Turkeys decade-long bull run reached a turning point last month, as clashes between police and protesters belied the countrys much-touted political stability, just as the US Federal Reserve signalled a possible scaling-back of quantitative easing.
Turkey has been one of the key beneficiaries of the global search for yield resulting from US monetary policy since 2008. But the emerging market sell-off showed Turkey to be particularly vulnerable to a tightening in dollar liquidity, with the lira heading for a record low against the dollar in late June.
Confidence in the political environment had helped spur foreign portfolio investments, reaching a record 25.7% in lira bonds in late April. But the government has taken a hard line against protests, which erupted last month, partly because of anger over a perceived authoritarian drift in Ankara.
"The rule of law and the political environment in Turkey have not been properly understood by market participants," says Botan Berker, formerly a senior official at the central bank. International investors over-optimistic sentiment was now in reverse, she says.
Meanwhile, the Feds comments on its bond-buying programme in June came in the thick of the political crisis, sparking fear despite some let-up in pressure on the lira late in the month that Turkeys unorthodox central bank policy might suddenly come unstuck.
This unorthodox approach has been seen as a factor of the political environment. Governor Erdem Basci, cut the benchmark rate by 50 basis points in April and again in May, for example, purportedly to cool the market and deter hot-money flows.
But during the protests, prime minister Tayyip Erdogan repeated diatribes made earlier this year and in 2012 against what he calls the interest rate lobby (his thinking may be partly that government supporters will worry more about jobs than the effect of the exchange rate and inflation on savings).
In response to last months events, on June 11 the central bank announced $250 million in sales of currency reserves, signalling that it could do more. It reduced repo funding, yet said monetary tightening would be temporary and depend on foreign exchange volatility.
"The central bank is clearly not in panic mode," says Gaelle Blanchard, strategist at Société Générale, in late June. As such, she says, Basci might not be in a rush to support the lira via emergency rate increases.
Still, according to research from Bank of America Merrill Lynch, the previous rate cuts did not sufficiently take into account risks to the lira from the possible evolution of US monetary policy. Maintaining the upper end of the central banks rate corridor now risks a sharper and more destabilizing hike later.
The central banks currency reserves are a linked debate and another potential worry. Since spring 2012, Basci has introduced varying new rules for the proportion of foreign currency that can count towards banks obligatory cash reserves at the central bank.
As a result, in gross terms, the central banks currency reserves have risen to record highs. But net of the new allowances, according to BAML, the figure would be around $25 billion: roughly the same level as in early 2012, just after currency-market interventions of around $13 billion.
In June, banks reduced these foreign-currency placements with the central bank. However, given that a large part of the placements were funded internationally via swap agreements, it is uncertain whether or not this supported the lira, says Serhat Gurleyen, economist at Is Investment.
Continued currency interventions now could therefore result in dangerously low reserves. But the central bank might be tempted to hold off increasing the benchmark rate for longer than it did in 2011, says Gurleyen, partly because of already weaker economic growth potential.
Even before last month, Turkeys economy was becoming more reliant on domestic consumption, as corporates wary of still sluggish demand in western Europe held back on new investments. The benefits of diversifying exports to the Arab world have also largely already been achieved, says Gurleyen.
Low household and government debt metrics are a support for growth. Systemic capital adequacy is high, at 17.4%. Bad debt is low, less than 3%. As quantitative easing persists in Europe and, to an extent, in the US, foreign wholesale funding might remain available. Lower commodity prices could help the current account.
Nevertheless, after the events in June, many economists further downgraded their growth projections for Turkey. At the very least, for example, infrastructure concessions previously a key part of the governments growth agenda will be even more difficult to finance cheaply.
"Economic growth of around 5% has been the norm for the past five to 10 years in Turkey," says Gurleyen. "For the next five years it may be more like 3% or 4%. Compared with other emerging markets that could be good."