Recent economic indicators suggest that at least some of the risks to the Turkish economy that built up in 2010-11 have started to ease. Although this improvement may be partly due to external developments outside of the control of the Justice and Development Party (AKP) government, much of the rebalancing process has been policy-induced. By contrast, the government looks increasingly challenged by the escalating violence arising from the state's struggle with the secessionist Kurdistan Workers' Party (PKK) and by growing instability in neighbouring Syria, a haven for the PKK until 1999.
The risk of a hard landing has eased
The perception that the AKP, led by Prime Minister Recep Tayyip Erdogan, has managed the Turkish economy well has been the main factor behind its electoral successes since 2002. But in late 2011, Turkey's macroeconomic imbalances appeared to be coming to a head again. Its current-account deficit, driven by a credit-fuelled surge in domestic demand and high international commodity prices, ballooned to an alarming 10% of GDP by the end of the year; consumer price inflation started to accelerate, partly because a weaker lira pushed up prices of imported goods, edging back up into double digits in December; and global financial and economic policy instability rose as the euro crisis deepened, increasing the risk of a reversal of much-needed foreign capital inflows. Combined with the onset of a sharp slowdown in the Turkish economy, policy making became highly challenging, raising serious doubts about whether Turkey could avoid a "hard landing".
However, a coordinated response to Turkey's growing economic imbalances from the government, the banking regulator and the Central Bank of Turkey appears to have helped to do just that. In particular, the Central Bank's much-criticised "unorthodox" monetary policy has helped to curb excessive bank lending, eased pressure on the current-account, and put consumer price inflation back on a downward path without pushing the economy into recession. The government, despite 2011 being an election year, kept fiscal policy relatively tight, out of concern for the current-account deficit, a desire to keep public debt low and a preference for private-sector-led growth.
Available data suggest that economic activity held up better in the second quarter of 2012 than expected and that lower inflation and a declining current-account deficit may leave room for a cautious easing of monetary policy later this year or in 2013. Export performance has also picked up strongly since the start of the year as exporters have used the improved competitiveness arising from a weaker lira and productivity gains to increase sales to faster growing markets outside the sluggish EU. So far this year, the Istanbul Stock Exchange has been one of the best performers globally. Its strong performance has in part been because of a large drop in 2011. However, it has also reflected a higher level of investor confidence in Turkey's economic performance and policymaking compared with last year.
Less assured on issues of national security
In almost 12 years in office Mr Erdogan and his government have generally looked much less assured dealing with national security issues, whether domestic or external, than with economic policy challenges. In less uncertain times than these, the AKP took bold steps towards changing the state's approach to Turkey's decades-old Kurdish problem. In 2009 it announced its "democratic initiative" to provide a political solution to the Kurds' grievances. However, at the first signs of criticism from hardline nationalists, who are obdurately opposed to making concessions to any ethnic or religious minorities in Turkey, least of all the Kurds, the government appeared to lose its nerve and momentum was quickly lost.
The AKP then made promises before the general election that it would renew its efforts. But they never had much hope of succeeding. Since then, from its camps in the Kandil mountains of northern Iraq, the PKK has intensified its campaign of violence, which the Turkish Armed Forces (TSK) have struggled to contain in the Kurdish-inhabited south east of the country. In recent months not a day has gone by without reports of intense fighting, mainly close to the Iraq and Iran borders, which has left hundreds of PKK fighters and dozens of Turkish soldiers dead. On August 20th a car bombing in Gaziantep close to the Syrian border killed ten people and injured about 60 more, including women and children. Although it denied responsibility, the PKK or an affiliated group is widely believed to have carried out the attack. If the state fails to contain the threat of the PKK, the political cost to the AKP is now considerably higher because in recent years the government has largely succeeded in clipping the military's wings and bringing the TSK under civilian control. With greater control comes greater responsibility.
At the same time, the effects of civil war in Syria have spilled across the border into Turkey. The government is grappling with a growing humanitarian crisis caused by the influx of tens of thousands of Syrian refugees fleeing the fighting. The conflict also risks creating a power vacuum in Syria that will be filled by groups that are hostile to Turkey, including Syrian Kurds with close ties to the PKK. The Syrian regime of President Bashar al-Assad is proving harder to topple than the AKP government perhaps expected. As a result of its strong support for the opposition in Syria, the Turkish government is now in a difficult position with few options other than to hope that the conflict ends soon and that the country will remain united after it does. As its approach to foreign policy has become increasingly assertive in a desire to establish Turkey as a regional power, the government never seems to have considered that it might become embroiled in the turmoil that has spread across the Middle East and North Africa in recent years.
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