SCENARIOS-Turkish fiscal reform may depend on two votes

ISTANBUL, Aug 11 (Reuters)- The fate of a fiscal reform law to tighten the Turkish government's budget discipline may depend on two crucial votesas the ruling AK Party struggles to stay in power next year.

The government on Wednesday postponed the planned passage of the legislation to beyond the next general election, which is due by July 2011. The postponement will give it leeway to spend more freely and prompted warnings from credit rating agencies that deficit-reduction plans may be diluted. [ID:LDE67A0AJ]

Some degree of higher government spending now seems probable, given the AK Party's need to shore up support from voters. But much may depend on the result of another vote: a referendum on Sept. 12 this year on constitutional reforms backed by the AK Party. The referendum is widely seen as a test of support for the government.

An opinion poll by Turkey's Sonar on Wednesday showed voters narrowly rejecting the reforms with a projected "no" vote of 50.9 percent and a "yes" vote of 49.1 percent. [ID:nLDE67A19I]

Here are three scenarios for how the situation may develop in coming months.

GOVERNMENT WINS REFERENDUM, WINS ELECTION

SCENARIO: The AK Party wins the referendum; this boosts morale in the party and advances the party's efforts to reshape the Turkish political system. As a result, it sees only a moderate need to boost spending ahead of the election. It focuses on increasing spending in Turkey's poorer southeast area, where unemployment is high and many feel the nation's growing affluence of the last eight years has passed them by.

After the election the AK Party, wishing to restore its reputation as a market-friendly party, and with dissenting ministers silenced by the victory, puts draft fiscal reform back on the agenda and secures its passage through parliament, partly in order to gain Turkey an investment grade rating and reduce the cost of borrowing.

PROBABILITY: Quite likely. Opinion polls show the vote on the constitution will be extremely close. There is a consensus in Turkey that the constitution needs to be changed, which could persuade the high number of undecided voters to back reforms.

MARKET IMPLICATIONS: Government spending before the election could drive up inflation, which has only just resumed an easing trend after spiking at the start of the year, causing it to overshoot the central bank's forecast for this year of 7.5 percent. Bond yields rise, and Turkey's debt rollover ratio rises, but not to an extent that Turkey experiences external financing difficulties. After the passage of fiscal reforms, debt dynamics improve and Turkey is eventually rewarded with investment grade ratings.

GOVERNMENT LOSES REFERENDUM, WINS ELECTION

SCENARIO: The AK Party loses the referendum, prompting a rapid increase in spending as it fights for its political future. During its 2011 election campaign it pledges to dilute the fiscal reforms, allowing the government to continue to spend more freely on social welfare. On winning the election, the government passes fiscal reforms which are less stringent than originally planned; they might limit the budget deficit to 3 percent of GDP rather than 1 percent within the next 10 years.

PROBABILITY: Quite possible. If it does lose the referendum, the AK Party will face heavy internal and external pressure to boost spending to keep a strong economic recovery going. Within the government, some senior officials think Turkey need not impose fiscal rules stricter than those of the European Union's Stability and Growth Pact, which mandates a 3 percent deficit limit; these officials would rather keep spending on stimulus measures.

MARKET IMPLICATIONS: A large increase in spending drives inflation up sharply, potentially bringing forward central bank interest rate rises expected in 2011. A stimulus-fuelled rise in domestic demand fuels Turkey's growing current account deficit, unsettling its external creditors and pushing up its borrowing costs. Interest rate hikes eventually endanger economic recovery in Turkey, particularly given the fragile external environment.

GOVERNMENT LOSES REFERENDUM, LOSES PARLIAMENTARY MAJORITY

SCENARIO: The AK Party loses the referendum, and the resulting increase in government spending is not enough to help it win a parliamentary majority in the 2011 election, forcing it into a possible coalition government with the CHP opposition. Fiscal discipline is no longer a priority for the new government; instead of a permanent law, the government merely pledges to set sensible medium-term guidelines for spending.

PROBABILITY: Less likely. Even if it were forced into an awkward coalition, the AK Party might retain control of the economy and finance ministries given its experience and the need to calm investors unsettled by an unfamiliar government; in this case, there could still be a large chance for fiscal reform legislation.

MARKET IMPLICATIONS: Investors would probably be alarmed if the AK Party lost the election, because the opposition has not yet spelt out a clear or credible economic agenda, and because there would be concern about how well the new ruling coalition could function. So there would be a period of market weakness and instability, after which prospects for the markets would depend on the result of policy discussions in the coalition and its internal dynamics. (Editing by Andrew Torchia)