For decades, when Turks spoke of their relationship with Kurds in the south-east of Turkey, the topic was usually terrorist bombings, or youthful years spent manning a military outpost on a remote mountainside in sub-zero temperatures. In 2013, the topics are the potential for resolution talks to bring about an investment upgrade, the big oil deals in Iraq’s Kurdish region that are being linked to those talks, and how many percentage points a deal could add to the long-term potential growth rate.

The progress being made in Turkey is not all about money, although business opportunities are an important driver of the process. As Erkin Şahinöz, managing director and CIO of Rhea Portföy Yö netimi, told OBG, “I keep talking about the peace process in my meetings with investors because it’s so important for the economy. It’s much more important than whether we get a second upgrade.”

A Long History

Talks have been under way off and on since 2009, and they fell apart badly in 2012, when terrorist bombings and fighting between the Turkish army and the outlawed Kurdistan Workers’ Party (PKK) flared up. Turkey’s 30-year conflict with the PKK has killed more than 40,000 people and caused incalculable monetary losses. Talks are mainly between the government of prime minister, Recep Tayyip Erdoğan, and the jailed PKK leader, Abdullah Öcalan, who has turned into an advocate of peaceful compromise since his capture in 1999.

Kurdish political leaders in Turkey and Iraq and current PKK leaders are also involved in shuttle diplomacy. On March 21, 2013, a message from Öcalan was read out in Diyarbakır, south-eastern Turkey’s main city, calling for a ceasefire and a withdrawal of PKK forces. Although Öcalan came short of calling on the PKK to disarm, this was the biggest step yet taken towards a deal. This was followed in late April by an announcement from the PKK’s military leader, Murat Karay›lan, that the outlawed group’s fighters will begin to withdraw from Turkey in early May 2013.

Market Response

The ratings agency Standard & Poor’s (S&P), which had rated Turkey two notches below investment grade, reacted by announcing that it was upgrading Turkey one notch closer. S&P cited general economic improvements and the government’s progress in talks with the outlawed PKK. “We expect this to be more lasting than previous efforts: if so, security-related costs would decline and the regional economy, as well as cross-border trade flows, would be boosted,” S&P said in a news release.

The ratings agency Moody’s, which currently rates Turkey one notch below investment grade, made no immediate change but hinted that one was likely. A report issued on April 11, 2013 called the cease-fire “credit positive” and said defusing tensions was likely to encourage investment. According to the report, “The prospect of peace promises to boost investor confidence and improve south-eastern Turkey’s attractiveness as a destination for foreign direct investment, which would deliver economic benefits and reduce Turkey’s external vulnerabilities, enhancing sovereign creditworthiness.” Ümit İzmen, an economics professor, newspaper columnist and former chief economist of the Turkish Industry and Business Association, said the resolution process was “the most important economic issue going on in Turkey today. Turkey’s long-term potential growth rate could increase by a few percentage points.”

The Role of Iraq

The resolution process is closely linked with the burgeoning trade relationship with the Kurds of northern Iraq, who are rich in oil and eager to cooperate with Turkey. There are also connections to the civil war in Syria, where Kurds in that country’s north-east are a third force largely uninvolved in the fighting but hoping to achieve greater autonomy. Moreover there is also a strategic motive for Erdoğan, who wants to change Turkey’s constitution to allow him to become president with executive powers. To do that he needs the support of parliament’s pro-Kurdish Peace and Democracy Party.

As İzmen told OBG, “The big picture tells us that the Kurds in all three states will be better off if the problem in Turkey is settled. Solution of the Kurdish problem may also help Erdoğan achieve his ambitions of becoming president under a changed constitution. But what has surprised me is the change in society’s mindset. People are really ready for a peace deal. For a long time there have been such strongly negative feelings among people of Turkish origin towards the Kurdish rebels; I never could have imagined such a rapid change.”

Encouraging Investment

The government has struggled to encourage economic development in neglected eastern regions. In 2012 the government offered substantial incentives to investors in underdeveloped regions, including rebates of value added tax of up to 60% of investment expenditures. As Şahinöz said, “The government came out with great incentive plans for producers to move to south-east Turkey, but so long as the peace issue is unresolved it’s not easy. Few investors are willing to take the risk.” İzmen said investors are often discouraged by higher costs for credit and insurance, or by their inability to get them. “A peace deal could bring credit risk premiums down by 6-7 percentage points,” she said. Yarkın Cebeci, executive director at JP Morgan’s branch in Turkey, told OBG, “South-east Turkey is where humans first started farming. But today, a lot of the land there hasn’t been used in decades, because of the security issue. The growth potential in agriculture alone is huge.”

Iraqi Kurdish Oil

Much of the impetus for the resolution process has come from growing trade relations with the Kurdish region of northern Iraq, which has emerged since the US-Iraq war in 2003 as Iraq’s wealthiest and most secure region. Iraq’s post-war constitution granted broad autonomy to a Kurdistan Regional Government (KRG), based in Erbil. Turkey was initially alarmed by that move, worrying it could embolden PKK members in Turkey. Indeed, Turkey’s army invaded northern Iraq over suspected cooperation with to the PKK as recently as 1997. However, the Turks and Iraqi Kurds soon found common ground in what has become a burgeoning trade relationship. For Iraqi Kurds, Turkey is an ideal export route for northern Iraq’s long-neglected oil reserves. The KRG has brought in international oil majors, as well as a British-Turkish joint venture, Genel Energy, in which Turkey’s Çukurova Group and a former CEO of BP, Tony Hayward, are the key players.

Moreover, economic ties may extend far beyond oil. Özgür Altuğ, the chief economist at brokerage BGC Partners, told OBG there was huge potential for Turkey to export to Iraq. “According to some projections Iraq will become the world’s biggest oil producer. They need everything there. They especially need transportation infrastructure,” he said.

However, the government in Baghdad has asserted that only it has legal authority over northern Iraq’s reserves, and it has declared the KRG’s efforts to launch an autonomous oil industry illegal. The US has urged Turkey not to accept any oil until the KRG and central government find a compromise, but their relations have broken down to the point that they hardly talk. In March 2013, Erdoğan appeared to take a decisive step to accept oil from Iraqi Kurdistan by signing an oil and gas trade agreement with the KRG. He later said he had also proposed to Baghdad that Turkey build additional oil and gas pipelines from northern Iraq. The immediate upshot of his move appeared to be that oil would begin flowing to Turkey through an old gas pipeline that was being converted and extended to the border by the KRG. Genel’s Hayward told Bloomberg in April 2013 that he expected the pipeline to be working by summer.

Israeli & Cypriot Gas

In another possible example of hydrocarbons overcoming antagonisms, recent major offshore gas finds by Israel may partly explain a recent rapprochement between Israel and Turkey. The two have had limited relations since an incident in 2010 when a private Turkish aid flotilla announced plans to breach Israel’s naval blockade of the Gaza strip and Israeli marines reacted forcefully, killing nine activists when they resisted a boarding.

In March 2013 Israeli Prime Minister Benjamin Netanyahu formally apologised for the deaths and agreed to pay compensation to the victims’ families. While there were other reasons for that move, such as common positions on the war in Syria, another motivator may have been Israel’s need to find an export route for its offshore gas. The companies developing the fields were looking at the possibility of a pipeline to Turkey, a major gas consumer and transport hub, according to a Financial Times report.

What is more, the project could even prod Cyprus into a rapprochement with Turkey. Cyprus is planning a liquefied gas plant to export gas from its recently discovered offshore fields, near Israel’s. But analysts have cast doubts on whether Cyprus could raise financing. Joining an Israel-Turkey pipeline project could turn out to be Cyprus’s only practical option.