Turkey's Political Crossroads: How Institutional Erosion Threatens Market Stability and Investment Returns

The Turkish economy has oscillated between hope and instability in recent months, with central bank data showing annual inflation falling to 35.4% in May 2025—down from 37% in April—amid aggressive rate hikes. Yet beneath this veneer of progress lies a deeper crisis: the systematic erosion of judicial independence and political crackdowns targeting dissent are undermining the very institutions needed to sustain reforms. For investors, this creates asymmetric risks: while short-term gains may tempt speculators, the long-term erosion of governance threatens to unravel progress and amplify volatility.

Judicial Politicization and the Central Bank's Fragile Credibility

The arrest of Istanbul Mayor Ekrem Imamoglu—a leading opposition figure—and the ongoing imprisonment of Kurdish politicians like Selahattin Demirtas, despite rulings from the European Court of Human Rights, signal a pattern of institutional subjugation to executive authority. This politicization extends to the Central Bank of the Republic of Turkey (CBRT), whose credibility has been repeatedly compromised by abrupt policy shifts.

While the CBRT has maintained a hawkish stance—keeping the one-week repo rate at 46%—its ability to sustain market confidence is questionable. Independent analysts estimate actual inflation may exceed the official 35.4%, citing manipulated data and the lingering impact of 2021's disastrous rate cuts. The central bank's transparency is further clouded by its reliance on macroprudential tools (e.g., credit caps) and foreign exchange interventions, which mask deeper structural weaknesses.

The TRY's 25% year-on-year decline in May 2025 reflects investor skepticism. Even as core inflation improves, services-sector inflation (51.2% annually) and wage dynamics remain unresolved, leaving the CBRT's 24% 2025 target at risk.

Sectors in the Crossfire: Banking and Real Estate

Political instability disproportionately impacts sectors tied to state patronage. Turkey's banking sector—where state-owned lenders face capital adequacy gaps—is particularly vulnerable. While private banks have adapted to rate hikes, state institutions' weaker balance sheets amplify systemic risks.

Real estate, a key driver of domestic demand, faces dual pressures: 1. Geopolitical Risk: Foreign investors face restrictions on purchasing property outside major cities and may face retroactive asset freezes. 2. Currency Risk: Developers reliant on foreign currency loans now confront TRY depreciation, squeezing margins.

The index's 15% decline YTD 2025 underscores investor caution. Overvalued equities—particularly in politically connected firms—may face further downgrades as ESG-conscious funds divest.

Foreign Capital Flight and Asymmetric Risks

Foreign direct investment (FDI), which grew 8.7% in 2024, is now at a crossroads. While manufacturing and trade sectors remain attractive, geopolitical risks are deterring long-term commitments. The EU's muted response to Turkey's authoritarian turn—prioritizing its role in Syria and Ukraine over democratic backsliding—has emboldened Erdogan's regime. Yet this pragmatic stance cannot offset the reality:

• ESG Compliance: Investors must avoid firms benefiting from repression (e.g., construction firms tied to controversial urban projects).
• Currency Exposure: The TRY's volatility makes unhedged positions risky. Even the CBRT's $153 billion in reserves may prove insufficient to stem panic.

Investment Strategy: Proceed with Extreme Caution

Short-Term:
- Sell TRY-denominated assets: The lira's 2025 decline (projected to reach 20% against the USD by year-end) justifies exiting bonds and equities.
- Avoid overvalued equities: BIST sectors like banking and real estate trade at premiums to fundamentals, with ESG liabilities compounding risks.

Long-Term:
- Divest from ESG non-compliant firms: Investors should exclude companies benefiting from repression or environmental violations (e.g., energy projects flouting climate norms).
- Monitor policy consistency: Only sustained judicial independence and CBRT transparency could rebuild credibility—scenarios now deemed low probability.

Conclusion

Turkey's political crackdowns have created a paradox: economic indicators improve, but governance deteriorates. Investors face a stark choice—speculate on short-term rate cuts or recognize that institutional decay will eventually outpace technical fixes. For now, the path of least risk is clear: exit speculative positions and avoid entanglement in a system where politics, not economics, dictates outcomes.

The widening gap between reality and rhetoric tells the real story.