Turkish Developments Net Positive But Tail Risks Fatten

 

November has been a momentous month for Turkey and markets seemed to have already made up their minds about how to weigh different events. To simplify the analysis, let’s group them into two sets of events and their respective market response: (1) Geopolitical: between Turkey’s worsening relation with Russia and improved relationship with the EU, markets seem to put more weight on the latter. Domestic: (2) between political stability of a new AKP mandate and the deepening conflict with the Turkish Kurds, markets seem to put more weight on the former. As a result, Turkish assets have rallied. But the story is not as straight forward, of course. When all is said and done, it looks like Turkey traded net positive gains for fatter negative tail risks.

It has been a momentous month for Turkey in domestic and geopolitical terms, and markets seemed to have already made up their minds about how to weigh different events. To simplify the analysis, let’s group them up into two sets of events and their respective market response: (1) Geopolitical: between Turkey’s worsening relation with Russia and improved relationship with the EU, markets seem to put more weight on the latter. Domestic: (2) between political stability of a new AKP mandate and the deepening conflict with the Turkish Kurds, markets seem to put more weight on the former. As a result, Turkish assets have rallied. But the story is not as straight forward, of course, so let’s look at them separately.

(1) Domestic: Erdogan’s political gambit paid off and the AKP won an outright majority to form a new government in the last elections, but it came at a cost. The rift with the Kurds (which make up as much as 20% of Turkey’s population, depending on how you count it) has deepened during the campaign and its aftermath. Just a few weeks ago, the Kurdish military organization, the PKK, undertook a series of deadly attack. Then tensions rose further following this week’s assassination of a prominent Kurdish lawyer and political activist, Tahir Elci. Overall, markets netted out all these events as positive for Turkish assets.

For us, this looks more like a different distribution of risks. Avoiding a hung parliament and acrimonious coalition building is unquestionably positive, at least in the short term. However, it could also set up the country for problems down the line. Some believe that it delays the inevitable process of re-distribution of power needed to quell the festering social tensions in Turkey. Aside from the obvious Kurdish conflict, recall the massive Gezi Park protests of 2013. Those divisive issues have not gone away, and a possible bid for constitutional change to increase Erdogan’s powers as president can set them alight again. So now we have an AKP majority government antagonizing the Kurds and with a large secular-minded slice of the population with little political representation. In other words, we get much fatter tail risks of social tensions boiling over in the future.

(2) Turkey downed a Russian plane and as result Russia imposed a series of sanctions, but it also scored a profitable deal with the EU. Russia placed a ban on food and non-food imports. Turkish firms and nationals will have their economic activities halted or curbed. Charter flights from Russia to Turkey would be banned, and holiday travel discouraged. According to a Putin’s spokesman, up to 200,000 Turkish citizens could be on Russian soil. According to a Turkish news agency: there are currently around 90,000 Turkish people working in Russia, mostly on construction projects; more than 4 million Russians visited Turkey last year, 3 million of them visiting the Mediterranean resort province of Antalya; Turkey still exports food to Russia, especially fresh fruits and vegetables grown in Antalya, and the estimated cost of the sanctions on the Antalya province alone could be as high as $6.5 billion next year.

On the other side of the scale, Turkey agreed to step up its restrictions on migrant flows into Europe in exchange for financial aid (€3 bln), better visa deals for Turkish nationals and a resumption of talks about joining the EU. This is the materialization of the windfall political leverage Turkey got over Europe with the refuge crisis. And this leverage is not likely to go away, leaving Turkey in a good position to continue extracting economic benefits and shush criticism from the EU over domestic political matters.

One reason why markets weighed the EU deal over the Russian sanctions was could have been because energy was not mentioned by Russia. Roughly, Turkey produces 45% of its electricity using natural gas, 23% hydraulic, 13% imported coal, 11% domestic coal/lignite, while the rest comes from other sources (wind, geothermal, fuel oil, etc). Natural gas is almost entirely imported, with 45% of it is used for power generation and the rest mainly for heating. Russia provides 58% of the imported gas, Iran 19%, Azerbaijan and Algeria 9% each, Nigeria 3%, and 2% comes from the spot market. Imported coal is also an issue: Russia provides 33%, the rest comes from Colombia, US and South Africa, respectively. Separately, in 2014, the two countries signed a memorandum of understanding to build the Turkish Stream gas pipeline through the Black Sea, and Russia is building the first nuclear plant in Turkey, a $20 bln deal. In short, good thing for Turkey that energy was not mentioned.

So the net effect here is that Turkey has gained political leverage over the EU, but has put itself in a position where Russia may continue to exert the strong economic leverage it has over Turkey. And judging by the latest comments by Putin over the illegal oil trade from ISIS, there is a lot of room for the situation to escalate from here. So similarly to the domestic side, geopolitical developments seems less like a straight forward net positive outcome and more like a case where Turkey is better off but at the same time the tail risks have become fatter.