Outlook for 2011-15

• The Economist Intelligence Unit expects the Justice and Development Party (AKP) to win the general election on June 12th and to remain in office throughout the forecast period.
• Domestic resistance to reforms, notably to resolve the Kurdish issue and improve the judicial system, will continue to hinder Turkey's EU negotiations, as will the Cyprus issue and opposition in some EU states to Turkish accession.
• Following a sharp rise in 2009, the budget deficit is expected to ease, despite some election spending in 2011, from 3.6% of GDP in 2010 to about 2% of GDP by 2015.
• We expect the Central Bank of Turkey to start to raise its policy interest rates in the second half of 2011. The inflation outlook seems fairly benign, despite higher food and oil prices, so rates are expected to stay below pre-crisis levels.
• After an expansion of 8.9% in 2010, growth is expected to slow to a still solid 4.5-5% in 2011-12 before picking up to 5-5.5% a year in 2013-15.
• The current-account deficit is expected to reach 7-7.5% of GDP in 2011, before easing gradually to a still large 6-6.5% in 2012-13 and 5.5-6% in 2014-15 as domestic demand growth moderates and commodity prices ease.

Monthly review

• The ruling AKP and the main opposition party, the Republican People's Party (CHP), have overhauled the election candidate lists by deselecting around 50-65% of current members of parliament.
• On April 5th parliament authorised the government to issue decrees with the force of law for a period of up to six months, without having to put bills to a vote in the national assembly. The opposition has strongly condemned the move.
• March saw some fiscal loosening ahead of the election as the central government budget showed a deficit of TL6.1bn (US$3.9bn), after surpluses in the previous two months. But fiscal policy has remained cautious on the whole.
• On April 18th Erdem Basci became Turkey's central bank governor. He was a long-standing deputy governor, which should ensure policy continuity, but he is also seen as being close to the deputy prime minister, Ali Babacan.
• Some of Turkey's bankers have complained about the high level of taxation on the sector and the fact that rising required reserves bear no interest.
• In the fourth quarter of 2010 real GDP grew by 9.2% year on year and by a calendar-and seasonally adjusted 3.6% in quarter-on-quarter terms.
• Despite strong domestic demand growth, a weaker lira and rising commodity prices, consumer price inflation fell to a 41-year low of 4% in March.

The Economist Intelligence Unit's baseline political forecast for Turkey is that the religiously conservative, pro-EU Justice and Development Party (AKP), led by the prime minister, Recep Tayyip Erdogan, will win the general election on June 12th 2011, allowing the AKP to form a single-party government for a third consecutive term. We expect the political scene to remain volatile up to and beyond the election, mainly as a consequence of the tension between the AKP and the secularist/nationalist elites, including the main opposition party, the Republican People's Party (CHP), and sections of the military and the judiciary, who view the ruling party with suspicion because of its pro-Islamist roots and its tightening grip on Turkey's civilian institutions, especially the judicial system. However, following the government's convincing victory in the constitutional reform referendum in September 2010, we believe the risk of a political crisis that could destabilise the government and undermine the confidence of the financial markets in Turkey's medium-term economic prospects has diminished.

In the referendum, a larger than expected majority (58%) voted in favour of the AKP's constitutional reform package, which increased civilian oversight of the military and overhauled Turkey's two highest judicial bodies, the Constitutional Court and the Supreme Board of Judges and Prosecutors (HSYK), which is responsible for appointing judges and prosecutors. The hardline secularist chief prosecutor of the Supreme Court of Appeals, who launched a lawsuit to try to close the AKP during 2008, warned the party in October 2010 against another attempt to lift the ban on women wearing the Islamic-style headscarf in universities and public offices. However, the Constitutional Court would probably be reluctant to take up another petition to close the party. The military, once the most respected institution and self-appointed guardian of the secular state, is likely to maintain a low profile, as its reputation has been tarnished by allegations of plots to destabilise the AKP government and the perception that the deaths of many Turkish soldiers fighting the militant Kurdistan Workers' Party (PKK) could have been avoided.

The AKP is setting the election agenda, based on its calls for increased democratisation and a new constitution to replace the current 1982 military-inspired constitution. This is forcing its main rival, the CHP, to refresh its image and revamp its traditional policies. If the AKP wins a third term, it may try to introduce a presidential system, giving executive powers to the president. This will be hard to achieve, as it will encounter significant political opposition, and we do not expect the AKP to have a large enough parliamentary majority to change the constitution without opposition support or a referendum. The debate surrounding such far-reaching institutional change would be highly divisive. However, we believe that it is unlikely to affect Turkey's overall political stability, as illustrated by the constitutional reform referendum in 2010. That campaign was hard fought but generally peaceful. The CHP and the smaller right-wing Nationalist Action Party (MHP), which also opposed the reforms, as well as the conservative sections of the judiciary immediately acknowledged the legitimacy of the result.

The Kurdish issue, one of Turkey's most enduring sociopolitical and security problems, will feature strongly in the general election campaign and after. It will continue to pose a threat to political and social stability and hinder Turkey's EU accession prospects, as finding a lasting settlement is likely to be difficult. The democratic initiative launched by the AKP in 2009 to try to improve Kurdish rights and bring about an end to violence may be revived after the general election, but progress will depend not only on the AKP's determination to make progress but also on the positions that will be adopted by the pro-Kurdish Peace and Democracy Party (BDP) and the CHP, which under its new leader, Kemal Kilicdaroglu, has promised a sea change in its traditionally hardline nationalist stance on the issue of Kurdish cultural rights. The initiative made little progress in 2009-10 owing to hardline nationalist opposition to concessions to the Kurds and the refusal of pro-Kurdish political parties to distance themselves completely from the militant Kurdistan Workers' Party (PKK), which has resumed its campaign of violence.

At the general election on June 12th 2011, we expect the AKP to win a clear majority in the 550-seat parliament. The composition of the next parliament and the distribution of seats will depend largely on how many political parties get over the threshold of 10% of the national vote required for political party representation in parliament. A major factor in this regard will be the performance of the MHP, which according to opinion polls is marginally above the 10% barrier. If the MHP fails to reach the threshold, the AKP would almost certainly obtain more than 330 seats, enough to approve constitutional changes in parliament so that they can be put to a referendum, and might even win a two-thirds majority.

The new CHP leader, Mr Kilicdaroglu, who was elected in May 2010, is seeking to transform his party into a credible alternative to the AKP in government. However, the CHP has been beset by internal divisions and Mr Kilicdaroglu's control over the party has been fragile, despite successfully rejuvenating the executive in December 2010. It will be a tough challenge to persuade voters that the party will maintain a more liberal stance on democratic reforms to improve the protection of minority rights, promote freedom of expression and exclude the military from politics. The AKP's trump card will be the perception that since first coming to power in 2002 it has managed the economy well.

During the forecast period Turkey will elect a head of state by universal direct suffrage for the first time. However, uncertainty exists regarding the timing of the election. In August 2007 parliament elected the current president, Abdullah Gul, for a single seven-year term. Subsequent constitutional changes introducing the direct election of the president also reduced the presidential term to five years, for a maximum of two terms. Under Turkey's current parliamentary system, the powers of the president are limited. However, the election will be fiercely contested. As happened in 2007, it is likely to become a battleground in the power struggle between the AKP and the secularist/nationalist elite. If the AKP were to introduce a presidential system, Mr Erdogan would probably be the front-runner to replace Mr Gul.

Assuming that the AKP will remain in office after the general election in June 2011, we expect a good degree of continuity in Turkish foreign policy. The mainstay of the AKP's foreign policy will remain striking a balance between maintaining good relations with the US and EU and improving ties with Turkey's neighbours, notably Iraq, Syria, Iran and Russia, its main energy supplier. The government's more assertive approach and its independence from Western positions, especially on issues such as Iran's nuclear programme and the Israeli-Palestinian conflict has won Mr Erdogan popular support at home and in the Arab world, but risks raising tensions with the EU and the US from time to time. Slow progress on EU membership negotiations, closer ties with Iran and a sharp deterioration in relations with Israel have led to accusations that under the AKP, Turkey is turning away from the West. We believe that this view is misplaced. The AKP's policy of "zero problems with neighbours" is consistent with EU requirements and has boosted trade links in the region. Moreover, as turmoil has spread in the Arab world, many Western observers have pointed to Turkey as a democratic model for other Muslim countries.

The AKP has supported UN-backed efforts to resolve the division of Cyprus. However, a solution that is acceptable to both the Greek and Turkish Cypriots is unlikely to be found. The differences between the two sides remain considerable and the government will have no pressing reason to facilitate a settlement on the Cyprus question, as Turkey's EU accession process is likely to remain in the doldrums.

Turkish-US relations have been better under the current US president, Barack Obama, than under his predecessor, George W Bush. However, major areas of disagreement persist, and there is a considerable risk that this could lead to another sharp deterioration in the short to medium term. The crisis in Turkey's relations with Israel, Turkey's efforts to maintain positive relations with Iran and the threat of a full vote in the US Congress to recognise as genocide the massacre of Armenians by Ottoman Turks in 1915-17 will continue to cause tension.

Regardless of the outcome of the general election, we expect Turkey to remain an open, largely market-driven economy with adequately prudent public financial management and a well-regulated financial sector. Although Turkey suffered a deeper recession in 2008-09 than most other emerging markets, financial system stress and interest- and exchange-rate volatility were limited. After the election, reforms in areas such as taxation and employment are likely to be attempted. Investment, export and employment incentives may be used more selectively to improve external competitiveness. Privatisation will continue, particularly under the AKP, with the pace depending on market conditions. The privatisation of the three main state banks is on the government agenda, but may not be completed by 2015 owing to the large size of the banks and political sensitivities.

It is unclear whether or not the idea of a "fiscal rule" will be revived; in any case, the government will keep some flexibility to support growth in output and jobs and to distribute patronage, in so far as it is able to do so without damaging investor confidence. Although Turkey's strong budget and economic growth performance in 2010 have reassured investors, the economy is likely to remain vulnerable to sudden shifts in international sentiment because of its large external financing needs.

Aided by indirect tax increases, low global and domestic interest rates and the positive impact of the economic recovery on tax receipts, the deficit in the central government budget, which covers most of the public sector, fell from 5.5% of GDP in 2009 to 3.6% in 2010. Because of the forecast slowdown in economic activity, we expect the deficit to decline more gradually during the forecast period, to about 2% by 2015. A small improvement is expected in 2011, despite some election spending. Deficit reduction will also be helped by lower interest payments as a percentage of GDP owing to the fall in yields on government securities compared with the period up to the 2008-09 crisis.

As a result of the smaller deficit and strong GDP growth, central government debt fell to 42.8% of GDP in 2010. Given our deficit and growth forecasts for 2011-15 and our expectation that privatisation activity will pick up, we expect the downward trend to continue, with the debt/GDP ratio falling to below 40% by 2013-15.

Concern about Turkey's growing current-account deficit and the impact on the country's financial stability of this and strong short-term capital inflows will continue to make the Central Bank of Turkey's task of setting monetary policy highly challenging. Instead of raising rates, as central banks in most booming emerging markets have done, the Central Bank of Turkey cut its key interest rate, the one-week repo (repurchase) lending rate, by 50 basis points in December 2010 and by 25 basis points in mid-January 2011, to 6.25%, and aggressively hiked banks' required reserves for short-term liabilities. We think further reserve hikes may be announced if credit growth does not start to moderate but interest rates will remain on hold until after the June election and then start to rise gradually as inflation picks up. Our forecast assumes that higher reserve requirements will start to slow credit growth, which has fuelled increased spending on imported goods, but with a lag of several months. However, there is a risk that they do not succeed and the current-account deficit rises by more than we are currently forecasting, requiring much tighter monetary and/or fiscal policy in the first half of the forecast period.

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Following the 2008-09 recession, economic activity rebounded in Turkey in 2010, reflecting some base effects but also strong domestic demand growth driven by low real interest rates, strong capital inflows and a rapid acceleration in bank credit growth. We expect the pace of growth to be more moderate in 2011-15, slowing from 8.9% in 2010 to about 4.5-5% a year in 2011-12 and 5-5.5% during the remainder of the forecast period. During the second half of the forecast period, we expect growth to be more balanced between external and domestic demand.

Although unemployment is expected to remain above pre-crisis levels and wage growth is likely to be moderate in real terms, employment growth and still low interest rates (even taking account of our forecast that the Central Bank raises them in 2011-12) are expected to continue to support household spending growth, which we forecast will average 5-5.5% a year in 2011-15.

In 2010 the government curbed public spending, resulting in a sharp deceleration in government consumption growth from 7.8% in 2009 to an estimated 2% in 2010. However, we expect that the government has loosened the purse strings to some extent in the first half of 2011, pushing up public consumption growth to 5% for the whole year. In 2012-15 we forecast a moderate deceleration to 4-4.5% per year as the government tightens fiscal policy moderately.

After a collapse in 2008-09, gross fixed investment rebounded by 29.9% in 2010. We forecast that growth will moderate from 2011 owing to base effects and softer external and domestic demand growth, but will remain strong at about 8% in 2012-15.

As we expect robust domestic demand to drive import growth and demand in Turkey's main European markets to remain subdued, especially during the first half of the forecast period, the foreign balance is forecast to reduce GDP growth by 4-4.5 percentage points in 2011 and by 2-2.5 percentage points in 2012. The impact is forecast to remain negative during 2013-15 but at a more moderate 1-1.5 percentage points.

There are substantial risks to our projections, on the upside for 2011-12, but on the downside for the second half of the forecast period. If the Central Bank's monetary policy fails to moderate credit expansion, GDP growth is likely to be substantially stronger than we expect in the next two years. However, continued above-trend economic growth would exacerbate Turkey's imbalances posing risks to stable growth in the second half of the forecast period. If private-sector debt levels continue to rise sharply (by OECD standards they are relatively low at present, at around 50% of GDP) and the current-account deficit is not reduced in two to three years, a decline in global liquidity could cause severe problems, including an abrupt fall in the value of the lira leading, as it has done in the past, to higher inflation and a sharp tightening of monetary policy followed by a rapid slowdown in economic activity, with possible private-sector debt-servicing difficulties.

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We expect the annual rate of consumer price inflation to accelerate moderately from a 41-year low of 4% in March 2011, given some upward pressure from the impact of low interest rates, a weaker lira and rising commodity prices. That said, we believe that the inflation outlook is fairly benign, as we expect the strong rebound in economic activity to moderate in 2011-15. Our baseline forecast is that end-of-year rates will be over the Central Bank's targets of 5.5% in 2011 and 5% in 2012 and 2013, but within the band of uncertainty of ±2 percentage points. Given our forecast that domestic demand growth will stabilise in 2013-15 and international oil prices will ease slightly, we expect inflation to decline to 4-4.5% in 2014-15.

Our baseline forecast is that the Turkish lira will average around TL1.60:US$1 and TL2:EUR1 in 2011-15, despite substantial volatility. Global liquidity is expected to tightened only gradually during the forecast period, which should ensure adequate capital inflows into lira-denominated assets to support the exchange rate. We see a moderately high risk of a much weaker lira, especially if global risk aversion increases sharply, making it difficult for Turkey to meet its large external financing needs.

Strong credit expansion, real currency appreciation, rising oil prices and strong domestic demand growth caused Turkey's current-account deficit to rise from a six-year low of 2.3% of GDP in 2009 to 6.6% in 2010. We expect similarly large deficits of 7-7.5% of GDP in 2011 and 6-6.5% in 2012-13 as credit growth will slow only gradually and import demand will remain strong. We also expect oil prices to ease only gradually from around US$100/barrel (dated Brent blend) and fiscal tightening in the EU, Turkey's largest market, to dampen demand for Turkish exports. In 2014-15 a slight improvement is forecast as we expect export demand to recover gradually and international oil prices to ease. However, the deficit will still be large at 5.5-6% of GDP.

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The deadline set by the Higher Electoral Council (YSK) for political parties to submit their lists of parliamentary election candidates passed on April 11th. Seventeen parties will compete in the election on June 12th. However, only two or three will manage to win enough votes to reach the high 10% national threshold for party representation in parliament. These will almost certainly be the three main parties in parliament: the religiously conservative ruling Justice and Development Party (AKP); and the two main opposition parties, the secularist/nationalist Republican People's Party (CHP) and the hard-right Nationalist Action Party (MHP).

The pro-Kurdish Peace and Democracy Party (BDP) is fielding independent candidates to bypass the 10% barrier and will form a parliamentary group if they manage to obtain 20 seats, the minimum required, as they did in 2007. A controversial YSK decision on April 18th to ban 12 independent candidates, six of whom were backed by the BDP, for having a criminal record, has thrown the party's election plans into turmoil and will make that task of forming a political group in parliament after the election much more difficult. The decision has caused severe tension in the mainly Kurdish south-east of the country, fuelling distrust among Kurds regarding the Turkish state.

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Based on available information about the candidates on the party lists, it is expected that over 50% of members of parliament (MPs) will be new after the election; that their average age will be one of the lowest in Turkey's parliamentary history; and that the next parliament will contain more female members than previous parliaments (currently 9% of the total number of MPs are women).

The main parties adopted different approaches to the selection of their candidate lists. The AKP's selection process was heavily centralised, as is the tradition in Turkish politics, with the leader of the AKP and prime minister, Recep Tayyip Erdogan, closely involved. Of the AKP's 340 sitting MPs, 167 were left off the list of candidates either because they had gone against Mr Erdogan on key issues or votes in parliament, or because they were deemed unpopular in their electoral districts. Mr Erdogan appears to have favoured applicants who have not served in parliament before but have been active in the party organisation. The list contains few candidates considered close to the AKP's old Islamist roots or to Abdullah Gul, the party's deputy leader until he was elected to the presidency in 2007. Several former cabinet ministers such as Kursad Tuzmen, Hilmi Guler and Kemal Unakitan have also been excluded. On April 2nd Mr Erdogan stated that he expects the AKP to obtain 315-335 seats out of a total of 550 in parliament. This would give the party an outright majority, but insufficient votes to amend the constitution, although 330 seats would be enough to secure parliamentary approval for constitutional changes and put them to a referendum.

The process followed by the leader of the CHP, Kemal Kilicdaroglu, has also resulted in major changes to the composition of the party's candidates list and points to a shift in its ideological orientation. The CHP held primary elections in 29 out of 81 provincial districts to select its candidates, reflecting the leadership's efforts to make the CHP a more representative and participatory party. Of the party's current 101 MPs, approximately two-thirds have not been reselected. The supporters of the party's old guard have been largely excluded, which has helped Mr Kilicdaroglu to consolidate his position as leader, although his survival will depend on whether he succeeds in increasing his party's share of the vote to at least 30%, from about 20% in the 2007 election. The former secretary-general, Onder Sav, who orchestrated Mr Kilicdaroglu's election as leader in May 2010 but subsequently sought to challenge him, is not a candidate. The former long-standing CHP chairman, Deniz Baykal, who was forced to resign in 2010, has been selected but appears to have few supporters in the party. The new secretary-general, Gursel Tekin, played a key role in the selection of candidates, many of whom have not been in the CHP for more than five years. However, the decision to put forward three detained suspects in the Ergenekon trial has drawn strong criticism from inside and outside the party. In the criminal trial they are accused of belonging to an illegal ultra-nationalist gang, Ergenekon, comprising leading civilians and retired military officers intent on creating instability to bring down the AKP government.

In contrast to the AKP and the CHP, the MHP's candidate list includes most of the MPs elected to the current parliament. The list also includes a retired general, Engin Alan, who is a suspect in another alleged coup case.

In the run-up to the election, the AKP is displaying a high level of confidence as the incumbent with a solid lead in opinion polls. It is also showing a steely determination to push ahead with its legislative agenda, which it is expected to carry into the next parliament. On April 5th parliament authorised the government to issue decrees with the force of law for a period of up to six months on the grounds that the business of parliament has slowed down and many deputies are away campaigning in their constituencies, making it difficult to pass legislation. The government will be able to legislate without having to put bills to a vote in the national assembly. This is the first time that the AKP has resorted to such measures. The opposition parties condemned the move, claiming it is unconstitutional. However, provisions for rule by decree are permitted under article 91 and previous administrations have utilised them.

The government has continued to implement the constitutional reforms that were approved in a referendum in September 2010. Having first overhauled the Supreme Board of Judges and Prosecutors (HSYK), which has responsibility for appointing judges and prosecutors across the country, in late 2010 (November 2010, The political scene), the government has more recently passed legislation to implement changes to the structure, appointment and powers of the Constitutional Court. This limits appointments to the court to a maximum of 12 years, increases the number of members appointed by the president and makes it more difficult for the court to close a political party.

The government has generally adopted a cautious approach to fiscal policy since the 2008-09 recession, but has broadly sought to maintain a degree of flexibility ahead of the general election on June 12th 2011. In March the central government budget swung back into deficit by TL6.1bn (US$3.9bn), following surpluses in the two preceding months. However, for the most part the deficit represents a return to more normal spending levels after the vagaries of the previous three months, when a combination of one-off factors caused government outlays to fluctuate sharply. Expenditure was surprisingly low in January and February, possibly owing to the absorption of funds disbursed in December 2010, when expenditure was particularly high. The Economist Intelligence Unit believes that a substantial portion of the large deficit in December was actually the result of cash distributed for use during the first half of 2011.

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The deficit in the first three months of 2011 of TL4.1bn compares favourably with both the TL11.3bn deficit of January-March 2010 and the official target of TL33.5bn for the whole of 2011. Expenditure increased by 14.3%, to TL26.8bn, in March and by 6.6% to TL72.9bn in the first quarter. The acceleration in March reflected higher spending on several items including social security subsidies, agricultural support payments and transfers to local government. The payment of increments to non-civil service pensions, backdated to January, was partly responsible for the rise in social security costs.

Revenue growth has remained strong, reflecting the continued strong economic activity. Tax receipts rose by 14.7% in March, to TL16.6bn, and by 19.9% to TL57.5bn for the three-month period. The slowdown in year-on-year tax revenue growth in March was largely attributable to a base effect affecting income tax and domestic value-added tax (VAT) payments. Revenue from special consumption tax, which is charged mainly on fuels, motor vehicles, alcohol and tobacco, was up by 23% on a year earlier at TL3.5bn, and VAT revenue from imports was 61% higher at TL2.7bn. Non-tax revenue, which includes profits transferred from state banks and privatisation receipts, was 34.8% higher at TL4.1bn.

Unorthodox monetary policy causes tensions with private banks

On April 18th Erdem Basci took over from Durmus Yilmaz as governor of the Central Bank of Turkey. Mr Basci was a long-standing deputy governor, which should ensure continuity at the central bank. However, he is seen as close to the deputy prime minister, Ali Babacan, which has given rise to some concern that the bank's independence from the government may be weakened. With the Justice and Development Party (AKP) government reluctant to tighten fiscal policy much ahead of the general election on June 12th, the central bank has had to shoulder most of the burden of tackling the financial risks associated with Turkey's ballooning current-account deficit, which has been fuelled by a credit-driven surge in domestic demand. This deficit is financed mainly through short-term capital inflows, which could quickly go into reverse in the event of tighter global liquidity or a deterioration in investor sentiment.

The central bank's unorthodox two-pillar monetary policy in place since December 2010 has combined steady increases in banks' reserve requirements at the same time as reductions in short-term interest rates. The aim of hiking reserve requirements on short-term liabilities is to curb the growth of bank credit, and hence domestic demand, while encouraging banks to increase the average maturity of their funding. As of February 2011, around 90% of bank deposits had a maturity of less than three months, and 40% less than one month. The latest changes, which took effect on April 15th, raised the reserve requirements on deposits and equivalent instruments with maturities of less than six months by up to 5 percentage points. Reserve ratios will now range from 5% for deposits with a maturity of more than one year to 15% for current accounts and deposits with a maturity of one month or less. The bank estimated that the latest increases in reserve requirements would reduce liquidity by TL19.1bn (US$12.5bn)-almost as much as the previous two adjustments, in December 2010 and January 2011, combined.

The objective of the cuts in its benchmark policy interest rate, the one-week repo lending rate, of 50 basis points in December 2010 and 25 basis points in January 2011 (following cuts during the global credit crisis of 1,025 basis points over the 12 months to November 2009) has been to dampen short-term capital inflows, which until late 2010 were driving up the value of the lira, increasing import penetration and thereby contributing to the rise in the current-account deficit. At its meeting in March 2011, the bank's Monetary Policy Committee (MPC) determined not to change its policy rates. The weekly repo lending rate remained at 6.25% for a second month, with the MPC expressing the view that the increase in the reserve requirements would provide the additional monetary tightening needed to offset the upward pressure on inflation of rising international commodity prices. Consumer price inflation has declined steadily decline since September 2010, falling to a 41-year low of 4% in March 2011, but is expected to rise again in the coming months.

The Central Bank and the banking sector watchdog, the Banking Regulation and Supervision Agency (BRSA), have set a goal of limiting bank credit growth in 2011 to around 25%, but so far credit growth has not shown any signs of slowing substantially. In late March domestic lending by deposit money banks (excluding Sharia-compliant "participation banks") was still rising by 40-45% year on year. Government ministers have praised the policies of the Central Bank and the BRSA, but Turkey's bankers complain that recent measures unduly punish the industry, pointing to the level of taxation on the sector and the fact that required reserves bear no interest. After registering record profit growth of around 50% in 2009, earnings growth at Turkish banks slowed sharply to 8-9% in 2010. Higher reserve requirements and tighter interest-rate margins are expected to squeeze profits further in 2011.

The pace of economic growth, which had moderated in the third quarter of 2010 after a sharp recovery from the 2008-09 recession, accelerated in the final quarter of 2010. Real GDP grew by 9.2% year on year and by a calendar- and seasonally adjusted 3.6% in quarter-on-quarter terms. For 2010 as a whole, the GDP growth rate worked out at 8.9% following a contraction 0f 4.8% in 2009. The private sector remained the main driver of the recovery. Against a backdrop of relatively low interest rates and rapid credit growth, in the fourth quarter private consumption rose by 9% year on year and private-sector investment, which accounts for about 15% of GDP, expanded by a remarkable 49.5% year on year. Public-sector investment growth was also strong, but government consumption expenditure growth was restrained, increasing by 3.2% year on year in the final three months of 2010.

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The sharp increase in domestic demand was accompanied by a further deterioration in the external balance, which shaved about 4.5 percentage points of GDP growth in 2010 as a whole. In the final quarter exports of goods and services rose by 4.3% year on year while growth of imports of goods and services accelerated to 25.4%. The reversal of the adjustment in inventories that accompanied the recession and the collapse of external demand appears to have run its course. Changes in stocks shaved 0.7 percentage points off fourth-quarter year-on-year growth. Changes in stocks made a positive contribution of 2.5 percentage points in 2010 as a whole following a reduction of a similar size in 2009.

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All major sectors of the economy contributed to growth in the final quarter of 2010. The largest increases in gross value added came from the most cyclical sectors, construction and manufacturing. Financial services, one of the few sub-sectors to record strong growth during the 2009 recession, saw the rate of expansion accelerate in the final quarter of 2010. However, gross value added in hotel and catering services contracted by 0.9%, partly reflecting the impact of sluggish Western tourism markets. Growth in public services was also minimal, in line with the government's spending restraint.

Economic data suggest that activity remained strong in the first quarter of 2011, compared with the same period of 2010. Industrial production rose by 19% year on year in January and by 13.9% in February 2011. Output of capital goods, durable consumer goods such as automotives and intermediate goods including refined products was particularly high compared with a year earlier. On a month-on-month basis, industrial production declined by a seasonally and calendar-adjusted 1.7% after rising in the previous two months. In March capacity utilisation in the manufacturing industry held up at 73.2%, compared with 73% in February and 67.3% in March 2010, suggesting that output growth was still robust, at least in year-on-year terms.

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Indicators of consumer and investor confidence have been mixed. The official consumer confidence index rose from 91.3 points in January to 93.6 in February 2011, but remained below the neutral 100 threshold. The real sector confidence index published by the Central Bank, which measures sentiment in manufacturing industry, dipped to 110 in February from 113.6 in January, but bounced back to 114.8 in March-its highest level since May 2010.

Despite strong domestic demand growth, a weaker lira and rising commodity prices, the annual rate of consumer price inflation has declined steadily since September 2010, falling to another 41-year low of 3.99% in March 2011. In March motor fuel prices rose by about 3% month on month, clothing and footwear prices were 0.8% higher for seasonal reasons, and the prices of some durable goods increased, possibly in response to the recent weakness of the lira. However, the index for food and non-alcoholic drinks prices, which usually continues to rise in March, owing to the impact on output of winter conditions, fell by 0.4% month on month.

Although inflation surprised on the low side in March, the annual rate is expected to rise again from April, reflecting a less favourable baseline in 2010 and the impact of higher global commodity prices. The official target for end-2011 is 5.5%, with a tolerance band of ±2 percentage points. The upward trend in global commodity prices was reflected in strong producer price inflation data, which will feed into consumer prices with a lag of a few months.

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The lira, which depreciated following the Central Bank's shift in monetary policy in November 2010, stabilised in early March 2011 and went on to recover some of its value in late March and early April. The lira recovered most noticeably against the US dollar, which weakened against the euro. On April 8th the lira traded at TL1.51:US$1 and TL2.17:EUR1. This compares with strong points of TL1.39:US$1 and TL1.94:EUR1 in early November 2010, when the lira was very strong by historical standards, and weak points of TL1.62:US$1 and TL2.24:EUR1 in the first week of March 2011.

Share prices on the Istanbul Stock Exchange (ISE) stabilised in March, following a bout of weakness at the end of February, and rose further in early April. On March 2nd, the main National-100 index had closed as low as 58,664 points, amid concerns about events in the Middle East, the impact of Central Bank policy on bank profits and a Competition Board investigation into the banks. In the last three weeks of March, however, the index recovered to hover at 63,000-65,000 points-similar to the level which prevailed for much of January and February. The Central Bank's surprise decision to raise banks' reserve requirements further caused the index to shed 1,655 points on March 23rd, when it closed at 63,220 points. At the close on April 19th, it had recovered to 67,742, still below the peak of 71,543 recorded on November 9th 2010.

The yield on the most-traded government bond, maturing in November 2012, has remained well above its level of about 7% in early January 2011. In March it rose to close to 9% following the announced reserve requirement ratio hikes in late March, which were interpreted as a sign of steeper than expected policy rate rises later in the year. The yield subsequently eased to 8.6% in early April following the release of lower than expected March inflation figures-seen as reducing the likelihood of sharp rate rises.

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The current-account deficit, which surged to a record US$48.5bn, or 6.6% of GDP, in 2010, continued to widen in early 2011. The increase was entirely attributable to the deterioration of the merchandise trade deficit, which in the first two months of 2011 more than doubled compared with a year earlier, to US$11.8bn. Strong domestic demand and high global commodity prices continued to boost the import bill in the first two months of 2011, notwithstanding the Central Bank's efforts to curb credit growth and the recent relative weakness of the lira. Meanwhile, exports to some countries in political crisis started to fall-according to customs-based data, exports to North Africa declined by 10% year on year in the first two months of 2011 while sales to almost all other regions recorded strong growth.

Capital inflows were more than sufficient to offset the current-account deficit in the first two months. In February, foreign investors made net purchases of US$1.8bn in the domestic government bond market. The balance-of-payments data also included another high positive figure of US$3.3bn for net errors and omissions, which encompasses payments which cannot be classified.

According to weekly Central Bank data, official gross foreign-exchange reserves have remained on an upward trend in 2011, rising from US$82.3bn at the end of January 2011 to US$86.8bn on April 1st. The increase reflects continued strong capital inflows but also the strength of the euro against the US dollar, which boosts the dollar value of euro-denominated reserves.

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Please see graphic below

Please see graphic below

Please see graphic below

Land area

783,562 sq km (including lakes and islands), of which 30% arable, 3% orchards, olive groves and vineyards, 26% classified as forest

Population

71,158,000 (mid-year estimate, US Census Bureau)

Main towns

Population (2007 census)

Istanbul: 11,174,257

Ankara (capital): 4,140,890

Izmir: 3,175,133

Bursa: 1,979,999

Adana: 1,611,262

Climate

Mediterranean on the south coast, continental inland

Weather in Ankara (altitude 861 metres)

Hottest month, August, 15-31°C (average daily minimum and maximum); coldest month, January, -4-4°C; driest month, August, 10 mm average rainfall; wettest month, December, 48 mm average rainfall

Language

Turkish

Measures

Metric system

Currency

Turkish lira

Time

2 hours ahead of GMT; 3 hours ahead in summer

Fiscal year

Calendar year

Public holidays

January 1st; April 23rd; May 19th; three days for Ramadan and four days for Kurban or Eid (dates vary according to the Muslim calendar); August 30th; October 28th (half-day); October 29th

Official name

Republic of Turkey

Form of state

Parliamentary republic

Legal system

Based on European models and constitution of 1982

National legislature

Unicameral Meclis (parliament) of 550 members directly elected for a four-year term

Electoral system

Universal direct suffrage over the age of 18. Only parties with more than 10% of the national vote are eligible for seats in parliament. Individuals may run as independents

National elections

July 22nd 2007; next election June 12th 2011

Head of state

The current president, Abdullah Gul, was elected by parliament for a single seven-year term in August 2007, but the subsequent introduction of election by universal direct suffrage and a maximum of two consecutive five-year terms makes the timing of the next presidential election uncertain

National government

The present government is formed by the Justice and Development Party (AKP)

Main political parties

Islamist-liberal: Justice and Development Party (AKP); Islamist: Prosperity Party (Saadet, SP); centre-right: Motherland Party (Anap), Democrat Party (DP); centre-left: Republican People's Party (CHP), Social Democrat Populist Party (SHP), Democratic Left Party (DSP); nationalist right: Nationalist Action Party (MHP); pro-Kurdish: Peace and Democracy Party (BDP), the successor of the banned Democratic Society Party (DTP). In the 2007 election the AKP, CHP/DSP and MHP exceeded the 10% national vote threshold. Members of the DTP and two other parties were elected as independents

Council of Ministers

Prime minister: Recep Tayyip Erdogan

Deputy prime ministers & ministers of state:

;Bulent Arinc

;Ali Babacan (Economy)

;Cemil Cicek

Ministers of state

Mehmet Aydin Mehmet Zafer Caglayan

Egemen Bagis Faruk Celik

Hayati Yazici Cevdet Yilmaz

Faruk Nafiz Ozak Selma Aliye Kavaf

Key ministers

Agriculture & rural affairs: Mehmet Mehdi Eker

Culture & tourism: Ertugrul Gunay

Defence: Vecdi Gonul

Education: Nimet Cubukcu

Employment & social security: Omer Dincer

Energy & natural resources: Taner Yildiz

Environment & forestry: Veysel Eroglu

Finance: Mehmet Simsek

Foreign affairs: Ahmet Davutoglu

Health: Recep Akdag

Interior: Besir Atalay

Justice: Sadullah Ergin

Public works & housing: Mustafa Demir

Tourism & culture: Ertugrul Gunay

Trade & industry: Nihat Ergun

Transport: Binali Yildirim

Central Bank governor

Erdem Basci