The erosion of Turkey’s institutional strength and rising economic and external imbalances drive the placement under review. High growth potential, exchange rate flexibility, sound public finances and banking sector resilience support the rating.
Scope Ratings GmbH has today placed the Republic of Turkey’s long-term local- and foreign-currency issuer and senior unsecured debt ratings of BB+, as well as the short-term issuer rating of S-3 in both local and foreign currency, under review for downgrade.
The placement under review for downgrade of Turkey’s sovereign ratings reflects the following two drivers:
- Deterioration in Turkey’s economic policy and governance framework both before and in following the June election, which weigh on the effectiveness and credibility of fiscal, monetary and structural economic policy management. Recent developments cast doubt on the authorities’ commitment to address the country’s fundamental macroeconomic weaknesses and raise questions on the long-term trajectory of Turkey’s creditworthiness.
- Increasing downside risks to Turkey’s macroeconomic stability stemming from external vulnerabilities caused by: i) a widened, largely debt-financed current account deficit; ii) steep depreciation of the Turkish lira against the US dollar and deterioration in the inflation outlook, with a to date incoherent policy response; iii) the negative impact of currency devaluations alongside more challenging global external financing conditions on the Turkish private sector, which has significant foreign-currency and external-debt exposures; and iv) the impact of balance of payments weaknesses on modest levels of international reserves.
The placement of Turkey’s sovereign ratings under review for downgrade reflects changes in Scope’s assessments in the ‘external economic risk’ and ‘domestic economic risk’ categories of its sovereign methodology. Turkey’s BB+ ratings remain supported, however, by the country’s high growth potential and large, diversified economy, flexible exchange rate regime, sound public finances, and aspects of resilience within the banking sector.
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The first driver underpinning Scope’s decision to place Turkey’s sovereign ratings under review for downgrade is Scope’s view that Turkey’s economic policy predictability and credibility has deteriorated both before and following the presidential and parliamentary elections of 24 June, given governance changes and policy decisions that have raised questions on the direction of economic management and Turkey’s credit trajectory over a longer time window. President Tayyip Erdogan’s term and mandate to guide the economy now extends until 2023.
President Erdogan’s electoral victory has given him extremely broad powers in the new Executive Presidency. These capacities range from the ability to rule by decree to the means to stamp out dissent (evidenced in the July dismissals of more than 18,000 civil servants) to greater influence over monetary policy. Post-election economic governance reorganisations, including the appointment of Erdogan’s son-in-law as Minister of Treasury and Finance, departures of economic-moderates such as former Deputy Prime Minister Mehmet Simsek, and alterations in the appointment procedure for the central bank governor and monetary policy committee (MPC) members have cumulatively raised doubts in the administration’s resolve to rebalance the economy onto a more sustainable footing.
The Turkish central bank’s decision function, MPC governance changes, alongside the President’s statements on his greater role in setting monetary policy alongside a preference for lower rates, have increased concerns around the independence of monetary policy and increased uncertainty surrounding future rate decisions. For example, the market had priced in an interest rate hike of around 100 bps at the central bank’s MPC meeting on 24 July. The outcome of this meeting – to maintain the policy rate at 17.75% – has damaged investor confidence. In Scope’s view, the unpredictable and frequently overly reactionary monetary policy decision framework risk further bouts of market turbulence with increasing spill-over onto the real economy.
At the same time, fiscal performance has worsened in recent years, with a budget balance of -2.3% of GDP in 2017, down from -1.3% of GDP as of 2015. Pre-election spending caused further deterioration in the general government balance over the first six months of 2018. Scope anticipates the general government deficit to widen to 2.9% of GDP in 2018, reflecting partly the slowing economy’s impact on fiscal revenue growth. In addition, government bond yields have risen significantly, making debt financing more expensive. In general, in Scope’s view, a reorientation in Turkey’s economic agenda favouring lower but more sustainable economic growth, including via structural economic reform, is the most direct route to increasing the credibility of Turkey’s policy-making institutions, stabilising the lira, and, in turn, supporting a stabilisation in Turkey’s rating trajectory.
The second driver underpinning the decision to place the ratings under review for downgrade is the increased risks to Turkey’s macroeconomic stability facilitated by external vulnerabilities.
Turkey’s current account deficit has widened this year, to 6.3% of GDP in the 12 months to May 2018 (from 3.3% of GDP in the 12 months to May 2016), on the back of energy price hikes alongside elevated economic growth and domestic demand. Scope expects that higher oil prices and higher interest payments will result in a current account deficit of 6.8% of GDP in the full year 2018 from 5.6% in 2017, before narrowing slightly to 6% of GDP in 2019. Moreover, the current account deficit is largely fuelled via less stable forms of external financing, exposing Turkey to greater vulnerabilities of capital account reversals in a more challenging global interest rate environment and wider emerging market stresses.
Next, the Turkish lira has devalued by 22% against the US dollar (to 4.9 at the time of this writing) and 19% on a nominal trade-weighted basis since the beginning of 2018. With the pass-through of currency declines, inflation reached 15.4% YoY in June—the highest level since December 2003 and well above the central bank target of 5%. This has forced a central bank tightening of 500 bps since December 2017. However, the inflation outlook is worsening, and Scope expects headline inflation to peak at around 17% in September 2018, reducing the real policy rate and risking a longer-lasting de-anchoring of inflation expectations.
The significant lira depreciation has meaningful implications on open net foreign exchange positions of the private sector, totalling USD 223bn in Q1 2018. High levels of foreign exchange liabilities increase the vulnerability of firms with insufficient foreign exchange income and assets or with maturity mismatches on balance sheets. Firms and households are also simultaneously stressed by tighter domestic borrowing conditions, with bank lending rates to commercial enterprises increasing to 23.5% in June, from 15.2% in January 2018.
Turkey’s gross external financing needs will remain around USD 240bn in 2018 and next year, up from around USD 220bn in 2017. Gross external debt totalled 52.8% of GDP in Q1 2018. In addition, modest gross international reserves of USD 130.9bn (106% of short-term external debt) as of May 2018 are at risk of further decline. Given Turkey’s sizeable external financing needs of approximately 30% of GDP per annum, declining reserves may exacerbate balance of payments stresses.
At the same time, Scope notes that Turkey’s BB+ credit ratings are underpinned by continued strength in public finances with a large tax base and strong tax revenue growth, moderate public-debt burden and resilient debt structure (though 42% of central government debt is in foreign currency), reducing to an extent Turkey’s vulnerability to shocks. Despite budgetary deterioration, Turkey’s deficit remains at manageable levels and the public-debt ratio stands at only 28.4% of GDP as of Q1 2018 – below that of ‘bb’-rated sovereign peers. Under Scope’s debt sustainability analysis, Turkey’s general government debt ratio is forecast to remain under 35% of GDP over the medium term, reflecting in part the low risk of crystallisation of modest though rising contingent liabilities, which are mostly in the form of PPP-infrastructure projects.
In addition, Turkey benefits from a large, diversified economy (with nominal GDP of USD 849bn in 2017), supported further by a flexible exchange rate. Real growth in the first quarter of 2018 was 7.4% year-over-year. Scope expects economic growth to remain strong at 4-5% in 2018 and 2019, assuming some rebalancing in the economy owing to tighter economic and financial conditions but boosted by external demand.
Bank profitability has been affected by the weaker economic environment. Despite higher financing costs, external-debt roll-over of banks has continued at a rate of above 100%. While restructuring of large corporate loans has seen a limited increase, mostly in the form of maturity extensions, the quality of loan portfolios has remained stable with the non-performing loan (NPL) ratio falling to below 3% of total loans. This reflects areas of resilience within the banking sector, including a favourable structure of external debt, enabling the sector to bridge short-lived market shutdowns. Moreover, banking sector capitalisation, supported by adequate NPL provisions, is sufficient to absorb moderate shocks, but remains sensitive to further lira depreciation given the high level of foreign currency loans on bank balance sheets and the risk of asset quality deterioration.
Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)
Scope’s Core Variable Scorecard (CVS), which is based on relative rankings of key sovereign credit fundamentals, signals an indicative “BB” (“bb”) rating range for the Republic of Turkey. This indicative rating range can be normally adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis.
For the Republic of Turkey, the following relative credit strengths have been identified: i) the growth potential of the economy; ii) economic policy framework; iii) fiscal policy framework; iv) public-debt sustainability; v) market access and funding sources; and vi) banking sector oversight and governance. Relative credit weaknesses are: i) macro-economic stability and sustainability; ii) current account vulnerabilities; iii) vulnerability to short-term external shocks; iv) recent events and policy decisions; and v) geo-political risk.
The combined relative credit strengths and weaknesses indicate an upward adjustment and signal a sovereign rating of BB+ for Turkey. A rating committee has discussed and affirmed these results.
Outlook and rating-change drivers
Scope will use the review period to further assess the direction of policy-making and the extent of the administration’s commitment to address the country’s macroeconomic challenges.
The ratings could be downgraded if, individually or collectively: i) fiscal, monetary and economic policies remain inconsistent with a rebalancing in the economy in favour of lower, but more sustainable, economic growth, failing to reduce inflation and macroeconomic vulnerabilities; ii) macroeconomic instability is accentuated via further external deterioration and/or shocks, undermining Turkey’s modest international reserve levels and exacerbating the balance of payments crisis; and/or iii) further institutional degradation or renewed security concerns arose, sparking market turbulence and interfacing with Turkey’s external vulnerabilities.
Conversely, the ratings could be confirmed at BB+ if: i) credible fiscal, monetary and economic policies were to be adopted, suspending market volatility and providing enhanced clarity on policies that rebalance the economy towards more sustainable growth and lower inflation; ii) the country’s external vulnerabilities were reduced, including its reliance on volatile forms of capital inflows, resulting in a lower and more sustainably financed current account deficit; and/or iii) the deterioration in Turkey’s governance framework reversed, underpinning greater confidence in the nation’s economic policy framework.
In Scope’s view, an upgrade is highly unlikely in the near term.