Scope Ratings AG has today upgraded the Republic of Turkey's long-term local currency issuer rating to BB+ from BB, following the release of its revised sovereign rating methodology, and has converted its status from subscription to public. The agency has also assigned a long-term foreign-currency issuer rating of BB+, along with a short-term issuer rating of S-3 in both local and foreign currency. The sovereign’s senior unsecured debt in foreign and local currency was rated BB+. All Outlooks are Stable.

Rating drivers

The rating upgrade is driven by improvements in Scope’s ‘domestic economic risk’ and ‘external economic risk’ analysis categories in an analysis against rating peers, and reflects Scope’s assessment of Turkey’s (1) improving economic performance that proved resilient to event and financial shocks; (2) well-managed public finances with a moderate debt burden and improving debt structure, reducing vulnerability to financial shocks; and (3) effective economic policy response, which alleviated the economic downturn in 2016 with the sovereign and private sector maintaining good external market access and banking sector proving resilient thanks to its strong capital structure and liquidity buffers. However, the ratings are constrained by large external financing needs that expose the country to capital outflows, weaknesses in the application of the rule of law, and political and geopolitical uncertainties. The Stable Outlook reflects Scope’s view that risks to the ratings are now broadly balanced.

Turkey’s ‘V’-shaped recovery is gaining momentum in 2017. Half-year GDP data confirms that downside risks to growth have abated. Compared to previous periods, growth spilled over to all main sectors, signalling a stable recovery. Given the strong GDP growth in the first half of 2017, and considering a gradual and partial reversal of growth-supportive measures this year, Scope expects real GDP growth to accelerate to 5% in 2017, exceeding a 4.4% government target. Monetary policy will likely be tightened in line with higher global interest rates, which would slow down real growth to around 4% in 2018, while fiscal policy should remain broadly expansionary ahead of the election year 2019.

Turkey’s ratings are also underpinned by sustained fiscal discipline, which has been a key factor in reducing the vulnerability of the Turkish economy to external shocks. Thanks to the government’s commitment to fiscal consolidation, sound public finances have facilitated the implementation of countercyclical measures of the government, leading to controlled budget deficits of around 3% of GDP in 2017 and 2018. Successful consolidation efforts reduced public debt to GDP from 44% in 2009 to 29% in 2016 while Turkey maintained primary surpluses of on average 0.7% of GDP from 2010 to 2016, demonstrating strong fiscal discipline over an extended period. Scope assesses Turkey’s public-debt dynamics as robust. The key risk to Turkey’s public debt sustainability is a scenario of protracted weak growth; however, public-debt dynamics are resilient in scenarios of external financial shocks, due to an only moderate sensitivity of public debt to exchange rate and global interest rate changes thanks to an improving composition of the moderate external public debt stock. Turkish debt management successfully lengthened the average time to maturity of external public debt in recent years to 9.4 years in 2016. Moreover, the share of fixed interest rate debt in overall debt has increased from 54% in 2005 to 70% in 2016 (and in external public debt from 58% in 2006 to 86% in 2016), providing an adequate buffer against global liquidity tightening and exchange rate fluctuations, underpinned further by low financing needs.

The Turkish banking sector remained profitable and resilient to the domestic shocks of 2016, thanks to its strong capital structure, asset quality and liquidity buffers. The stability of the financial sector has been underpinned by supportive measures from the government, through for example the injection of TRY 25bn in capital in the existing but hardly utilised credit guarantee fund (CGF) during the end of 2016 to boost bank lending to small and medium-sized enterprises. Accelerating credit growth for consumer loans in the first half of 2017 thanks to the CGF has been a key factor contributing to the economic recovery while macroprudential policies for consumer loans, which were strictly implemented over the last years, were loosened to some extent at the end of 2016.

Despite its resilience, the Turkish economy faces several challenges. The ratings are constrained by persistent current account deficits that remained broadly unchanged at 3.8% of GDP in 2016, reflecting Turkey’s reliance on importing energy, high import-intensity of export goods and elevated funding needs owing to low domestic savings. Turkey remains vulnerable in view of the strong reliance on non-resident investors’ sentiment, given the low but improving coverage of the current account deficit with net foreign direct investment. The financing of the current account through instead volatile capital inflows was recently insufficient in 2016, which weighed on Turkey’s modest international reserve stock. The current account deficit contributes to an elevated external funding need of 25% of GDP in 2017, which will remain at a similar level in 2018, reflecting maturing private external debt. However, the sizeable financing needs have been comfortably met recently due to low external debt costs within generally supportive global financing conditions.

The monetary policy framework is constrained by pressures on the lira, already elevated domestic interest rates, low reserve adequacy and insufficient financing coverage of persistent current account deficits with stable capital inflows. However, the central bank’s response has started to have favourable effects on inflation and the lira in 2017. According to the Central Bank of Turkey, inflation is still likely to follow a fluctuating course in the short to medium term, and be slightly below 10% at end-2017. Against this backdrop, the central bank decided to maintain high interest rates until the inflation outlook displays a significant improvement. Furthermore, monetary policy will be influenced by the speed of normalisation in global interest rates, which also impacts portfolio flows to Turkey.

The domestic political environment remains a key constraint to Turkey’s credit rating. The legacy of the failed military coup attempt in July 2016 is weighing on the institutional capacity in view of extensive dismissals and arrests of judges, academics and civil servants. The government’s reaction raised concerns regarding the application of the rule of law and resulted in risk aversion against Turkish financial assets, as reflected by a lagging recovery in investment. Indeed, Turkey’s governance indicators show a declining trend in the rule of law, which will be further exacerbated by the government’s push to establish a presidential system. However, political uncertainties have somewhat declined after the conclusion of the constitutional referendum in April 2017.

The possibility of an escalation in regional crises in Iraq and Syria constitutes an additional downside risk. International relations with Turkey’s traditional Western allies have become more strained, resulting in lagged negotiations related to the current Customs Union agreement between the European Union (EU) and Turkey. However, cooperation between the EU and Turkey will be maintained due to Turkey’s strategically-important location, as reflected in the 2015 refugee deal. Scope believes that Turkey’s transformation to a presidential system will continue to impact the business climate before implementation in 2019, thus making measures to restore and improve the investment climate a key priority for the government.

Sovereign rating 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 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 performance, iv) public debt sustainability, v) market access and funding sources, v) financial sector performance; and vi) financial sector oversight and governance. Relative credit weaknesses are: i) current account vulnerabilities, ii) vulnerability to short-term shocks, iii) recent events and policy decisions; and iv) 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 confirmed these results.

For further details, please see Appendix 2 of the rating report.

Outlook and rating-change drivers

The confirmation of the Stable trend reflects Scope’s view that risks to the ratings are broadly balanced.

The ratings could be downgraded if: i) a balance of payment crisis were triggered by external shocks, which undermine Turkey’s modest international reserve adequacy; ii) GDP growth were to deteriorate sharply, iii) renewed political shocks weigh on external financing conditions and materially weaken market access; iv) public finances were to deteriorate materially, weakening the country’s resilience.

Conversely, the ratings could be upgraded if: i) Turkey’s economic recovery results in sustained and balanced growth rates, ii) Turkey’s reliance on volatile sources of capital inflows were reduced via attraction of more stable net FDI inflows, resulting in a more sustainable current account financing structure; iii) Turkey’s political situation normalises resulting from political reform, underpinning price and exchange rate stability.

For the detailed research report, please click HERE.

Rating committee

The main points discussed by the rating committee were: i) Turkey’s growth potential, ii) economic policy framework, iii) fiscal performance, iv) public debt sustainability, v) current account vulnerabilities, vi) external debt sustainability, vii) vulnerability to short-term shocks, viii) market access and funding sources, ix) macro-financial vulnerabilities, x) peers consideration.

Methodology

The methodology applicable for this rating and/or rating outlook ‘Public Finance Sovereign Ratings’ is available on www.scoperatings.com.
The historical default rates used by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/governance-and-policies/regulatory/esma-registration. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default and definitions of rating notations can be found in Scope’s public credit rating methodologies on www.scoperatings.com.
The rating outlook indicates the most likely direction in which a rating may change within the next 12 to 18 months. A rating change is, however, not automatically a certainty.

Regulatory disclosures

This credit rating and/or rating outlook is issued by Scope Ratings AG.
Rating prepared by Jakob Suwalski, Lead Analyst.
Person responsible for approval of the rating: Dr Stefan Bund, Chief Analytical Officer.

The ratings/outlook were first assigned by Scope as a subscription rating in January 2002. The subscription ratings/outlooks were last updated on 05.05.2017.

The senior unsecured debt ratings as well as the short term issuer ratings were assigned by Scope for the first time.

As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on the Republic of Turkey are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Sovereign Ratings Calendar of 2017" published on 21.07.2017 on www.scoperatings.com). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. In this case, the deviation was due to the recent revision of Scope’s Sovereign Rating Methodology and the subsequent placement of the ratings under review, in order to conclude the review and disclose these ratings in a timely manner, as required by Article 10(1) of the CRA Regulation.

Solicitation, key sources and quality of information
The rating was initiated by Scope and was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the ratings process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party.

The following material sources of information were used to prepare the credit rating: public domain and third parties. Key sources of information for the rating include: Ministry of Finance of the Republic of Turkey, Central Bank of the Republic of Turkey, TURKSTAT, European Commission, IMF, OECD, and Haver Analytics.

Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.

Prior to publication, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Conditions of use / exclusion of liability
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Scope Ratings AG, Lennéstrasse 5, 10785 Berlin, District Court for Berlin (Charlottenburg) HRB 161306, Executive Board: Torsten Hinrichs (CEO), Dr. Stefan Bund; Chair of the supervisory board: Dr. Martha Boeckenfeld.