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Rating action

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

Summary and Outlook

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

1. long-run deterioration in the sovereign’s capacity to service debt outstanding in foreign currency, due to structural depletion of Turkey’s foreign currency reserve stock, severe external sector vulnerabilities, including structural current account deficits, significant exposures to lira depreciation and periods of capital outflow; and
    
2. monetary, fiscal and foreign policies that remain inconsistent with the assurance of the Turkish economy’s long-run sustainability, including failure to address significant and increasing macroeconomic and external sector imbalances.

The downgrade of the foreign currency long-term ratings reflects an analyst adjustment under the methodology’s ‘extraordinary circumstances’ to account for increasing risk of balance of payment crisis.

The affirmation of Turkey’s long-term local-currency ratings at B+ acknowledges outstanding credit strengths, including comparatively moderate levels of central government debt, a well-capitalised and resilient banking system able to provide significant liquidity to the sovereign, and lesser sensitivity of Turkey’s local-currency-denominated government debt to economic vulnerabilities linked to declining foreign-currency reserves, risks from currency depreciation and exits of foreign investors, as well as from elevated rates of inflation. In addition, a large, diversified economy (with an estimated nominal GDP of USD 649bn in 2020), a floating exchange rate regime, and high medium-run growth potential are credit strengths.

The revision of long-term rating Outlooks in foreign and local currency to Negative reflects an inadequate macroeconomic policy framework as well as governance deficits that contribute to furthering macroeconomic imbalances, risks to public debt and external sector sustainability. It also reflects downside risks associated with vulnerabilities such as growing foreign exchange risk on the government balance sheet, risk of more severe currency crisis, and elevated risks related to geopolitical tensions.

The Negative Outlook represents Scope’s opinion that risks to the sovereign ratings are tilted to the downside over the next 12 to 18 months. The foreign- and/or local-currency rating(s) and/or Outlook(s) could be downgraded if, individually or collectively: i) macroeconomic stability is undermined due to deterioration in external sector stability and/or a more severe balance of payment crisis is witnessed; ii) fiscal, central bank and structural economic policies remain inadequate, resulting in greater macroeconomic imbalances; and/or iii) institutional degradation, geopolitical tensions or renewed security concerns arise, sparking market turbulence, accentuating Turkey’s external vulnerabilities.

Conversely, the rating Outlook(s) could be revised to Stable if, individually or collectively: i) credible monetary, fiscal and economic policies are adopted, returning comparative stability to the currency and supporting a rebalancing of the economy; ii) the country’s external vulnerabilities are curtailed; and/or iii) the deterioration in Turkey’s governance framework is reversed and/or geopolitical tensions are reduced.

Rating rationale

The downgrade of Turkey’s foreign-currency long-term ratings to B reflects deterioration in the sovereign’s capacity to service debt payments in foreign currency longer term due to acute external vulnerabilities.

Gross official reserves (including gold) have declined to USD 84.4bn as of 1 November 2020, compared with a 2013 peak at USD 134.6bn (and USD 105.7bn entering 2020). In addition, adjusting for an increasing use of short-term FX swap liabilities¹ (totalling USD 58bn as of end-September, from USD 4bn as of February 2019) with domestic banks that are currently being excluded from central bank FX liability data, swap-corrected net foreign assets² have declined more speedily, reaching a record low of USD -47.5bn in September, from USD +18.5bn less than a year earlier as of year-end 2019 (and USD +56.2bn at a 2011 peak). Scope notes that, acknowledging negative net reserve stocks swap-adjusted since March 2020, the Turkish central bank is increasingly reliant upon borrowing and continuous roll-over of foreign currency on short-term bases with domestic banks for use in slowing lira depreciation: this dependence upon FX from the Turkish resident sector increases risk of balance of payment crisis due to unsustainable depletion of the economy’s FX resources in view of structural current account deficits and capital outflow pressures.

Turkey’s gross reserves cover around 64% of short-term external debt, from 114% as of mid-2016 – currently under an IMF adequacy threshold of 100%. In addition, more than USD 15bn of reserves are denominated in less liquid Qatari rial, reflecting swaps with the Qatari central bank. While Turkish reserve figures remain more than sufficient to meet near-term sovereign debt service requirements, declining reserves increase long-term repayment stresses in foreign currency. One-year dollar credit default swaps trade around 491bps, compared with 65bps as of end-January. Instead of dependence upon more restrictive Eurobond market access to raise foreign currency – replenishing reserve stocks via international capital inflows, the central government has relied upon drawing on foreign currency from the domestic sector – issuing nearly USD 30bn in local law but foreign-currency-denominated debt, almost exclusively to domestic banks³. This is alongside the resident sector holding 41% of international Eurobond debt. This growing dependence of the government on foreign currency borrowing from domestic institutions to substitute for exits of international investors reduces the economy’s resilience.

Central government debt is currently 56% in foreign currency, with this FX share having doubled from 27% mid-2013 – amplified by valuation effects on foreign-currency liabilities due to structural lira depreciation (the lira devalued 16.7% on average per year between 2015-19 and has depreciated 31% against the dollar in 2020). Scope foresees an increase in the government debt ratio to a still moderate 46% of GDP in 2020, from 33% in 2019 (and versus 27% at a 2015 low). As Turkey’s debt in foreign currency increases as a share of total government liabilities, supporting factors that have anchored government debt sustainability in the past such as seigniorage of a formerly largely domestic-currency-denominated structure of government debt from elevated inflation attenuate in weight. Instead, the speed of increases in the debt ratio increases due to a compounding effect of lira losses on the valuation of debt in foreign currency.

Over the immediate future, Turkish state-owned and private-sector banks have adequate dollars available to swap with the central bank or loan to the government: residents’ foreign-exchange deposits at local deposit-taking lenders reached record highs of USD 196bn, due to locals’ preference for deposits in dollar to avoid foreign exchange risk. However, availability of system-wide hard currency has limits accounting for an average current account deficit of 1.2% of GDP expected over 2021-25 – after a severe deficit of 3.7% in 2020 due to the temporary drop in goods and tourism services exports – and ongoing net capital outflows. In addition, non-financial companies require foreign exchange to service FX liabilities with a net FX debt position that, while cut from a 2018 peak of USD 223bn, stood at USD 165bn in August 2020.

The second driver of the downgrade of Turkey’s foreign-currency ratings to B relates to monetary, fiscal and foreign policies that remain inconsistent with the assurance of long-run economic sustainability, reducing Turkey’s external foreign-currency funding options and raising risk of balance of payment crisis.

The erosion in Turkey’s economic sustainability reflects concerns about the independence of monetary policy and a confidence crisis in the central bank’s ability to restore inflation to sustainable rates. The real policy rate is -1.5% as of October, against inflation of 11.9% YoY. An accommodative monetary policy has amplified credit imbalances, with lira lending to the domestic economy increasing an elevated 46.4% YoY in October – although central bank actions have begun to ease credit growth. Risks link, moreover, to shifts in the government’s floating exchange rate framework – historically a core credit strength – including interventions of state-owned banks in support of the lira that have cut reserves alongside imposition of forms of capital controls, which ease currency devaluation near term by restricting international access to lira, but also reduce Turkey’s funding flexibility medium term in FX by affecting Eurobond market access.

An increasing frequency of economic crises in recent years has seen frequent counter-cyclical use of fiscal resources in crisis periods, which have challenged the robustness of public finances. Scope expects a 2020 general government deficit of 9.3% of GDP – this comes after an elevated deficit pre-crisis of 5.6% of GDP in 2019, having been increased from 1.3% as of 2015. In March, in response to the health crisis, Turkey appropriately announced a TRY 100bn (2.1% of GDP) support package – the Economic Stability Shield⁴. The total package has been enhanced since to TRY 371bn (7.7% of GDP) excluding loan deferrals. Scope expects deficit levels to remain structurally high post-crisis compared with pre-crisis. Over the period 2021-24, Scope foresees the deficit remaining at about a 7.7% of GDP level, pushed up by spending objectives such as on health and education as well as significant increases in defence and security spending planned under the 2021 Budget amid military engagements. Alongside the impact from currency depreciation on the government debt trajectory, spending programmes underscore an expectation of the general government debt ratio to increase to above 60% of GDP by 2024.

Geopolitical developments have amplified market instability and weighed on government spending. This includes confrontations with the United States and NATO over the deployment of Russian S-400 missile defence systems, Turkey’s engagement in the wars in Syria and Libya, tensions around gas exploration and pipeline construction in the eastern Mediterranean, and engagement in conflicts between Armenia and Azerbaijan. Alongside impeding access to hard currency bilateral and multilateral funding sources, Turkey’s foreign policy also risks sanctions including from the European Union and the United States.

Despite credit weaknesses, Turkey’s ratings benefit from a large and diversified economy, a well-capitalised and resilient banking sector, and moderate levels of government debt.

Turkey’s diversified economy is expected to contract 1.4% in 2020, prior to growth of 7.2% in 2021 under Scope’s baseline scenario. Under a stressed scenario of renewed full lockdown in the economy in Q4 in response to the public health crisis, Scope foresees, under this adverse scenario, 2020 Turkish growth of -4.4%, before 5.7% growth in 2021. Turkey’s medium-run growth potential is comparatively high at an estimated 3.9%, although frequent crises constrained realised growth to 1.1% over 2015-19. In addition, the customs union with the European Union and diversification of trading partners are credit strengths.

Bank capital cushions have been a significant buffer against deterioration in asset quality, weakening in profitability and depreciation in the lira with the capital adequacy ratio of banks rising to 19.4% of risk-weighted assets as of September 2020, from 14.6% in 2015. Non-performing loans have declined to 4.1% of overall loans as of September 2020, after reaching highs of 5.4% in December – cushioned by the government’s extraordinary policy support. In addition, Turkey enjoys moderate private sector debt, including with respect to non-financial corporate debt, which stood at 74.4% of GDP in Q2 2020.

Turkey’s general government debt levels remain moderate under international comparison. Though on a steeply rising curve, central government debt amounts to a manageable 33% of GDP, allowing the government time to amend an unsustainable policy framework. The Turkish sovereign wealth fund held USD 33.5bn in equity as of end-2018, which could provide some liquidity under severe scenarios. The central bank will be able to provide a degree of support in government debt markets, having been actively engaged in purchases of government bonds in 2020 to contain medium- to long-term rates – with central bank holdings rising to about 1.5% of GDP (7% of domestic debt securities outstanding) this year. However, any expansion of quantitative easing purchases is likely to facilitate currency weakness. In addition, exits of international investors have curtailed the share of domestic debt (denominated mainly in lira) held by non-residents to only 4% from 20% as of late 2017 – meaning that, near term, there is likely reduced selling pressure that impacts lira from remaining international investors.

Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides a first indicative rating of ‘bb+’ for the Republic of Turkey. Turkey receives no positive adjustment under the reserve currency adjustment. As such, a ‘bb+’ indicative rating can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses against a peer group of countries.

For Turkey, a relative credit strength is signalled for: i) banking sector performance. The following relative credit weaknesses are signalled: i) monetary policy framework; ii) macro-economic stability and sustainability; iii) fiscal policy framework; iv) debt sustainability; v) debt profile and market access; vi) current account resilience; vii) external debt structure; viii) resilience to short-term shocks; ix) banking sector oversight; x) financial imbalances; and xi) institutional and political risks.

The combined relative credit strengths and weaknesses generate a three-notch downside adjustment and indicate B+ long-term ratings for Turkey. The lead analyst has recommended a further adjustment of the rating to B for foreign currency issuer and senior unsecured long-term debt ratings to account for increasing risk of balance of payment crisis.

A rating committee has discussed and confirmed these results.

Factoring of Environment, Social and Governance (ESG)

Scope explicitly factors in ESG sustainability issues during the ratings process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 20% weight in the quantitative model (CVS). Under governance-related factors, Turkey scores weakly on the World Bank’s Worldwide Governance Indicators in the CVS, lagging behind scores of OECD peers. The qualitative (QS) governance-related assessments reflect Scope’s evaluation of the ‘institutional and political risk’ QS category as ‘weak’ compared with Turkey’s sovereign peer group. Turkey’s governance challenges contribute to the three-notch downside QS adjustment (from the CVS indicative rating) in determining B+ local-currency and B foreign-currency ratings.

Socially related factors are captured under Scope’s sovereign methodology in the CVS via accounting for Turkey’s comparatively average level of labour force participation versus that of economies in the ‘bb+’ CVS peer group, but high level of income inequality. Turkey’s healthy old-age dependency ratio compares well, however, against that of sovereign peers. Progress has been made 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 a declining sustainability regarding the economic growth model. As such, social factors are also considered in the QS evaluation with an evaluation of ‘neutral’ on ‘social risks’.

Environmental factors are explicitly considered in the ratings process via the environment sub-category under the ESG risk pillar. Here, the CVS considers Turkey’s comparatively low level of CO2 emissions per unit of GDP versus that of peers. However, risk to Turkey’s ratings from exposure to natural disasters is elevated compared with peers’ as evidenced in the earthquake impacting the coastal city of İzmir and surrounding regions. Lastly, Turkey has middle-of-the-range scores compared with ratings peers on the ecological footprint of its consumption compared with biocapacity. Environmental risks are also considered under the QS, under which the agency has assigned an evaluation of ‘neutral’ versus sovereign peers.

Rating committee
The main points discussed by the rating committee were: i) external vulnerabilities; ii) risk of balance of payment crisis; iii) monetary policy credibility; iv) debt structure and investor base; v) banking system strengths; and vi) geopolitical risks.

Rating driver references
1 Central Bank of the Republic of Turkey 
2 Laura Pitel, Financial Times 
3 Brad Setser, Council on Foreign Relations 
4 Presidency of the Republic of Turkey Investment Office 

Methodology
The methodology used for this rating and/or rating outlook, ‘Rating Methdology: Sovereign Ratings’ 9 October 2020, is available on https://www.scoperatings.com/#!methodology/list.
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, Sovereign and Public Sector
The ratings/outlook were first assigned by Scope in January 2003. The ratings/outlooks were last updated on 10 July 2020.

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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