The fall in the value of the Turkish lira in recent weeks and the accompanying dip in equity prices have come as no great surprise, given the evident need for a correction in the country's financial markets. However, domestic political factors and trends in global markets have sharpened the adjustment, and brought an increased risk of damaging consequences for the economy as a whole. Remedial steps by the authorities should stabilise the lira in the short term, but we expect further instability later in the year.

Since May 8th the Turkish lira has been in almost continuous decline, losing almost 15% against the US dollar and the euro. The correction was long overdue. The real effective lira exchange rate appreciated by almost 40% in 2002-05, which, combined with strong domestic demand and rising international oil prices, has seen the current-account deficit balloon to 6.5% of GDP last year and increase by almost 40% in the first quarter of 2006 compared with a year earlier. The fall was triggered by the unwinding of carry trades (short dollar positions that have been used to fund investments in high yield countries) as investor sentiment turned negative towards Turkey (and other highly indebted emerging markets). This change of mood has occurred despite the government's impressive disinflation record, its strong fiscal performance and a commitment to structural reforms in recent years. However, the lira was always going to be vulnerable given Turkey's large government debt, its burgeoning current-account deficit, substantial external debt-servicing and heavy reliance on short-term capital inflows.

In addition, several domestic factors have contributed to the size of the recent fall and the prolonged uncertainty regarding the future level at which the lira will stabilise again. In March the government delayed the appointment of the new central bank governor, creating doubts about the future independence of the Central Bank of Turkey from political influence. After a prolonged stand-off between the prime minister, Recep Tayyip Erdogan, and the president, Ahmed Nezdet Sezer, the latter finally approved the appointment of Durmus Yilmaz, an existing board member, as central bank governor at the end of April. At its first meeting under the new governor, the monetary policy committee decided to cut interest rates by 25 basis points, reducing the overnight borrowing rate to 13.25%, despite the gradual rise of consumer price inflation since the beginning of the year.

In a further blow to market confidence, on May 10th Mr Sezer blocked several articles of the social security reform laws, which are needed to help to check the steady rise in the social security deficit. The IMF has been awaiting final approval of social security reforms before agreeing to release the next credit tranche under the May 2005 standby agreement. Even though the government could bypass the president's objections by passing the bills again unchanged, the delay increased uncertainty among investors and probably contributed to the initial fall of the lira.

EU doubts

Periodic domestic political tensions and potential obstacles to Turkey's EU membership bid in the coming months have also contributed to the change of investor sentiment. Accession negotiations, which were officially opened in October 2005, are considered an important anchor for the political and economic reform process in Turkey over the medium to long term. To ensure that the negotiations move forward in the short term, however, the government will need to produce clearer evidence of further progress on human-rights reforms, particularly on the Kurdish issue, than it has done in recent months. In addition Turkey has to ratify an additional protocol to its existing customs union agreement with the EU, which would oblige it to open its ports and airports to Greek Cypriot ships and aircraft by end-2006. Turkey has so far refused to do this, arguing that any implementation should be tied to measures to facilitate direct trade with the EU for the Turkish Cypriots in the north of the island, something the Greek Cypriot government of Cyprus has not accepted.

Murder in court

The murder of a Council of State judge by an Islamist extremist on May 18th also exacerbated lira volatility, as it increased fears of a destabilising collision between the government and the secularist establishment, which includes the president Mr Sezer, the judiciary and the military. They view Mr Erdogan's Justice and Development Party (AKP) with suspicion because of its Islamist roots. Secularists attacked the AKP saying that its criticism of the court's ruling in favour of the ban on the wearing of Islamic style headscarves in schools, universities and public offices had encouraged the attack. In return, the AKP criticised the Turkish Armed Forces chief of staff Hilmi Ozkok's praise of secularist street protests after the murder.

IMF mollified

Faced with continued financial market turmoil, the government agreed on May 22nd to IMF demands for spending cuts of US$3bn to help to meet its 2006 fiscal targets. The social security laws appeared to be back on track to obtain final approval so that the third and fourth tranches of IMF credit worth a total of about US$1.9bn should be released by July.

This should help to stabilise the lira in the coming months. But we expect further tightening of international liquidity and higher inflation in Turkey to contribute to a further fall of the lira to around TL1.65:US$1 by the end of this year, before a stabilisation in nominal terms in 2007. In the medium term maintaining the momentum of the reform process will prove increasingly challenging. The temptation to loosen fiscal policy or even abandon the IMF agreement may increase as the next election due in November 2007 draws nearer.