| The general elections of June 2011 delivered a clear victory for the religiously conservative Justice and Development Party [AKP]. As a result, the AKP can rule with an absolute majority for the third consecutive term. However, the AKP has failed to reach a two thirds majority in parliament - the threshold for constitutional amendments. The nationalist Republican Peoples Party CHP and the pro-Kurdish Peace and Democracy Party gained additional seats but remain in opposition, as does the far-right National Movement party MHP. In recent years, the AKP government has been successful in gradually curbing the armys political powers and increasing democratic control over the courts. A comprehensive reshuffle of the top military leadership has further strengthened the position of civilian rule. A shift in foreign policy priorities away from EU membership Accession talks between Turkey and the EU have been effectively on hold since December 2006, when the EU suspended further negotiations for eight of the 35 chapters until Ankara opens its ports and airports to Greek Cypriot traffic. Other major obstacles to EU entry are the Kurdish issue, the need for reform and the covert resistance of some of the EUs major states to Turkish entry. Because of this slow progress, the formerly widespread popular support for EU accession has declined considerably. While the AKP at first pressed hard to begin negotiations, it has since then partially shifted its foreign policy, and now focuses more on relationships with the Middle East and Central Asia: aiming to strengthen political and economical ties with the countries in those regions. Relations with Israel have deteriorated rapidly since May 2010, when Israeli soldiers raided a Turkish-led aid flotilla to the Gaza strip. Ankara demanded an official apology and compensation for the families of the victims, but Israel refused. Turkey consequently stopped its long-standing security cooperation with Israel. Meanwhile Turkey firmly supports the opposition forces in the Syrian civil. This is no doubt why the Syrian government has resumed its tacit support of the Kurdistan Workers´ Party [PKK]. Together with Ankaras tougher stance on the Kurdish question, this has led to renewed violent clashes between the PKK and Turkish forces since July 2012. Turkeys stance has also damaged its relations with neighbouring Iran. Growth has weakened in H1 of 2012 After two years of high domestic demand-led GDP growth [9.1% year-on-year in 2010 and 8.5% in 2011], the Turkish economy has recently begun to lose momentum: growing just 3.3% in Q1 of 2012 and 2.9% in Q2. Manufacturing and construction output growth has fallen markedly, with sales to the Eurozone declining and domestic demand becoming less buoyant than in 2011. Industrial production growth slowed to 4% year-on-year in the first half of 2012. However, capacity utilisation remained fairly stable at 74.2% between January and August, compared to 74.9% in the same period last year. The slowdown in domestic demand also owes much to government and Central Bank initiatives to prevent the economy from overheating. After a period of monetary easing to discourage the strong capital inflow in lira-dominated assets, since October 2011 the Central Bank has tightened its policy [e.g. by increasing the overnight lending rate] to cool down the economy. Moreover, banks have been asked not to grow their loan books by more than 25% this year: a target that is likely to be achieved. High inflation remains an issue After falling to 6.5% in 2011, inflation increased to 10.4% in Q1 of 2012. While consumer price increases have tailed off a little in recent months, they remain structurally above the regional average. Turkey is a net energy/commodity importer and very vulnerable to higher world market prices, and this is exacerbated by the volatility of the Turkish lira. In August 2012 inflation was still high at 8.9% after 9.1% in July. Moderate budget deficits Public finances deteriorated sharply in 2009 with a deficit of 5.5% of GDP: the result of a combination of lower tax income and subsidies and public expenditure aimed at boosting economic activity. While fiscal consolidation reduced the budget deficit to 1.4% of GDP in 2011, it is expected to increase slightly: to 1.9% in 2012 and 1.8% in 2013. In general, the pace of reform to the labour market, social security and tax administration is still too slow to tackle structural unemployment and widespread informal economic activities. The move to privatisation of state banks and the power sector are also proceeding too slowly. Fewer non-performing loans, but a steep increase of bounced cheques The banking sector is still strong, with a high capital adequacy ratio of over 16%, robust profitability and a transparent loan portfolio that does not involve mortgage products. In line with the continued economic growth nonperforming loans decreased to 2.7% in July 2012 from 2.9% in July 2011. Bounced cheques, usually an excellent indicator of payment behaviour because of the common use of cheques in Turkey, increased by 56% in the first eight months of the year. This sharp increase is mainly explained by the fact that the regulations for cheques have been amended at the beginning of 2012, i.e. the penalties for bounced cheques having been lowered. However, the slower economic growth this year also had an impact. External economic situation: Lower external imbalances Between 2009 and 2011, imports -including oil- increased much more than exports, because of strong domestic demand, and this has led to large trade and current account deficits. Turkeys current account deficit deteriorated substantially in 2011 to 10% of GDP - compared to 2% of GDP in 2009 and 6.4% in 2010 - compounded by the weaker lira exchange rate that increased import prices. However, since the end of 2011 the current account deficit has improved slowly [US$ 31 billion in the first half of 2012 compared to US$ 44.7 billion in the same period of 2011] as import growth declines. Outlook: Improving, but with large finance gaps still to be covered In the next parliamentary elections, scheduled for 2015, the AKP has a good chance of again prevailing as the opposition parties remain weak and divided. Turkeys entry to the EU is unlikely before 2020 at the earliest. While progress on the Cyprus issue is possible in the medium term, many other hurdles remain: such as human rights, freedom of religion, and the Kurdish question. Whats more, EU members remain divided over Turkeys membership, and in Turkey itself doubts about the benefits of EU entry -particularly the costs- are rising, while its foreign policy has shifted focus away from the EU and towards the Middle East and Asia. Economic growth is expected to slow to 3.5% this year, followed by a slight increase to 4% in 2013. Inflation is forecast to decrease to 7.6% in 2013 - still structurally high. Much depends on future developments in the Eurozone, which accounts for nearly 50% of Turkeys exports and is the main source of capital investments. The cooling economy is helping to mitigate the effects of Turkeys structural problems, i.e. persistent high inflation rates and current account deficits, the latter expected to decrease to 7% of GDP in 2013 after peaking 10% of GDP in 2011. The current account reacts quite swiftly to changes in the domestic business climate: this years economic slowdown has already contributed to an improvement in the trade deficit, with growth in exports exceeding that of imports. This is a positive development, given Turkeys weak external financial position in the last couple of years. Capital imports [foreign direct investment and portfolio capital] have had to be substantial to cover Turkeys high current account deficit. However, as much of that deficit is financed from volatile short-term portfolio investment, any shake-up of financial markets may trigger a massive withdrawal, making the economy more vulnerable. Fortunately, so far there has been a healthy inflow of capital although sometimes too much, with short-term capital flooding the Turkish capital markets and its banking sector. This has regularly created a dilemma for the Central Bank: while in times of economic overheating its normal practice would be to raise the official interest rate, it has to lower the rate to control capital inflow. Turkeys international solvency and liquidity position will remain reasonably good. Because of its high debt service, Turkey will continue to have considerable borrowing requirements on the financial markets and, while covering the finance gaps is not a problem at the moment, they remain a potential risk. As said above, much of the required capital investment is short-term and therefore volatile, which can also lead to more fluctuations in the lira exchange- rate. | 
