MIDEAST DEBT-Global economics equal politics in Turkey market rout
* Political unrest not so far doing major damage to economy
Global trends a big factor for Turkey asset prices
* CDS curve unchanged, spreads small
* Erdogan's anti-market rhetoric may not mean policy change
By Mala Pancholia and Andrew Torchia
DUBAI, June 12 (Reuters) - Turkish markets have plunged since fierce anti-government protests began two weeks ago but global trends are as much responsible as domestic politics, suggesting some scope for a rebound if foreign markets stabilise.
The demonstrations, which began as protests against a plan to develop an Istanbul park, have become a major challenge to Prime Minister Tayyip Erdogan and his AK Party, feeding off secular-religious tensions in Turkish society.
As a result, investors may never again be as relaxed about political risk in Turkey as they were in the past year and further underperformance is likely.
"Turkey is a classic example of absolute risk in investments. There should have always been a premium for political risk in the country given the country and its neighbours," said Gary Dugan, chief investment officer for Asia and the Middle East at private bank Coutts.
But many fund managers and analysts say the political unrest has not so far done severe damage to Turkey's long-term economic outlook, although if the crisis becomes protracted that may change.
"I think the sell-off has been quite muted given what I do think are very significant political developments in Turkey," said Timothy Ash, head of emerging market research at Standard Bank in London.
"Part of the reason is that perhaps foreign investors still have an enduring faith in Erdogan, the AKP and Turkey which have been a great success story over the past decade."
A big reason for the slide in Turkish assets is that emerging markets around the world have been hit since late May by rising U.S. Treasury yields, which threaten to reverse heavy fund inflows that buoyed them in the past year.
If the stock market is any guide, the 18 percent fall in Istanbul's main share index since May 22 is double the nearly nine percent drop in the global MSCI Emerging Markets index - suggesting domestic turmoil and the worldwide emerging sell-off have had a roughly similar impact.
Matthieu Belondrade, portfolio manager for global emerging markets at Natixis, said the European firm had gone underweight on Turkey but the process had begun before the demonstrations and was partly because Turkish assets had become too expensive.
"We still think that Turkey is one of the most promising economies in the emerging universe, and we may consider reinvesting later this year if these events do not spill over into a more severe political crisis," he said.
The other "if" is that the broader emerging market sphere does calm down rather than escalate into full-scale capital flight, as with the Asian financial crisis of the late 1990s. Under the latter scenario, all bets are off.
Turkish markets are more vulnerable than most for two reasons. One is Turkey's large current account deficit, which widened in the first four months of this year to $24.34 billion from $20.76 billion a year earlier - the country needs capital inflows to offset that gap.
Also, before the demonstrations Turkish markets had reached sky-high valuations, leaving them ripe for a pull-back. Portfolio investment inflows last year soared 60 percent to $35 billion; foreigners' Turkish bond portfolios rose $16 billion.
Even so, Turkey has actually outperformed some emerging markets in the past fortnight. For example, the yield on its $1 billion sovereign bond maturing in 2022 has risen 86 basis points since May 28 to 4.16 percent on Wednesday.
That is a big jump, but not as large as a 112 bp rise for Bahrain's 2022 sovereign bond to 5.43 percent. The yield on Indonesia's 2022 bond is up 110 bps.
Turkey's five-year credit default swaps, used to insure against the possibility of a sovereign default, have shot up since the demonstrations began. But they are still at last September's levels and, at 177 basis points, below the CDS of booming Dubai, at 235 bps.
In contrast to the CDS of other emerging markets hit by big political crises, such as Arab countries during their 2011 uprisings, bid-ask spreads on Turkish CDS have not widened significantly; they are between 3 and 4 bps. Changes in the slope of the CDS curve between short and long maturities - another sign of panic - have not happened in Turkey's case.
The lira has sunk against the U.S. dollar in the past two weeks, until the central bank intervened on Tuesday. Some other emerging market currencies have suffered similar falls; the Philippine peso is down 3.3 percent.
One risk for investors in Turkish debt is that political unrest could start affecting economic policy - for example by prompting the government, which runs a moderate budget deficit, to spend more heavily to ensure the AK Party wins next year's local and presidential elections, and general elections in 2015.
Whether this happens may not be clear for months. In the meantime, continuing unrest could add to the economic pressures cutting portfolio fund inflows, and even - if the protests spread - start reducing tourism revenues and corporate direct investment in Turkey.
Zin Bekkali, chief executive of Silk Invest, an emerging markets investment manager, said that while European investors - the main source of fund flows into Turkey - could be deterred by the politics, the economy might be aided to some degree by its growing focus on other regions.
"Turkey's economy has become over the last years increasingly integrated with the Middle East, Asia and Africa. These regions have a bigger tolerance for political upheaval and we do not see them scaling down business," he said.
A question mark for investors is Erdogan's intentions when he vowed on Sunday to "choke" financial market speculators who were growing rich off "the sweat of the people".
In the worst case the vow could signal a repeal of some of the market-friendly policies which attracted funds to Turkey - conceivably, if pressures on its balance of payments increase, some form of capital controls to slow outflows of money.
But analysts think it is unlikely that Erdogan will reverse policies which brought the AK Party economic success over the past decade. Instead, they view his comments as rhetoric to shore up his working class base of support.
"His fairly unfriendly market commentary is perceived to be for the domestic audience, and there will not be an about-turn in terms of the environment for foreign capital - direct and portfolio," Ash said.
(Additional reporting by Dinesh Nair, editing by Mike Peacock)