Scope Ratings GmbH has today downgraded the Republic of Turkey’s long-term local- and foreign-currency issuer and senior unsecured debt ratings to BB- from BB+, with the Outlook revised to Negative. The short-term issuer rating was confirmed at S-3 in both local and foreign currency, with the Outlook revised to Negative.

Rating drivers

The downgrade of Turkey’s sovereign ratings to BB- reflects the following three drivers:

1. Deterioration in Turkey’s economic policy predictability and credibility, in view of monetary, fiscal and structural economic policies inconsistent with the rebalancing of the economy onto a more sustainable path. Recent developments cast doubt on the authorities’ commitment to address the country’s fundamental macroeconomic weaknesses. These have been compounded by geopolitically-driven external shocks, as reflected in reciprocal sanctions vis-à-vis the United States, further sparking market concern and testing Turkey’s external vulnerabilities.
    
2. Accentuated macroeconomic imbalances including a deteriorating inflation outlook with to date an incoherent monetary and fiscal policy response. This has been facilitated by the steep depreciation of the Turkish lira against the US dollar. The effect of turmoil in Turkish markets alongside more challenging global external financing conditions is resulting in rising challenges for the Turkish private sector, which carries significant foreign-currency exposures.
    
3. The impact of balance of payment weaknesses on modest levels of international reserves, which are at risk of further erosion under current policy settings. The large currency devaluation and slowing economic growth could support some redressal of Turkey’s large current account deficit down the road, but capital outflows raise risks of reserve depletion and stress future private sector external repayments.

The downgrade of Turkey’s sovereign ratings reflects changes in Scope’s assessments in the ‘domestic economic risk’, ‘public finance risk’ and ‘external economic risk’ categories of its sovereign methodology. Turkey's BB- ratings remain supported, however, by the country’s high growth potential, large, diversified economy, flexible exchange rate regime, robust public finances (despite a recent adverse trajectory), and aspects of resilience within the banking sector.

The first driver underpinning Scope’s decision to downgrade Turkey’s sovereign ratings is Scope’s view that Turkey’s economic policy predictability and credibility have 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 effectiveness of economic management over a longer-term window and have to date failed to reduce inflation and macroeconomic vulnerabilities.

President Recep Tayyip Erdogan’s term and mandate to guide the economy now extends until 2023. The country’s weakened institutional framework under the new Executive Presidency affords the President extremely broad powers, raising the likelihood of significant economic policy errors and geopolitically-driven external shocks, as reflected in reciprocal sanctions vis-à-vis the United States.

The Turkish central bank’s decision function, monetary policy committee 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. Finance Minister Berat Albayrak has signalled ‘new economic model’ objectives of lower deficits, lower inflation and more sustainable growth, however significant and coherent monetary, fiscal and structural economic policy actions are still needed to substantiate stated objectives and increase the credibility of Turkey’s policy-making institutions.

The second driver behind Scope’s decision to downgrade Turkey’s long-term ratings is accentuated macroeconomic imbalances including a deteriorating inflation outlook with to date an incoherent policy response. The Turkish lira has devalued by 35% against the US dollar (to 5.8 at the time of this writing) since the beginning of 2018. The announcement of curbs on the short selling of lira buys time but does not resolve the fundamental causes of weakness. With the pass-through of currency declines, inflation reached 15.9% YoY in July—the highest level since December 2003 and well above the central bank target of 5%. This has forced interest rate tightening of 500 bps since December 2017. However, the inflation outlook is worsening, with the Turkish central bank’s inflation forecast of 13.4% for end-2018 (raised from a previous forecast of 8.4%) at risk of further upside revisions. This reduces the real policy rate and risks a longer-lasting de-anchoring of inflation expectations. The central bank’s recent attempts to support financial stability against the steep lira depreciation, using measures intended for providing FX liquidity but refraining from additional tightening in monetary policy to curb risks on inflation demonstrate an ongoing reluctance to raise interest rates.

The significant lira depreciation has meaningful implications on open net foreign exchange positions of the private sector, totalling USD 223bn in Q1 2018 – with certain sectors lacking natural hedges. Private sector external assets and a positive net foreign exchange position on a one-year horizon mitigate near-term risks, however, to an extent. The external debt roll-over of the banking sector has remained robust, although the cost of rollover and hedging has increased. Firms and households are also simultaneously stressed by tighter domestic borrowing conditions, with bank lending rates to commercial enterprises rising to 24.3% in July, from 15.2% in January 2018.

At the same time, fiscal performance has worsened in recent years owing to a series of spending measures. Scope anticipates the general government deficit to widen to (a still-moderate) 2.5% of GDP in 2018, from an average of 1.2% of GDP over 2013-2017, with an ongoing pursuit of new infrastructure and other capital-intensive projects. A slowing economy will moreover affect tax revenue growth going forward. The impact of expansionary fiscal policy has boosted already-high inflation with important local government elections, scheduled for March 2019, meaning that the scale of fiscal retrenchment in the coming months may be restricted. Government bond yields have risen, making debt financing more expensive. In addition, with 42% of central government debt in foreign currency, the lira devaluation in 2018 automatically increases the public debt-to-GDP ratio by about 7pp (from the 28.3% at end-year 2017).

The third driver supporting the downgrade decision is the impact of balance of payments weaknesses on modest levels of international reserves, which are at risk of decline.

Turkey’s current account deficit has widened, to 6.2% of GDP in the 12 months to June 2018 (from 3.3% of GDP in the 12 months to May 2016), although the large currency devaluation and slowing economic growth could support some redressal of Turkey’s large current account deficit in the future. Alongside meaningful capital outflows due to both Turkish stresses and a more challenging global interest rate environment, modest gross international reserves of USD 130.9bn (106% of short-term external debt) as of May 2018 are at risk of decline. The pledge of USD 15bn in investment from Qatari authorities is favourable but does not resolve underlying balance of payment risks. Turkey’s overall external borrowing needs of around 15% of GDP for the remaining months of 2018 and around 25% for the full-year 2019 remain sizable, mostly stemming from private sector debt amortisations.

The assignment of a Negative Outlook on Turkey’s BB- ratings reflects continuing heightened macro-economic, policy and event-related uncertainty and risks, which threaten to further test Turkey’s external vulnerabilities. The absence to date of a proactive policy response to address macro-economic issues and escalation of confrontations with the United States and capital markets raise risks that Turkey’s crisis may deepen.

At the same time, Turkey’s 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 areas of resilience in the debt structure – including a 6.2-year average government debt maturity and a high and rising share of fixed-rate central government debt (75% of total debt as of June 2018), which limits changes to the government’s low interest payments (of 1.8% of GDP in 2017). These reduce to an extent Turkey’s vulnerability to shocks.

In addition, Turkey benefits from a large, diversified economy, supported further by a flexible exchange rate. Real growth in the first quarter of 2018 was 7.4% year-over-year. However, Scope expects economic growth to slow to around 3.5% in 2018 and 3% in 2019, owing to tighter economic and financial conditions and as the effects of previous pro-growth policies fade, but supported nonetheless by external demand.

Despite higher financing costs, external-debt roll-over of banks has moreover continued at a rate of above 100%, reflecting areas of resilience within the banking system, including a favourable structure of external debt, enabling the sector to bridge short-lived market shutdowns. However, recent central bank measures have forced Turkish banks to borrow overnight, with a cost increase of 1.5% compared to normal one-week cash auctions (to 19.25%). This negatively affects bank profitability and ability to support the real economy in a stressed environment. A key uncertainty for the upcoming period in case of a stress scenario, in which the Turkish lira depreciates further and domestic demand contracts, is the extent of bankruptcies in the real economy and the extent to which an increase in currently low levels of non-performing loans (of 3% of total loans) may place pressure on bank balance sheets.

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) fiscal policy framework; and ii) banking sector oversight and governance. Relative credit weaknesses are: i) macro-economic stability and sustainability; ii) current account vulnerabilities; iii) external debt sustainability; iv) vulnerability to short-term external shocks; v) recent events and policy decisions; and vi) geo-political risk.

The combined relative credit strengths and weaknesses indicate a one-notch downward adjustment and signal a sovereign rating of BB- for Turkey. A rating committee has discussed and affirmed these results.

Factoring of Environment, Social and Governance (ESG)

Scope considers ESG sustainability issues during the rating process as reflected in the sovereign methodology. Governance-related factors are explicitly captured in Scope’s assessment of ‘Institutional and Political Risk’ in its methodology, in which Turkey scores weakly in the World Bank’s Worldwide Governance Indicators on the CVS, lagging behind OECD peers on a composite index of six indicators. Qualitative governance-related assessments reflect Scope’s QS evaluation of ‘recent events and policy decisions’ as ‘inadequate’ and ‘geo-political risk’ as ‘poor’ compared with Turkey’s sovereign peers – these QS governance assessments contributed to Scope’s decision to downgrade Turkey’s credit rating to BB-. Turkey’s governance performance and institutional framework have been affected by deterioration in the rule of law.

Socially-related factors are captured in Scope’s CVS in Turkey’s high GDP per capita (USD 10,512 in 2017), fairly high level of unemployment but a healthy old-age dependency ratio compared with peers. Some progress has been made in social factors, such as the reduction in absolute poverty and improvements in education. However, there has been weakening in Turkey’s commitment to market-oriented reforms, with a deteriorating business environment and weakening sustainability of economic growth. These social considerations are captured in Scope’s QS evaluation of ‘growth potential of the economy’ and ‘macro-economic stability and sustainability’.

Turkey’s record on environmental, energy and urbanisation issues also compares weakly against OECD peers. Good progress has been made on the renewable energy transition, which is a key pillar of the national energy strategy. However, air and water quality are under OECD averages. Environmental factors are considered during the rating process, however did not play a direct role in this rating action.

Outlook and rating-change drivers

The ratings could be downgraded over the next 12-18 months if, individually or collectively: i) fiscal, monetary and economic policies remain inconsistent with a rebalancing in the economy, failing to address macroeconomic vulnerabilities; ii) macroeconomic instability is further accentuated via 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, geopolitical tensions or renewed security concerns arose, sparking market turbulence and interfacing with Turkey’s external vulnerabilities.

Conversely, the Outlook could be stabilised if, individually or collectively: i) credible fiscal, monetary and economic policies were to be adopted, suspending market volatility and providing enhanced clarity on policies that rebalance the economy; 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, a rating upgrade is unlikely in the near term.

Rating committee

The main points discussed by the rating committee were: i) impact of the currency devaluation and inflation outlook; ii) economic policy framework developments; iii) corporate and banking sector foreign currency exposure; iv) external debt structure and reserve adequacy; v) debt sustainability; vi) contingent liabilities; and vii) peer analysis.

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 of Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. 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 as well as 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 of the rating if the rating were to change within the next 12 to 18 months.

Regulatory disclosures

This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Rating prepared by Jakob Suwalski, Associate Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director, Public Finance
The ratings/outlook were first assigned by Scope as a subscription rating in January 2003. The ratings/outlooks were last updated on 26.07.2018.
The senior unsecured debt ratings as well as the short-term issuer ratings were last updated by Scope on 26.07.2018.

As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings of 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 2018" published on 22.12.2017 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 weak government reaction function and related policy and governance decisions since the presidential and legislative elections on 24 June, which have damaged the credibility of the economic policy framework of the Republic of Turkey, prompting the publication of the credit rating action on a date that deviates from the previously scheduled release dates per Scope’s public finance release calendar, published at www.scoperatings.com.

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 substantially 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, 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 the issuance of the rating action, 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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