Plumes of noxious tear gas in the sky above Istanbul have spooked investors in Turkey, and Prime Minister Recep Tayyip Erdogan's refusal to back down has sent many heading for the exit.
The premier's unrepentantly combative approach on Thursday deepened the turmoil rattling Turkish markets. The Istanbul stock exchange slumped another 4.7 per cent, to its lowest since December, and bond yields have shot up.
The local currency has also tumbled to its lowest against the dollar since 2011 – despite efforts by the central bank to prop up the lira. A few more bad days and it will be at its weakest against the U.S. dollar since at least 1981, when Bloomberg records begin.
With protests continuing and the government seemingly prepared for a fight, many investors remain cautious. "I am afraid elements of the administration are appearing a little bit out of touch at the moment," Timothy Ash of Standard Bank says in a note. "We continue to advise investors to reduce positions."
The turmoil comes at a sensitive time for Turkey. Although the country has made great progress in the past decade, its economic story is not spotless.
Growth slowed down markedly last year, and will only recover to 3.4 per cent this year, according to the International Monetary Fund. But even that forecast was made before the eruption of protests, which could depress domestic consumption and tourism. The economy will come under further pressure if the central bank is forced to hike rates to defend the currency and crimp inflation.
But a yawning current account deficit is the biggest vulnerability. This means the country is acutely dependent on foreign capital flows. It is not just the size of the deficit that is vexing, but its nature. Only a fifth is covered by sticky foreign direct investment, while the rest is plugged by portfolio flows, or "hot money."
The IMF estimates that Turkey's external financing needs are about 25 per cent of its annual economic output, and warns this will "continue to pose a significant vulnerability."
That has not proven a problem in recent years, given investors' affection for Turkey. Yet the political protests come at a time when there are simmering concerns over the end of 'quantitative easing' in the U.S. – which could expose this major vulnerability in Turkey's economy.
Over the past six years, central banks around the world have increased global liquidity by $12-trillion (U.S.), according to Bank of America Merrill Lynch, pushing western government bond yields to record lows. That has spurred investors to scour emerging markets for better returns, and Turkey has been one of the prime beneficiaries.
But the U.S. Federal Reserve's hint that it could soon 'taper' its bond purchases has triggered a selloff across global bond markets. Turkey appears very exposed, given its dependency on foreign fund flows, and was hit even before the protests erupted.
"Turkey is one of the most vulnerable emerging economies to a tapering of QE," argues Manik Narain, a strategist at UBS. "It's been funding economic growth with external financing, and if that comes to an end it could be painful."
However, fund managers and analysts largely remain upbeat on Turkey. They argue that the demonstrations do not meaningfully tarnish Turkey's credentials as one of the leading stars of emerging markets. Over the past decade its economy has grown rapidly, and Turkey is now rated investment grade by both Fitch and Moody's.
Most of all, asset managers have been impressed by the dynamism of Turkish companies. The Istanbul Stock Exchange has climbed 500 per cent over the past decade, for an annualised return of almost 20 per cent – beating both emerging and developed markets.
"Turkey is a great place to be invested," says Sam Vecht, head of BlackRock's emerging markets specialist equities team. "It has a very entrepreneurial culture and well-run companies."
Fund managers point out that the exchange recently hit a record high, and a correction was to be expected. "The market reaction was probably exaggerated by the fact that it had gone up a long way, and people were looking for an excuse to take money off the table," Mr Vecht says.
Although a tapering of Fed bond-buying is a risk, economists and investors point out that central banks are still going to be adding to global liquidity for the foreseeable future. Many expect appetite for Turkish stocks and bonds to remain healthy even when monetary policy is tightened, given the positive long-term economic story and returns on offer.
Still, Turkey's unrest is a timely reminder that even 'advanced' developing countries with seemingly entrenched democracies can be plagued by bouts of political turmoil.
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