Mark Bentley
Jan 29 2018

Turkey’s economy can handle protracted Afrin conflict

Turkey’s economy and financial markets can probably withstand a protracted war between the Turkish army and Syrian Kurdish fighters in Afrin.

Investors were surprisingly sanguine this week as President Recep Tayyip Erdoğan carried out a threat to send troops into northern Syria, flouting the wishes of NATO ally the United States.

Money poured into Turkish stocks, bonds and the lira. Vakıfbank, a Turkish state-run lender, was able to sell a record amount of bonds on international markets and at lower cost than expected.

With emerging markets awash with liquidity, Turkey could conceivably continue its war in Afrin for weeks or months without serious repercussions, said İnan Demir, an emerging markets economist at Nomura in London.

“Investors take the view that, unless Turkey clashes with one of the major forces on the ground in Syria - the United States, the Syrian army, or Russia - then this operation will not have a major impact,” he said.

Turkish units, working with the Free Syrian Army (FSA) – a mix of jihadist groups opposing Syrian President Bashar Assad – pushed into Kurdish-controlled territory last weekend after an initial air bombardment. Progress appeared to be slow at first, with soldiers focused on consolidating positions along the border.

Turkey embarked on the military campaign after it warned the United States repeatedly to halt its support for the People’s Protection Units (YPG), which Turkey says is dominated by an affiliate of the separatist Kurdistan Workers’ Party (PKK) that has been fighting in Turkey’s mainly Kurdish southeast for more than three decades. The United States and European Union both recognise the PKK as a terrorist group.

Despite the hostilities, the lira has risen 1.9 percent to 3.75 per dollar since the invasion. The main BIST-100 index climbed almost 3 percent. Political tensions with the United States over Syria and the prosecution of a senior Turkish banker in New York for Iran sanctions-busting had pushed the lira to a record low of 3.96 in late November.

The rally in Turkish assets was also supported by economic data. Business confidence for January surged the most since February last year and consumer confidence completely reversed five months of declines, according to data for January published by the government and central bank this week.

The overall positive tone for the markets and the economy appears to support the government’s assertion that the armed confrontation will have no significant impact.

Still, dangers for the economy, particularly the lira, remain.

A top White House official warned rather obtusely on Thursday that Turkey faced “grave consequences” should its forces miscalculate.

The warning appeared to refer to Turkish plans to press on from Afrin into Manbij to the east, where Washington has a number of troops to train and work with members of the YPG. U.S. cooperation with the Kurds has been key in defeating Islamic State (ISIS) in eastern Syria.

İlnur Çevik, senior diplomatic adviser at the presidential palace, warned the United States on Friday that its strategic position in Syria was tenuous and encouraged it to vacate Manbij. Washington had better work with Ankara behind the scenes to ensure that “mayhem” was avoided, he said.

Ahead of last week’s invasion, Erdoğan and other Turkish officials repeatedly warned the United States that it must take its threats to enter Syria seriously. Hence a further incursion into Manbij cannot be ruled out.

While the Turkish invasion of Afrin has caused a political storm in Washington, Manbij would constitute a red line for the United States, said Tim Ash, senior emerging markets strategist for BlueBay Asset management in London.

“If they go in on Manbij then it’s a different ball game,” he said. “The danger is if they do too well in Afrin, the more likely they are to want to go in elsewhere. The tougher the fight in Afrin, the more unlikely it is that they are going to extend it,” he said.

Live maps purporting to show Turkish positions in Syria indicated that troops and Turkish-backed FSA fighters had made multiple incursions, establishing a presence 10 km inside Kurdish territory, on average. The main push appeared to be from the southwest, with Turkish positions lying some 15 km from Afrin town along a major road running from Jandaris.

“If Turkey has success in Afrin and follows that up with an operation in Manbij, then I think markets would start pricing in a direct confrontation with the United States,” Demir said.

Investing in Turkish five-year bonds currently returns about 13 percent, while the country’s banking stocks trade below the average of peers elsewhere. Despite its gains last week, the Turkish lira is still the worst performing emerging market currency over the past six months.

While Turkish assets are drawing in investors – a Bloomberg survey published on Jan. 21 rated Turkey and Mexico as the most attractive emerging markets for 2018 – any danger of confrontation with the United States would likely expose the country’s Achilles heel; a large current account deficit that is funded by short-term portfolio inflows. The impact on the lira could be severe.

Bomb attacks by the PKK on major Turkish cities also cannot be ruled out.

 “The global backdrop is so favourable right – I mean how many times has Erdoğan been lucky in this regard,” Ash said. “There’s so much liquidity. People are looking through the geopolitics.”

Erdoğan could also use the campaign in Syria as a springboard for early elections, possibly to coincide with the anniversary of the July 15, 2016 coup.

Presidential, parliamentary and local elections are all due to be held next year. The prize for Erdoğan would be even more power – the election of Turkey’s next president is due to kick-start full implementation of a presidential system of government, approved in a referendum last April.

“He never goes for early elections, but if he sees opinion polls doing better, I think he’ll go,” Ash said. “I do think he’ll go this time.”