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Rating action

Scope Ratings has today downgraded Turkey's long-term issuer and senior unsecured debt ratings to B+ in foreign and local currency. The Outlooks on Turkey’s long-term ratings in foreign and local currency have been revised to Stable. The short-term issuer ratings have been downgraded to S-4 in foreign and local currency, with the Outlook revised to Stable.

Summary and Outlook

The downgrade of Turkey’s long-term ratings to B+ from BB- reflects:

1. increase in risks to external sector stability, including due to the structural depletion of Turkey’s international reserve stock and significant public and private sector exposures to future Turkish lira depreciation and periods of capital outflow; and
    
2. deterioration in the fiscal, monetary and economic policy frameworks, which remain inconsistent with the assurance of the economy’s long-run sustainability, including failure to address significant and increasing macroeconomic imbalances, including high inflation and elevated growth in credit.

This ratings change reflects revisions in Scope’s assessments in the ‘domestic economic risk’, ‘public finance risk’ and ‘external economic risk’ categories in its sovereign methodology.

The revision of the Outlook on Turkey’s credit ratings to Stable from Negative balances the economic downside risks stemming from the Covid-19 pandemic with Turkey’s several credit strengths, including a large, diversified economy (estimated nominal GDP of USD 754bn in 2019), comparatively moderate (although rising) levels of public sector debt, moderate private sector debt levels and favourable demographics. In addition, significant capital cushions in the banking system and high (although declining) rates of medium-run growth potential are credit strengths.

The Stable Outlook represents Scope’s opinion that risks to the sovereign ratings are balanced over the forthcoming 12 to 18 months. The ratings/Outlooks could be downgraded if, individually or collectively: i) macroeconomic instability is undermined due to deterioration in external sector stability and/or a significant balance of payment crisis is witnessed, including the continued degradation of Turkey’s reserve levels and/or acceleration in capital outflows; ii) fiscal, monetary and structural economic policies remain inconsistent with the assurance of a sustainable economic framework, including the non-redressal of growing macroeconomic imbalance; and/or iii) institutional degradation, geopolitical tensions or renewed security concerns arise, sparking market turbulence and accentuating Turkey’s external vulnerability.

Conversely, the ratings/Outlooks could be upgraded if, individually or collectively: i) fiscal, monetary and economic policies are credibly re-anchored, maintaining stability in the currency and supporting a rebalancing of the general economy; ii) the country’s external vulnerabilities are curtailed, including enhancement of international reserve levels, reductions of FX exposures in the economy, curtailment of Turkey’s sensitivity to sudden reversal in capital flows, and/or economic rebalancing toward a structurally-balanced current account; and/or iii) the deterioration in Turkey’s governance framework is reversed, underpinning enhanced confidence in the nation’s future economic policy framework.

Rating rationale

The first driver of the downgrade of Turkey’s long-term credit ratings to B+ is the impact on macroeconomic stability from severe and increasing external sector risks, including declines in Turkey’s reserve coverage adequacy and significant exposure to lira depreciation and periods of capital outflow.

Already inadequate international reserve levels entering 2020 have been curtailed. Gross official reserves (including gold) eased to USD 90.5bn as of 3 July 2020, compared with a 2013 peak at USD 134.6bn (and USD 105.7bn entering 2020). Netting out central bank FX liabilities to domestic banks and excluding bilateral short-term FX swap liabilities¹ (totalling USD 51.9bn at end-May*) that are currently being excluded from central bank FX liability data, swap-corrected net reserves have declined to a record low of USD -28.6bn as of May*, from USD 18.8bn at end-2019 (and USD 56.0bn at a 2011 peak). Scope notes that the Turkish central bank has used swaps with domestic banks to temporarily raise gross reserve levels: absent roll-over of outstanding swap agreements, gross reserves would automatically be significantly curtailed – raising vulnerabilities to Turkey’s balance of payments.

Turkey’s gross reserves cover about 79% of short-term external debt, from 114% as of mid-2016 – currently under an IMF adequacy threshold of 100%. While reserve figures remain more than adequate to meet 2020 sovereign debt servicing needs, weakening reserves mean that the Turkish economy is increasingly less resilient to periods of crisis during which capital outflows or lira depreciation escalate, with the exchange rate interventions of state-owned banks, moreover, having reduced reserves. The government has additionally used swap agreements with foreign central banks to cushion FX assets; in May, Turkey tripled a swap line with the Qatari central bank to USD 15bn.

The lira has stabilised since a record low reached early May; however, at the time of writing, the lira still trades 25% under an August 2019 peak against the dollar. Deterioration in the exchange rate not only raises inflation, but also undermines debt sustainability in light of 51% of central government debt denominated in foreign currency (with this FX share doubling from 27% in mid-2013). In addition, non-financial companies have a significant net FX debt position, which, while trimmed significantly from a February 2018 peak of USD 223bn, nonetheless stood at USD 170bn in April 2020. Limitations to travel during the 2020 pandemic adversely impair private sector FX reserve liquidity as well as the current account (which returned to a modest deficit of 0.4% of GDP in the year to April 2020). Future weakening in the lira places the government, banks and Turkish corporates with FX debt in a challenging spot, even though a positive net foreign exchange position for companies on a one-year horizon mitigates immediate risk.

Susceptibility to reversal in capital flows contributes to external sector vulnerabilities. Net capital outflows, which eased after the 2018 lira crisis, re-escalated in the spring (to a total of USD 40.4bn from March to April 2020, including net errors and omissions). Sensitivity to short-term capital outflows reduces economic resilience against periods of global market turbulence, with bouts of outflow impairing reserve stocks.

The second driver of the downgrade of Turkey’s long-term ratings to B+ relates to fiscal, central bank and structural economic policies that remain inconsistent with long-run economic sustainability.

The quality of Turkey’s structural economic policies and institutional framework has weakened after the transition to the Executive Presidency in June 2018, which gave President Recep Tayyip Erdoğan broad powers. This has resulted in an erosion of Turkey’s economic policy predictability and has caused shifts in the country’s flexible exchange rate framework – historically a core credit strength – including frequent open market operations to defend the lira, recent imposition of a ban of six international banks from short selling and expansion of the definition of “manipulative (market) trades”.

The erosion in Turkey’s economic policy predictability also reflects concern about heightened uncertainty surrounding future interest rate decisions. The policy one-week repo rate was held unchanged at 8.25% at the June monetary policy meeting, although this came after nine consecutive rate reductions from 24% as of July 2019. The real policy rate is now -3.9% as of June against inflation of 12.6% YoY. Turkey’s real rate is among the world’s lowest. However, the central bank has actively bought government bonds to contain medium- to long-term borrowing rates. Accommodative monetary policy has, however, amplified bank lending, with lira lending to the domestic economy increasing an elevated 40.4% YoY in June. In addition, the banking regulator has announced unorthodox reforms that pressure banks to step up such lending, purchase government bonds and engage in FX swap transactions with the central bank. Under this programme, lenders have been required to maintain an “asset ratio” since 1 May, reviewed weekly.

Frequent crises that call upon counter-cyclical fiscal support have tested a traditional credit strength in Turkey’s strong public finances. In March, in response to the public health crisis, Turkey appropriately announced a TRY 100bn (2.2% of GDP) support package – the Economic Stability Shield², postponing debt payments and reducing some tax burdens. The total support package has since been enhanced to TRY 350bn (7.6% of GDP) – including raises in loan guarantees via the Credit Guarantee Fund. Scope expects a general government deficit this year of 9.7% of GDP – compared with a deficit of 5.3% of GDP in 2019 and only 2.2% per 2017. Scope expects deficit levels to remain structurally higher post-crisis.

After above expectation growth of 0.9% in 2019 (6% YoY in Q4 2019), Turkey’s economy is expected to decline 4.2% in 2020, prior to recovery of 5.8% in 2021. Under a stressed scenario of renewed lockdown in the economy in the second half of the year, Scope sees 2020 Turkish growth of -6.7% under this contingency, followed by recovery of 3.3% in 2021. However, case counts of Covid-19 have eased since mid-April, and Turkey’s economy has begun gradual reopening since 11 May. Over the medium run, Scope foresees Turkish potential growth of around 3.9%.

Despite the above credit weaknesses, Turkey benefits from a large, dynamic and diversified economy. Bank capital buffers have been a significant cushion against deterioration in asset quality, weakening in profitability and depreciation periods in the lira. Residents’ FX deposits – mostly denominated in dollars – at local deposit-taking lenders are at near record highs of USD 180.4bn as of 3 July, although the speed of build-up in resident FX deposits has slowed since 2019. Dollar denominated deposits held at local banks continue to provide resources for the state to rely upon via swap arrangements with banks in supplementing reserves. Non-performing loans declined to 4.5% of GDP as of May 2020, after highs of 5.4% in December. The capital adequacy ratio of banks rose to 19.4% as of May 2020, from 14.6% in 2015 – providing an abundant cushion against declines in profitability and/or rises in loan loss provisioning. In addition, Turkey enjoys moderate private debt, including non-financial corporate debt levels of 65.9% of GDP at end-2019.

General government debt levels entered the 2020 crisis below that of all bb-model-indicative sovereign peers – a major credit strength, although debt ratios had risen to 32.8% of GDP by end-2019, from 28.2% as of end-2017. However, this credit strength is being attenuated. Scope foresees an increase in the government debt ratio to at least 40% of GDP in 2020, before continuing to steadily increase over the medium run. Due to the high share of FX government debt, the speed of increase in the government debt ratio escalates as debt levels rise due to structural currency depreciation (the currency declined against the dollar on average 12.4% per year over 2010-19). In addition, 39.5% of general government debt is held by the non-resident sector (as of 2019), raising risks from portfolio outflows under risk-off environments.

Turkey’s credit ratings benefit from growing demographics. The share of the Turkish population that is of working age is rising, now standing at 68% (versus 65% on average in OECD member countries³), while the old-age dependency ratio decreased to about 49%, from 52% in 2010⁴. In addition, the customs union with the European Union and diversification of trading partners are credit strengths, especially under presently fragile geopolitical conditions, as the economy is less dependent upon a specific export destination or import source.

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 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 Turkey, the following relative credit strength has been identified: i) banking sector performance. Relative credit weaknesses are signalled for: i) the economic policy framework; ii) macro-economic stability and sustainability; iii) market access and funding sources; iv) current account vulnerabilities; v) external debt sustainability; vi) vulnerability to short-term external shocks; vii) financial imbalances and financial fragility; viii) recent events and policy decisions; and ix) geopolitical risk.

The combined relative credit strengths and weaknesses generate a two-notch downside adjustment and indicate a B+ long-term rating for Turkey.

A rating committee has discussed and confirmed 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’ under its methodology. Turkey scores poorly on the World Bank’s Worldwide Governance Indicators in the CVS (Scope’s quantitative model), lagging behind OECD peers. Qualitative governance-related assessments reflect Scope’s QS evaluations under the ‘recent events and policy decisions’ QS category as ‘very weak’ and ‘geopolitical risk’ as ‘weak’ compared with Turkey’s ‘bb’-indicative sovereign peers. Turkey’s governance challenges, as reflected in the QS, contribute to the two-notch downside adjustment (from the CVS indicative rating) in determining the credit ratings of B+. Turkey’s governance score and institutional framework have been affected by ongoing 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 comparatively high GDP per capita (of an estimated USD 8,958 in 2019) versus that of economies in its ‘bb’ CVS peer group, but high level of unemployment (13.8% in the three months to May 2020). Turkey’s healthy old-age dependency ratio compares very well, however, against that of country peers. Progress has been made, in addition, in the reduction of absolute poverty and improvements in education. However, there has been a weakening in Turkey’s commitment to market-oriented reform, with deterioration in business conditions and a declining sustainability of high economic growth. These social factors are considered in Scope’s QS evaluation of ‘neutral’ on ‘growth potential of the economy’ compared with ‘bb’ model indicative peers, ‘very weak’ on ‘economic policy framework’ and ‘weak’ on ‘macro-economic stability and sustainability’.

Turkey’s record on environmental, energy and urbanisation issues compares weakly with that of OECD peers. Environmental factors are considered during the rating process; however, they did not play a direct role in this rating action.

* This excerpt has been corrected on 13 July 2020. The original publication denoted short-term FX swap liabilities of USD 68.2bn at end-June, corresponding to swap-corrected net reserves of USD -46.3bn as of June.

Rating committee
The main points discussed by the rating committee were: i) external sector stability and developments, including FX reserves and the exchange rate, ii) monetary policy, iii) structural economic policies, iv) banking sector, v) economic outlook, vi) geopolitical situation, and vii) peers consideration.

Rating driver references
1 Central Bank of the Republic of Turkey 
2 Presidency of the Republic of Turkey Investment Office 
3 OECD 
4 The World Bank 

Methodology
The methodology used for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’ dated 21 April 2020, is available on https://www.scoperatings.com/#!methodology/list/5.
Information on the meaning of each rating category, including definitions of default and recoveries can be viewed in the “Rating Definitions - Credit Ratings and Ancillary Services” published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. 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 definitions of default and rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how Environmental, Social or Governance factors (ESG factor) are incorporated into the rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The rating was not requested by the rated entity or its agents. The rating process was conducted:
With Rated Entity or Related Third Party Participation  NO
With Access to Internal Documents                               NO
With Access to Management                                         NO
The following material sources of information were used to prepare the credit rating: public domain.
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, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0.
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 14 June 2019.

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
© 2020 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions 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. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5, D-10785 Berlin.

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