2017 will be a challenging year for Turkey

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• The year 2016 was full of events that shook Turkey. However, the recent Istanbul bombing by PKK and economic volatility point that next year may be even more challenging for Turkey. As the lira continues to plummet today, security and geopolitical risks from Turkey’s neighbours will continue to harm market confidence.
• It is likely that President Erdogan will win his bid for executive powers in a referendum. However, his empowerment will strengthen economic populism and worsen social polarization. Although Erdogan will have to wait until 2019 for full presidential powers, the referendum result will allow him to undertake a radical program of institutional and social change that will allow the deepening of a one-man regime. 
• The Erdogan administration’s inability to control events unfolding in the country’s south will continue to have destabilizing effects domestically. Across the border, as the Syrian conflict moves toward a resolution, along with a possible dissolution of ISIS, the PKK will be able to strengthen its position. This will force Ankara to respond, as a result, causing further geopolitical instability.
• SGA thinks that, in case of severe financial and economic stress, AKP Government may move to institute capital controls and restrictions on bank deposits that could cut into Erdogan’s popularity, though not enough for him to lose a referendum on the presidential system changes. In order to distance himself from economic failure, Erdogan may be forced to sack unorthodox economic advisers or possibly even replace Prime Minister Binali Yildirim. Yet, we expect no shift towards rational policy and any structural reform package will be piecemeal as opposed to addressing Turkey’s essential economic problems.

So far in 2016, Turkey has witnessed multiple terror attacks, a sudden ousting of Prime Minister Ahmet Davutoglu by President Recep Tayyip Erdogan, a spat that almost stalled relations with the EU, a failed coup attempt, a government crackdown on opposition and media, and military operations in Syria against the Islamic State (ISIS) and Kurdish nationalist groups. The year 2016 was a challenging one, but all indicators point that 2017 could be even worse as economic and security problems faced by Turkey continues to deepen. Deputy Prime Minister Mehmet Simsek has clearly said that Turkey is at its riskiest political era after the First World War. It is not an exaggerated statement. SGA has been one of few advisory firms to warn its clients that the deterioration of Turkey’s macroeconomic imbalances and political risk will outlive 2016. The Turkish lira has been in a free fall since early November and it is almost impossible to predict its direction as there is no sign that the government intends to act to calm the markets by shifting towards rational economic policy in the short term. Despite security forces have checked the Kurdistan Workers’ Party (PKK) in rural areas and pushed ISIS away from its border, the deadly attack in Istanbul on 10 December that claimed 39 lives shows the government will not easily prevent suicide attacks in urban centers. In 2017, geopolitical risks pertaining to Turkey’s southern region will escalate, preventing other risks from subsiding. Overall, we think the Erdogan administration’s inability to control events unfolding in the country’s south will continue to have destabilizing effects domestically. This piece assesses what can be expected for Turkey in three main fields: politics, security and economy.   

Turkey’s domestic stability will become further entangled in geopolitics

The ruling Justice and Development Party (AKP) has resumed its efforts to realize President Erdogan’s goal of establishing a presidential system following the failed coup attempt on 15 July. The AKP is 14 seats short of the 330 votes needed to take its constitutional reform proposal to a public vote. With other parties vehemently opposed to any reform that gives Erdogan executive powers, AKP relies on support from the Nationalist Movement Party (MHP) leadership and parliamentary group in order to pass the proposal in the parliament. The proposal brought to parliament on 10 December by both parties renders the president the head of executive and weakens checks and balances. 

Despite rising potential for public backlash in the referendum due to the slowing economy, rising unemployment, and the dissatisfaction of the MHP’s core support with Erdogan’s empowerment, we think the new constitution may win the popular vote, most likely in April 2017 (60% probability). While Erdogan needs MHP support, the latter is vary of an early election that might leave the party outside parliament due to the 10% electoral threshold. The two parties already are in line on central policy issues—such as continuing to fight the militants ofPKK—and largely share a common voter base. However, our alternative 40% scenario suggests the MHP leader Devlet Bahceli may force changes that strengthen the legislature’s role during plenary sessions most likely in the latter half of January. In any case, however, the result will nevertheless strengthen Erdogan, legitimizing some of his current de facto powers and allowing him to launch a radical program of social transformation, creating further political and social instability in the second half of 2017. 

Turkey’s political trajectory will be most affected by factors outside its borders, however. A victory by the Assad regime in Syria (though it will likely lead to a “federal Syria” as opposed to full control) and a post-sanction Iran will pose significant challenges to Turkey’s strategy of using Sunni Arabs and Turkmens in Syria and Iraq as a buffer against Kurdish and Shia expansion. In 2017, PKK-controlled Kurdish entities could become recognized parts of a federal Syria, thwarting Turkey’s chances of dictating the terms of a domestic peace to the PKK. Once ISIS dissolves, we think Ankara will not be able to confront Assad and Kurdish forces in the Syrian theatre via the Free Syrian Army (FSA) in the absence of support from its allies. In Iraq, the eventual collapse of ISIS due to the ongoing Battle of Mosul will likely commence acts of retribution to Sunnis for supporting ISIS and weaken Turkey’s foothold in the region—further opening space for the PKK. 

The key implication of this new strategic situation for Erdogan’s government will be the hardening of its stance towards secular, leftist and Kurdish nationalist opposition domestically. The forces of Turkish nationalism that the AKP has set in motion will force Erdogan’s government to blame “domestic enemies” in order to prevent being held responsible for the humiliating blunders in Syria and Iraq. Having won executive powers, Erdogan will have much more leeway in using state power in order to terrorize and criminalize the opposition. He will be ready to implement an anti-secularist political program just to provoke secular factions of society into street protests in an effort to distract the public majority from his failed foreign policy. Turkey’s political and social stability will continue to suffer in 2017 as a result.   

Security will remain fragile

Erdogan will continue to use the resumption of PKK attacks on security forces in order to consolidate his power both before and after the spring’s referendum. Following 32 years of guerrilla warfare against Turkish security forces, the PKK employed a strategy of mounting suicide bomb attacks in urban centers in 2014. This trend will continue in 2017. In the meantime, we are likely to see the radicalization of new groups emerging from Turkey’s protest-torn urban environment. The first of these is the working-class Kurds living in western cities that have so far remained largely distant from the PKK’s ideology favoring armed resistance and expected normalization and recognition of their ethnic identity—something which the right-wing constitutional consensus between the AKP and MHP will certainly deny. With the intensified AKP pressure over nationalist Kurds in the country’s southeast, this group carries a great potential for street action and being recruited by the PKK. The second group is the civil servants, military, and police personnel who have been cast away or fired for accused of being Gulenists. In addition, many members of an almost 7,000-strong group of cadets of dismantled military schools and academies who are currently disgruntled with the AKP could easily be manipulated by radical groups. 

Turkey has been heavily dealing with three major terrorist groups and since the outbreak of the Syria crisis in 2012. The AKP government had to struggle with the TAK (Kurdistan Freedom Falcons), YDGH (Patriotic Revolutionary Youth Movement), and DHKC (Revolutionary People’s Liberation Front), along with ISIS factions. Aside from the PKK and associates such as TAK and YDGH, two major actors, ISIS and DHKC (an extreme leftist group founded in Damascus in 1981) had some level of impact on Turkey’s daily life with their sensational but limited soft-target attacks on security forces and public in major cities such as Istanbul, Ankara, Izmir and Gaziantep. All of these groups are reportedly well-recruited and will be seeking opportunities to attack security, tourist, or civilian targets in 2017.

In response, ultra-nationalist and Islamist supporters of the AKP and MHP will likely target Kurdish nationalists—as they did against the pro-Kurdish Peoples’ Democracy Party (HDP) offices in Istanbul, Ankara, Antalya, Malatya, Osmaniye, Iskenderun, Tekirdag and Mersin between 2013 and 2016.  

This intricate structure described above indicates the growing risks for Turkey’s political and socioeconomic stability. Erdogan’s fixation with gaining executive powers and his party’s acute incapacity to find consensus with rival political forces are likely to increase discontent among rival factions. 

While ISIS will be ousted from northwestern Syria and northern Iraq, the group cleverly chose to consolidate in the Raqqa-Deir Az Zour region for a final major battle. Turkish ground forces and the allied FSA units will not take part in this battle, but will be engaged in sporadic skirmishes with the PKK-controlled People’s Protection Units (PYD) around the town of Al-Bab, in northern Syria. So far, ISIS was able to exploit disagreements between its enemies, as in the Kurdistan Regional Government’s dispute with Baghdad over Mosul’s control, Turkish resentment of the PYD’s role in the coalition, or the presence of Shiite sectarian elements in the Iraqi army. 

Even though it is hard to predict what a defeated ISIS would do, it will be realistic to assert that a major but slow disengagement within its ranks is inevitable. Most military analysts agree that ISIS’s current brigade-level troops will likely dissolve into smaller groups in order to mount sensational suicide attacks or harass the region’s militaries by ambushes. Many will likewise attempt leaving the region, especially through Jordan and Turkey, or melt into the local Sunni community.

No wholesale structural reform despite economic hardships 

The big question asked by markets is whether there is a threshold for economic difficulties to trigger a turn towards economic rationalism in policy-making. Our answer is that despite ongoing financial volatility and economic slowdown, we expect any move away from unorthodoxy in economic management and structural economic reforms to remain limited. Whilst lira’s weakening surpassed those of EM currencies over the past weeks, we understand the government views the problem as being sourced by exogenous factors that will subside as Donal Trump is sworn into the White House on 20 January. This failure to acknowledge the real drivers of Turkey’s economic management’s damaged reputation will remain largely intact over the course of 2017. The first reason for this is President Erdogan’s short term priorities. All indicators suggest in order to win executive powers through a referendum, Erdogan will remain reluctant to allow any real reform that could shift economic focus way from near-term growth-inducing construction sector, with which Erdogan’s political prospects are now fully aligned. Therefore, we expect economic policy to continue relying on one-off and short term measures instead of a comprehensive program of economic structural transformation. This means, up until the point where Erdogan views in public polls that he himself is increasingly becoming the main source of economic instability in the eyes of his core support base, economic populism will remain intact. The government’s new economic measures announced on 8 December and designed to keep private sector companies afloat until the referendum by increasing the supply of credit are in line with continued priority of near-term growth over fundamental restructuring.

A key to trigger an erosion of Erdogan’s popularity could be capital controls and restrictions on bank deposits by the government. Despite potential popular reaction, we still think a very narrow margin victory in the referendum is more likely. Yet, in order to distance himself from economic failure, Erdogan will likely decide to sack unorthodox economic advisers or in the worst case, replace Prime Minister Binali Yildirim. The launching of a new campaign for economic renewal in the second half of 2017 may include some elements of structural reform but will essentially be piecemeal and lack improvements in core issues such as social security and taxation. While there are mitigating factors for the risks concerning foreign currency denominated private debt – such as the fact that an important share of debt being actually sourced by Turkish companies’ own overseas funds – the treasury-guaranteed credits for PPPs presents a real risk for public finances under government’s current strategy of maintaining credit expansion and fiscal loosening at the same time. With an additional $28 billion guarantee on underutilized PPPs, 2017 will likely be the year where Turkey’s current account financing finally becomes a factor that constrain growth. One should note that all political changes in Turkish political history happened right after the economic crises. The looming economic crisis is significant different than the previous ones as this would result from the high private sector debt rather than the public sector. Fixing the problem is much more complicated and it may have longer-term repercussions. Erdogan is well aware that the current economic crisis is a direct result of mismanagement of economy and politics. In order to avoid political cost, Erdogan and his team already blame external factors for the crisis, but that may not work this time as it worked for democracy and security problems.

2017 will test the limits of Erdogan’s anti-establishment rhetoric that has so far worked well to keep him in power. Over the past years we have seen Turkey’s political trajectory being shaped by unforeseen events, such as an abrupt end to the ceasefire with the PKK on 11 July 2015, a failed coup on 15 July 2016 and MHP leader Bahceli’s reigniting a process of constitutional reform on 11 October 2016. The most likely “spikes” as such lies in a potential conflict between Turkish and Syrian/Iraqi armies and a government reshuffle that can bring Erdogan’s son-in-law and energy minister Berat Albayrak to second-in-command. 2017 may also see the formation of a centre-right party that includes former AKP heavy weights and alienated MHP figures can challenge the AKP in November 2019 elections – but this is a low probability.