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

Rating drivers

The affirmation of Turkey’s sovereign ratings at BB- acknowledges Turkey’s credit strengths, including a large, diversified economy (nominal GDP of USD 740bn in the four quarters to Q1 2019), a flexible exchange rate regime, comparatively low levels of public debt, capital cushions in the banking system, and high (albeit falling) rates of medium-run growth potential. However, these strengths must be viewed against significant challenges, including an ongoing erosion in Turkey’s economic policy predictability and credibility, with unorthodox policies that are inconsistent with a rebalancing of the economy and return to a more sustainable path, elevated external sector risks and vulnerability to sudden deteriorations in the Turkish lira, which facilitates volatility in the broader economy, as well as institutional and governance limitations.

The Negative Outlook reflects balance of payment drawbacks resulting in the erosion of international reserve levels. Reserve coverage ratios are at risk of further decline under current policy settings. Risks to reserve adequacy and a reliance on short-term capital inflows reduce the country’s resilience in the event that a sudden stop in capital flows were to precipitate a currency and economic crisis. Scope acknowledges the significance of external stresses as any sudden lira deterioration would impair the non-financial corporate, banking and government sector balance sheets – due to elevated dollarisation and euroisation and associated high foreign-currency-denominated liabilities. In addition, the Outlook reflects macroeconomic imbalances exacerbated by the economic policy framework, a gradual regression in Turkey’s public finance strengths, as well as institutional and geopolitical challenges.

Modest levels of international reserves have declined. Official reserves (including gold) dipped to USD 96.4bn as of 7 June from a 2019 peak of USD 100bn as of 1 March 2019 and remain well under a 2013 peak level of USD 135bn. Reserve coverage of short-term external debt at about 81% (in view of short-term external debt of USD 119.4bn outstanding in March) is well below the 114% level as of August 2016. This suggests that Turkey could struggle to meet external debt repayments in the scenario of an extended balance of payment crisis, during which external debt roll-over ratios regress materially below 100%. In addition, net international reserves totalled just USD 28.3bn as of 7 June, down on a 1 March peak of USD 35.2bn.

Since 25 March 2019, the Central Bank of the Republic of Turkey has sequentially raised its total lira swap sale limit to 40% from 10% for unmatured transactions. The amount of foreign currency the central bank borrowed from commercial banks via this swap channel from late March to 17 May was about USD 13.2bn. As a result, net international reserves would stand at only about USD 15bn if these one-week swaps were closed out. The government has explained that the swap instruments are needed for managing liquidity in forex markets. However, there has been speculation that the central bank has used the swaps to artificially inflate reserves figures in order to ease market anxiety. This would have been fuelled by reserves being used at the same time to indirectly support the lira around the 31 March¹ election period. On 27 May, reserve requirement ratios for forex deposits and participation funds were increased by 200 bps – withdrawing USD 4.2bn of FX liquidity from the market and boosting reserves. The central bank moreover introduced a new swap line on 9 May that allows it to add to reserves by borrowing gold from banks.

The central bank’s net foreign assets were down to USD 25.3bn as of 10 June, although above 25 March lows of USD 19.4bn – buoyed up since late March via the swap borrowings. With these reserve amounts, Turkey may not have adequate foreign currency to mount a sustained defence of the lira in a deep crisis, in the absence of contingent recourse to international support. A programme concentrating on rebuilding the reserve stock and regaining investor confidence, including through increased quality of and transparency in forex reserve management, could be credit positive. Conversely, further falls in Turkey’s reserve coverage ratios could support a rating downgrade.

Reserve levels have been supported by the temporary correction in Turkey’s current account deficit. Turkey’s current account deficit improved significantly to about 1.2% of GDP in the 12 months to April 2019, from peaks of 6.6% in the 12 months to May 2018, owing to: i) import contraction due to soft domestic demand; as well as ii) the impact of the large currency devaluation on goods and services export growth. Scope anticipates that Turkey will see a modest current account deficit of about 1% of GDP in 2019. As Turkey’s economy recovers, however, the roughly balanced current account position will edge back into a meaningful deficit. Here, adherence to a more sustainable economic growth model remains critical in achieving structurally-balanced current accounts over the longer run. Nonetheless, the smaller current account deficit in the year to April 2019 has already meant reserve savings of USD 48.4bn compared to a scenario in which the deficit remained at the same level as in the year to April 2018. On the other hand, reserves have been damaged by an increase in net portfolio and other investment outflows. However, such outflows might be eased under a more accommodative global interest rate environment going forward.

The Negative Outlook considers the erosion in Turkey’s economic policy predictability and credibility, in view of structural economic policies that have been inconsistent with adjustment to a more sustainable economic model. The country’s weakened institutional framework under the Executive Presidency since June 2018 affords President Recep Tayyip Erdogan extremely broad powers, raising the likelihood of significant economic policy errors in the period to 2023. Scope’s concerns have increased regarding the independence of monetary policy and heightened uncertainty surrounding future rate decisions. The central bank’s one-week repo rate has been held at 24% since September 2018 – representing a significant positive real policy rate. This is credit positive, in Scope’s view. However, additional rate tightening and loosening since September has occurred via ‘backdoor’ hikes and cuts vis-à-vis suspensions (including since 9 May) and reactivations of one-week repo auctions – questioning the role of political pressure in impeding outright rate increases.

Unorthodox policies were adopted ahead of the March local elections. This included shifts in the country’s flexible exchange rate framework via government restrictions on how much lira liquidity local banks can offer foreign counterparties to use for lira short sales. Policies have moreover been adopted aimed at artificially lowering high food inflation via the state purchasing fruits and vegetables from farmers and selling them at discounted prices. Inflation remains well above a central bank target of 5% at 18.7% YoY as of May, although it has fallen from a peak of 25.2% in October 2018. Food inflation is near its highest recorded level, at 28.4% YoY in May. Scope expects inflation to fall in the coming months as the effects on inflation from last year’s sharp lira sell-off drop out of year-on-year rates.

State-run banks have stepped up cheap loan extension, to support slumping domestic lira loan growth of only 1.9% YoY in April, after pre-crisis levels of 25.1% in October 2017. Aside from the government having signalled ‘new economic model’ objectives of lower deficits, lower inflation and more sustainable growth, policy actions that substantiate stated objectives and increase the quality of Turkey’s economic governance are required to support the credit ratings.

Turkey’s public finances have traditionally been a core credit strength. However, a challenging economic environment is testing this strength. The deficit of general budget institutions was 2.7% of GDP in the twelve months to April 2019, marking a deterioration from 1.9% in 2018. This is even after the government asked the central bank to pay over TRY 37bn in profits (1.0% of GDP) earlier than planned. The true extent of the deterioration excluding these profit transfers was more significant, owing mostly to expenditure increases and weak indirect tax collections. The government did not revise its fiscal targets (notably, a 2019 deficit goal of 1.8% of GDP) or add detail to new fiscal measures in its economic reform plan updated in April. In Scope’s view, the general government deficit may instead conclude 2019 at around 3.0%-3.5% of GDP.

General government debt levels are low compared with that of bb-indicative sovereign peers, despite a recent modest deterioration in public debt ratios to 30.4% of GDP as of end-2018, from 27.6% as of end-2015. Modest debt remains a significant support to Turkey’s credit ratings. However, public net debt has deteriorated somewhat more significantly to 13.7% of GDP in 2018, from 6.9% in 2015. Turkey has moved forward on its pledge to inject USD 4.9bn (0.7% of GDP) in new capital into state banks struggling with rising non-performing loans. This, however, contributes to rising public debt. 51% of central government debt was denominated in foreign currency as of April 2019, representing a significant risk to debt sustainability in any scenario of significant lira depreciation. At the same time, 77% of central government debt is structured with a fixed interest rate, and general government debt outstanding averages a maturity of 6.3 years. Government gross financing needs of 7.1% of GDP in 2019 are below the median of bb-indicative-peers. However, 41.4% of general government debt is held by the non-resident sector (as of 2018), highlighting risks to Turkish debt markets in global risk-off conditions (the 10-year lira yield was an elevated 17.7% at the time of writing).

Turkey’s economy exited recession in Q1 2019, with growth of 1.3% QoQ. This followed three consecutive quarters of contraction in 2018 that totalled 4.0% in lost output – representing Turkey’s first recession since 2008-09. Election-related fiscal stimulus and rapid credit growth from state-owned banks contributed to the momentary Q1 recovery, suggesting a likely reversal of momentum in Q2. The World Bank estimates -1.9% growth in 2019, before +3% in 2020. Over the medium run, Scope sees Turkey’s potential rate of growth slowing to 3.9% by 2024 (from 4.4%), as growth in the country’s working-age population moderates.

Turkey benefits from a large, diversified economy, supported by a floating exchange rate. Bank capital adequacy standard ratios have dipped somewhat to 16.9% of risk-weighted assets in April 2019, from 18.2% as of November. On the other hand, capital buffers have been a significant cushion against the deterioration in asset quality, weakening profitability and a 36% depreciation in the lira since end-2017 (to 5.9 to the dollar). The government’s capital injections programme combined with a plan to transfer some problem loans from banks into a separate fund would improve bank liquidity. Residents’ forex deposits – mostly denominated in dollars – at local deposit-taking lenders rose to a record high of USD 169.5bn as of 7 June. Banks remain full of dollars as resident companies and individuals have transitioned to foreign currency deposits. The central bank could therefore hypothetically continue to draw upon these resources via swaps with banks, especially if FX reserves were to decline further. Non-performing loans have risen to 4.05% of total loans (totalling USD 18.2bn) as of April 2019, from lows of 2.8% as of May 2018. At the same time, the extent of the increase in non-performing loans as a result of the 2018 crisis is not as great as anticipated. The banking regulator predicted that the non-performing loan ratio will climb to 6% in 2019, with ‘stage 2’ at-risk loans moreover on the rise.

However, non-financial companies maintain a significant open net foreign exchange position of USD 191.9bn as of March. This is a slight improvement from USD 222.7bn as of February 2018 but nonetheless significant enough such that any further lira devaluation would exacerbate at-risk loans and restructurings. A positive net foreign exchange position for corporates on a one-year horizon mitigates near-term risks to an extent.

President Erdogan’s AK Party (AKP) suffered losses in the March local elections, with the opposition winning control of five of Turkey's six largest population centres (the exception being Bursa). The Supreme Election Council approved an AKP appeal to have the Istanbul mayoral result annulled and a re-run scheduled on 23 June. While it is not certain who will win the re-run, the invalidation of the election result undermines free and fair elections and calls the independence of the Turkish judiciary into question. After the Istanbul re-run, the next polls are not scheduled for about four years. The steady erosion of democratic institutions in Turkey is relevant for the Negative Outlook.

Tensions between Turkey and the United States pose geopolitical event-driven risk. The United States has stated that Turkey will not receive its purchase of F-35 fighter jets after a 31 July deadline if the Turkish government goes ahead with a deal to buy a Russian missile defence system. The US administration did trim special tariffs on steel imports from Turkey back to 25% in May. At the same time however, it terminated Turkey's eligibility to participate in the Generalized System of Preferences programme, on the basis of Turkey’s level of economic development. In 2017, the US imported USD 1.66bn (0.2% of Turkish GDP) from Turkey under this programme.

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 strength has been identified: i) banking sector performance. Relative credit weaknesses are: i) the economic policy framework; ii) current account vulnerabilities; iii) external debt sustainability; iv) vulnerability to short-term external shocks; v) financial imbalances and financial fragility; vi) recent events and policy decisions; and vii) geopolitical 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. Turkey scores poorly 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 ‘geopolitical risk’ as ‘poor’ compared with Turkey’s sovereign peers – these QS governance assessments collectively contribute to a one-notch downward analyst adjustment (vis-à-vis the CVS model rating) in informing Turkey’s credit rating of BB-. Turkey’s governance performance and institutional framework have been affected by a deterioration in the rule of law. Tolerance of dissenting political views has been curtailed according to independent observers.

Socially-related factors are captured in Scope’s CVS regarding Turkey’s high GDP per capita (USD 9,346 in 2018) compared to that of bb-sovereign-peers, high level of unemployment (13.6% as of February) but a healthy old-age dependency ratio compared with peers. Some progress has been made as regards social factors, such as the reduction in absolute poverty and improvements in education. However, there has been a weakening in Turkey’s commitment to market-oriented reforms, with a deteriorating business environment and declining 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 poorly with 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 below OECD averages. Environmental factors are considered during the rating process, but 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) macroeconomic instability is further heightened via external sector deterioration and/or external shocks, including the further degradation of Turkey’s modest international reserve levels and/or an acceleration in capital outflows; ii) fiscal, central bank and structural economic policies remain inconsistent with assuring the economy’s long-run sustainability, including the failure to address macroeconomic vulnerabilities; and/or iii) further institutional degradation, geopolitical tensions or renewed security concerns arise, sparking market turbulence and accentuating Turkey’s external vulnerabilities.

Conversely, the ratings could be affirmed at BB- and the Outlook stabilised if, individually or collectively: i) credible fiscal, monetary and economic policies are adopted, stabilising the currency and providing enhanced clarity on policies that rebalance the economy; ii) the country’s external vulnerabilities are reduced, including enhancing levels of international reserve buffers, curtailing Turkey’s reliance on volatile forms of capital inflows, and/or rebalancing the economy towards a structurally-balanced current account; and/or iii) the deterioration in Turkey’s governance framework is reversed, underpinning greater confidence in the nation’s economic policy framework.

In view of the Negative Outlook, a revision of the Outlook to Positive or an upgrade of Turkey is highly unlikely in the next 12-18 months.

¹Editor`s note: The above section was corrected on 17 June 2019 following the publication of the credit rating on 14 June 2019. The original wording was: 29 March

Rating committee
The main points discussed by the rating committee were: i) external imbalances and international reserve levels; ii) inflation and monetary policy; iii) implications of further currency devaluation; iv) the economic policy framework; v) fiscal policy and debt sustainability; and vi) recent events and institutional risk.

Methodology
The methodology used for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on www.scoperatings.com.
Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. 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 as well as definitions of rating notations can be found in Scope’s public credit rating methodologies at www.scoperatings.com.
The rating outlook indicates the most likely direction in which a rating may change within the next 12 to 18 months.

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.
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, 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.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Lead analyst Dennis Shen, Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director, Public Finance
The ratings/outlook were first assigned by Scope in January 2003. The ratings/outlooks were last updated on 16.08.2018.
The senior unsecured debt ratings as well as the short-term issuer ratings were last updated by Scope on 16.08.2018.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
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