ANKARA – Escalating political tensions in Turkey over a court case to close the ruling Justice and Development Party (AKP) for alleged Islamist activities have created shock waves in the financial markets and now threaten economic stability. Analysts fear Turkey’s top court may take months to decide the case and that estimates of key economic indicators, ranging from the current account deficit to interest rates, will have to be revised as the political environment deteriorates. Increased political uncertainty will directly influence both foreign direct investment and domestic investment negatively and dent economic growth rates, they say. Turkey’s Constitutional Court agreed last month to hear a case brought by a chief prosecutor seeking to close the Islamist-rooted AKP and ban 71 party officials, including Prime Minister Recep Tayyip Erdogan, from politics for five years. The AKP – which came to power in 2002 and won a resounding re-election last July – denies any Islamist activities and says it will fight the case in court. The party says the charges are politically motivated. Analysts fear the case will bring key reforms to a halt. «If it becomes clear that political uncertainty will drag into the end of the year, we will cut our growth projection to a range of 3-4 percent,» said Garanti Bank’s Chief Economist Pelin Yenigun Dilek. The bank has been projecting 4 percent growth. The official growth target for 2008 is 5.5 percent, after a 4.5 percent growth in 2007, already bringing to a halt growth rates of 6.8 percent since 2002 on average. Business leaders warn that growth rates below 5 percent mean recession for Turkey, a relatively poor country with a fast-growing young population. The lira currency is now 5 percent weaker at 1.2840 against the dollar versus its level before the closure case was announced. A weaker lira will stoke inflation – already running at 9.1 percent in February compared with the central bank’s 2008 target of 4 percent – make imports more expensive, and worsen terms of trade. This could force the central bank to tighten monetary policy, which would hurt economic growth as a result. «A weaker lira is a reason for the central bank to show more prudence (not be so quick to cut rates). Inflation risk can rise relatively quickly depending on the pace of pass-through from foreign exchange to inflation,» UBS EMEA strategist Roderick Ngotho said. Monetary policy Some analysts said the Turkish central bank would first resort to liquidity management tools, intervention in the foreign exchange market before raising interest rates to cool down financial markets if the political climate worsens. «There is not much room in interest rates to go up and our rates are already very high, compared to other countries. We do not expect the central bank to raise interest rates as long as the shock waves are not too strong,» said Dilek. Turkey’s benchmark borrowing rate is 15.25 percent, higher than fellow emerging market South Africa’s key repo rate at 11 percent and Poland’s benchmark rate at 5.75 percent. But other analysts say the political uncertainty may push the lira much weaker and force the central bank to tighten monetary policy dramatically to stabilize the currency as was the case in mid-2006. Traders said they viewed 1.40 as a next level for the lira if the political climate worsens. «The lira can easily soften to 1.4 against the dollar if no solution comes out of this closure case. It will be seen as a serious political risk outside and even 1.5 may not be an abnormal level if you assume a very bad scenario,» said Ahmet Arslan, a forex dealer in Oyakbank. The financial markets have in the past tended to let Turkey-specific risks fade quite quickly, and even now the lira has strengthened a bit since its lows, despite the news of the Constitutional Court accepting the case against the AKP. «The risk is that the market gets caught out if things in Turkey worsen quickly… which in turn would imply that the lira could weaken much further, quite quickly,» said UBS’s Ngotho. Foreign investors have seen Turkey as a success story due to its strong recovery from a financial crisis in 2001 and prospects of European Union membership but now many fear the story is at risk. Changing sentiment «The sentiment has gradually changed since last year’s political trouble and the optimists are clearly harder to find,» said Danske Bank senior analyst Lars Christensen. Turkey was rattled by a row over the presidential election last year, which was resolved by a fresh parliamentary election. «Most corporate investors remain positive about Turkey’s long-term perspectives, but portfolio investors are much more nervous because of the global credit situation and the significantly increased political worries,» Christensen said. Turkey’s large current account deficit is another key indicator that will be affected by political uncertainty. «Turkey has made great progress on public finances and in the banking sector since the crisis in 2001 but its reliance on foreign financing has risen and it is certain that we will have a correction in current account deficit if the scenario worsens,» Garanti Bank’s Dilek said. The current account deficit, a major weak spot of Turkey’s economy, jumped 28 percent year-on-year to $3.93 billion in January, after topping $38 billion last year. But Turkish savers traditionally keep some of their savings in foreign exchange to shield themselves from sharp shifts in lira rates. Now at around $105 billion, savers’ foreign exchange holdings provide a safety valve for sharp changes in lira rates and current account deficit, analysts said.