New and Old Challenges for Turkey

Destination : TurkeyDevelopments in Turkey, including terrorist attacks and comments about a coalition government, indicate that the situation is becoming even more complicated and geopolitical risks are rising fast.

The situation in Turkey is becoming even more complicated, reinforcing our view that the tail risks are increasing. This is highlighted by two major developments. First, the series of deadly terrorist attacks this week. Second, recent comments about a possible coalition government between the AKP and the main opposition party (CHP) may have given investors a false sense of optimism about avoiding early elections.

The geopolitical risks for Turkey are rising fast, and nobody knows how far they will go. The deadly attack in the city of Suruç, which claimed the lives of 32 people, targeted a group of activists related to the Kurdish movement. Two days later, two police officers were found dead in a different city from the same province. It’s unclear yet whether the two attacks were connected, or even who is behind them. Most observers are pointing to ISIL as the most likely perpetrator. But because there are links being made between the attack in Suruç and the one against Kurds during the elections, some think that other local groups might be involved. Either way, it appears as if the conflict in Syria is starting to spill over into Turkey in a more tangible way, beyond the influx of refugees.

In theory, this should probably leave President Erdogan and his AKP party more open to a coalition. The attacks will be seen as a wide open flank for all three opposition parties to exploit in the event of new elections by criticizing the AKP’s handling of foreign policy. It should follow, therefore, that the AKP would become more inclined to compromise rather than rolling the dice at the ballots.

Still, we think a new election is the most likely outcome. Comments from the AKP and two of the opposition parties, the Kurdish HDP and the nationalist MHP, suggest that there are no grounds for a compromise. The MHP leader went as far as saying that, “we’re starting preparations to be ready for elections.” So coalition negotiations are entering into what PM Davutoglu called 2nd round “preliminary talks,” where the traditional opposition party, the CHP, is the main target. The CHP is the second largest party, winning 132 seats (+7) in the June elections, compared with AKP’s 258 seats (-53). A total of 276 seats are needed for a majority.

An AKP-CHP “grand coalition” may have given hope to some observers, but we just can’t see how this would work. Why would the CHP agree to it? Yes it has been in opposition for decades so many party members would welcome a chance to finally be part of a sitting government again. But falling into temptation here strikes us as a very short-sighted strategy with potentially catastrophic long-term costs to the party. By joining the government now, the CHP would isolate much of its anti-AKP support base, risking a backlash down the road. Moreover, the AKP appears to be in secular decline, as seen by the elections results. Why would the CHP jump into a sinking boat when things are finally moving their way? We can’t see why a coalition would be a good move – for either party.

We stick to our view that the Kurkish HDP is the party that has the most to gain from a coalition with the AKP. And at the same time, they are the ones who have the most to lose from another round of elections. Contrary to public statements, we still think they are the most likely candidate for an agreement, if there ever is one.

In short, the recent geopolitical and domestic developments leave us more confident about our negative view towards Turkish assets. When we add this to our view that the dollar is likely to resume its broad appreciation trend, we conclude that the lira is on its way to test its all-time high near 2.81 from July. But more importantly, we think the tail-risks emanating from Turkey may be greater than many appreciate.