Will the government try to thwart the corruption probe (this has already begun with several police chiefs being dismissed in Istanbul). Tomorrow expect more fireworks since the President is meeting with leading members of the judiciary. The opposition parties are calling for Prime Minister Erdoğan to resign.

I see an increase in political uncertainty that will impact long-term investors in Turkey as follows:

  1. Confidence in the rule of law is important for foreign direct investment (FDI). Thus, if the government seems to be interfering in the process or is implicated, Turkey which has seen billions in FDI inflows will see, thus GDP (Gross Domestic Product) growth will slow down or decline. Increased risk means an increase cost of capital, thus some projects will be abandoned.
  2. If the current party (AKP) survives this corruption probe, it could still win in the elections next year but the margin of victory will be much smaller. The result could be a coalition that results in a weak government. This weak government will be further weakened by in-fighting within the AKP (please see below for more details). This would certainly hamper GDP growth.
  3. A change from the current party to a new party will most likely result in a change of government policies that are likely to slow GDP growth. Unless the coalition from the opposition shows an economic acumen that in the past was not present, I don't see this scenario as being positive for the markets. Even though, it might have positive social and democratic payoffs for the population.
  4. Economically, Turkey also faces headwinds. In a previous article, I had discussed emerging market ETFs such as India (NYSEARCA:EPI), Turkey (NYSEARCA:TUR) and Indonesia (NYSEARCA:IDX) which have high current account deficits. In addition, I stated that how fast the era of easy money is wound down will have both economic and political implications globally. Most notably, election outcomes in some countries will depend when and how fast this easy money is wound down. I gave the example of Turkey . The delay of tapering certainly has helped Turkey and my estimate a month ago would have been that the AKP would easily win. The recent corruption probe has changed this scenario due to a much higher level of political risk.
  5. The bottom line is that in the long-term, I would expect Turkey to underperform depending on the impact of the corruption probe. The impact will be negative but the extent of damage will depend on how things are handled and how quickly they are handled. Investors need to be very cautious for the moment.
  6. Short-term, if this corruption probe is not handled correctly, I would expect to see significant street demonstrations of similar magnitude to the Gezi Park demonstrations. This might present a short-term buying opportunity, but you need to wear your trading hat and be quick to get in and out due to lots of volatility.

Current Political Background

After 11 years of power the AKP party led by Prime Minister Erdoğan is starting to show signs of internal fracture. During this time period, Turkey made impressive gains on the economic, political and social spheres. The other parties to the left of center (CHP) and to right of center (MHP) were a distant second and third. They did not have an answer for the AKP party. Failing to offer a credible alternative, the AKP won 3 general elections.

Thus, it became apparent that the only one who could stop the AKP juggernaut was the AKP itself. Unfortunately or fortunately, depending on which side of the political fence you are standing, this has recently started to happen. Of course, friction between the two main powers within the AKP party existed before the events yesterday.

During the Gezi Park protest in Istanbul, Turkish President Abdullah Gül, who is a strong supporter of the Gülenist movement, took a reconciliatory note towards the Gezi Park protestors. The Gülenist camp (movement) is led by a preacher named Fethullah Gülen who lives in exile in the USA. The so-called Gülenist control the judiciary and police in Turkey. Their power within the Turkish government and administrative functions is much larger than actual votes in any election. The actual number of voters in this camp is difficult to gauge with many conflicting estimates, but somewhere between 2 to 5% of the vote seems reasonable. Politically, they are the more liberal side of the AKP party. Fethullah Gülen, the leader of the movement, criticized the Turkish-led Gaza flotilla for trying to deliver aid without Israel's approval, for example. Most recently, Zaman the main newspaper in Turkey of the Gülenist movement has become very critical of Prime Minister Erdoğan.

In contrast, Prime Minister Erdoğan took a harsher line (some would say much harsher) against the Gezi Park protestors. In addition, some prominent businesspeople that outwardly supported the protestors faced either direct condemnation from the Prime Minister or visits from the tax office with hefty fines to follow. During his recent term in office, Prime Minister Erdoğan has come under sharp criticism as becoming more and more of an authoritarian. However, some see a strong leader as positive. Primarily they point to ineffective governments of the past with weak leadership. In contrast, they say Turkey has done well economically under the strong leadership of Prime Minister Erdoğan. Again, it depends on which side of the political fence you are on.

The fight between the two sides started when the government declared the closure of prep schools in Turkey. Over 25% of these schools are owned by the Gülenist movement and as you can imagine are a major source of revenue and recruits into the movement. In addition, some prominent businesspeople affiliated with the Gülenist movement were recently targeted by tax authorities.

Controlling the judiciary and police, the Gülenist movement struck back yesterday with the corruption probe. In retaliation, the government led by Prime Minister Erdoğan sacked 5 police chiefs (Gülenist) in Istanbul.

What does all this mean?

As recent as a month ago, I believed that Prime Minister Erdoğan would run for the powerful Presidency position with current Turkish President Abdullah Gül (or a weak candidate chosen by Erdoğan) running for the Prime Minister role. It should be noted, that there was a self-imposed limit of 3 terms within the AKP, thus Prime Minister Erdoğan could not run for again.

Prior the Gezi Park protests, he was working on obtaining enough support in parliament to change the constitution in order to make the position of President much stronger (similar to the US President). Peace overtures towards the Kurdish population was in fact a bid to obtain the additional votes needed. Gezi Park changed everything and took this option off the table.

In short, Prime Minister Erdoğan wanted to stay in power on way or another.

It seems that a calculation was probably made that the 2 to 5% of the votes garnered by the Gülenist movement was just not worth it. Thus, the recent announcement that prep schools would be closed down (a direct attack on the Gülenist movement).

In short, I expect to see Prime Minister Erdoğan take the only option he has left to retain power. That is, he will ignore the self-imposed limit of 3 terms within his own party and run for Prime Minister again in August 2014. That means that Turkish President Abdullah Gül will be only left with seeking another term as President, in effect a reduced political prize.

Of course, this all depends on how far the corruption probe continues and if Erdoğan is somehow implicated. Then a different scenario is on the table.

Source: Turkey - Political Headwinds