War on the doorstep compounds Turkey's economic worries

By Asli Kandemir and Jonny Hogg ISTANBUL/ANKARA (Reuters) - Already struggling for substantial growth after at least a year of foreign and internal turmoil, the Turkish economy could have done without an Islamic State onslaught against Syrian Kurds on Turkey's border. Investors who until mid-2013 saw Turkey as a relatively safe bet in a chaotic region are increasingly alarmed that it might not only be dragged into the war in Syria but also lose the hard-won prospect of peace and economic revival in its own Kurdish region. "This is ethnic turmoil, we are very worried," said Atilla Yesilada, an economist with the New-York based Global Source Partners. "Difficult days are ahead for Ankara, and investors will eventually see that reality, and will push up the political risk premium permanently." So far, Turkey has resisted Western and Kurdish pressure to enter Syria's complex war by sending its tanks a few metres over the border to confront the jihadists of Islamic State, who have already driven 200,000 Syrian Kurds to seek shelter in Turkey. But by refusing to bolster the Syrian Kurdish forces trying to defend the town of Kobani, it has infuriated their brethren in southeast Turkey, whose protests last week reached as far as Istanbul and Ankara and triggered clashes in which at least 35 people died. A peace process to end a three-decade insurgency by the Kurdistan Workers' Party (PKK) is under severe threat. Already, the Turkish lira has lost around 2.5 percent against the dollar since the Kobani crisis started nearly a month ago, underperforming other emerging market currencies, while Istanbul's main share index is down around 3 percent. Foreign investors sold a net $500 million (313.11 million pound) in Turkish equities in September. "Political risks are a ticking bomb," said Ugur Gurses, a columnist in the daily Hurriyet and a former central banker. "If Kobani falls, it will trigger further domestic violence and push the dollar/lira (exchange rate) through the roof." Officials are already acknowledging that Turkey is entering choppy financial waters, while blaming global conditions. Presenting their medium-term economic plan last week, Deputy Prime Minister Ali Babacan and Finance Minister Mehmet Simsek revised down their growth forecast for this year to 3.3 percent from 4.0 percent, and for 2015 to 4 percent from 5 percent. Economists say 5 percent is the minimum need to keep unemployment, currently around 10 percent, from rising and so damaging President Tayyip Erdogan's AK Party, which has based a decade of political dominance on rising prosperity. Gurses said growth could even sink to 2.0-2.5 percent, undermined by lira weakness that was boosting inflation and reducing domestic demand. "That will be very unpleasant for a government that is proud of high growth rates," he said. REFORMS ARE NEEDED Simsek himself told reporters on Wednesday that Turkey could not be satisfied with 3-4 percent growth. "With those numbers, the employment we can create is limited," he said. "We need to jump onto a high-growth path again. And the only way to do that is to make micro-level reforms, which we will announce soon." After Erdogan came to power in November 2002, Turkey averaged 7 percent growth until the financial crisis of 2008/09 triggered a recession. But after bouncing back strongly in 2010, growth has slowed as the investment climate clouded over, long before the turmoil of the last few weeks. Expectations grew that the U.S. Federal Reserve would reduce the availability of cheap funds, and the government took steps to dampen domestic demand as the current account deficit grew. That deficit, seen as Turkey's main economic weakness, has contracted somewhat, but remains near 6 percent of GDP -- about twice the rate of, say, Brazil or Indonesia -- although cheaper oil should provide substantial relief next year. Meanwhile the government now projects inflation of 9.4 percent for end-2014, higher than the central bank's latest forecast and almost twice the government's target. Then there is growing political turbulence. The violent quashing of a mass occupation of Istanbul's Taksim Square last summer, together with allegations of corruption among government officials, part of a toxic stand-off with the influential U.S.-based Islamist cleric Fethullah Gulen, have damaged Erdogan's standing. While his critics accuse him of authoritarianism and judicial manipulation, his AK Party's reputation for safeguarding investors' interests has also been tarnished. The Islamic lender Bank Asya says a fall in its share price is part of a government-orchestrated bid to punish it for its links to Gulen. The stock's 63 percent slide since last December has hurt Western investors including M&G Investment Management and Norges Bank. While the MSCI global emerging markets index stands almost exactly where it did a year ago, Istanbul's main share index is down nearly 10 percent. Now, the turmoil on the doorstep in Syria threatens to wreck a flagship government policy with the potential to unlock huge growth in the southeast, a region of 15 million people shut out of Turkey's expanding prosperity by its Kurdish conflict. Turkish warplanes were reported to have attacked PKK targets in the area at the weekend for the first time since the peace process began in March 2012. "For all the Western criticism of Erdogan, investors have long seen him as better than any previous leader in his efforts to make peace with the Kurds and open the southeast to foreign investment," said Jonathan Friedman, Middle East analyst and associate at the Centre for Turkey Studies (CEFTUS) in London. "The current unrest threatens to undermine that legacy." PLANS ON HOLD For investors in the region's promising hydro power, mining and oil opportunities, the unrest is a potential "game-changer", he said, adding that "companies considering new investment are putting their plans on hold". Developers have already begun to bring Turkey's building boom to the southeast on hopes of peace, and both Royal Dutch Shell and the oil and gas exploration and production firm Perenco have operations close to Diyarbakir, the biggest city in the southeast and centre of last week's protests. Instability has affected companies operating in the area before. In 2012, before the PKK announced its ceasefire, a Perenco helicopter was fired upon by suspected Kurdish militants, media reported. Even if the Kurdish peace process can be kept on track, diplomats say any Turkish role, albeit reluctant, in the fight against Islamic State could invite a terrorist attack that could devastate its tourism sector, a major source of foreign revenue. It may all mean that Erdogan's options are narrowing to secure the legacy he has promised: to lift Turkey from about 17th into the top 10 global economies, with a per capita income of $25,000, by 2023, the 100th anniversary of the foundation of the modern state. After rising in leaps and bounds early in his tenure, per capita income in dollar terms has stalled at around $11,000 since 2007. Foreign direct investment peaked the same year at $22 billion, and has since hovered around $12-13 billion a year. Economists say Turkey is stuck in the "middle income trap", where rising wages make the exports of an emerging economy less competitive, stifling the investment that might help it to make the leap to a developed, high-value-added economy. A parliamentary election is scheduled for June, and Erdogan, fresh from being elected president with 52 percent of the vote, needs his AK Party to win two-thirds of seats to pass constitutional reforms that would give the post wider executive powers. Opinion polls suggest that this goal is already very ambitious. With growth rates falling, reducing poverty and empowering the middle class will require structural reforms such as more comprehensive tax collection, according to Seyfettin Gursel, director of BETAM, an economic think-tank in Istanbul. "It means more challenging and politically costly reforms, and the government's willingness to undertake such reforms (before an election) is questionable," he said. All of this comes at a time when the prospect of rate hikes by the U.S. Federal Reserve could further suck investment out of emerging markets such as Turkey. "Local banks are very worried. It is impossible to be optimistic if you are a local and reading headlines every day," one senior treasury manager at a bank told Reuters. "Investors are switching their portfolios from equities to bonds. If they start to think that the government's sustainability and political stability is at risk, then we could see mass capital outflow." (Editing by Kevin Liffey)