Scope downgrades Turkey’s long-term foreign-currency ratings to B-, and maintains a Negative Outlook
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Scope Ratings has today downgraded Turkey's foreign-currency long-term issuer and senior unsecured debt ratings to B-, from B. Turkey’s long-term issuer and senior unsecured debt ratings in local currency are downgraded to B from B+. The Outlooks on Turkey’s long-term ratings in both foreign- and local-currency remain Negative. The short-term issuer ratings have been affirmed at S-4 in foreign- and local-currency, with Outlooks Stable.
Summary and Outlook
The one-notch downgrade of Turkey’s long-term issuer ratings and maintenance of Negative Outlooks reflect ongoing deterioration of the nation’s credit profile due to inadequate governance and likelihood of deeper balance of payment, financial and/or political crises. Evolving vulnerabilities, associated with structurally loose monetary policy, high inflation, negative net foreign-currency reserves as well as elevated and rising sovereign FX exposure, raise risks to the sovereign’s repayment capacity in scenarios of further lira depreciation. This could also adversely affect the nation’s banking-system resilience and its capacity to continually finance the sovereign – critically in foreign currency. Such risk for deeper crisis is, moreover, elevated under conditions of financial-market spill-over from a neighbouring Russia-Ukraine crisis to emerging markets such as Turkey with heightened external vulnerability as well as G4 central banks normalising their monetary policy – amplifying capital outflow from emerging economies. A potential of adverse contingency is further intertwined with possibility of heightened domestic instability in a period surrounding presidential and legislative elections currently scheduled mid-2023.
The ratings downgrade reflects an analyst adjustment under the methodology’s ‘extraordinary circumstances’ to account for significant weaknesses in macro-financial management and contingent risk of economic crisis.
Concurrently, Turkey’s ratings are supported by multiple strengths underlying the sovereign’s credit profile, importantly reflecting comparatively moderate levels of central government debt, a resilient banking system able to supply liquidity to the sovereign, a large, diversified economy as well as comparatively elevated medium-run growth potential. However, core credit strengths such as public finances and robustness of the banking system are being gradually eroded due to economic mismanagement.
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) could be additionally downgraded if, individually or collectively: i) macroeconomic stability were undermined due to further deterioration in external sector stability and/or a more severe balance of payment and/or financial crisis is observed; ii) fiscal, central bank and structural economic policies remain inadequate, resulting in deepening of long-run macroeconomic imbalances; and/or iii) a severe domestic crisis, such as surrounding elections, raise risk of further erosion of Turkish democratic institutions and escalation of political and civil instability, accentuating market turbulence and external risk.
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) deterioration of Turkey’s governance framework is reversed and/or geopolitical tensions were significantly reduced.
The downgrade of Turkey’s long-term ratings and maintenance of Negative Outlooks reflect ongoing deterioration of the sovereign’s credit profile due to inadequate governance and deepening vulnerabilities to balance of payment and financial crises. Risk of crisis is, moreover, elevated under conditions of financial-market spill-over from an ongoing Russia-Ukraine conflict in the Black Sea region as well as under conditions of ongoing G4 central bank normalisation of monetary policy settings.
Inflation in February 2022 was 54.4% YoY, having risen significantly from a level of 8.6% as of October 2019. This was driven by supply-side factors such as rise of global energy, food and agricultural commodity prices, recovery in demand since Covid-19 crisis depths as well as depreciation of lira and associated consequences with respect to import inflation. Core inflation increased to 44.1% YoY. In view of likelihood of further significant global price pressures after the Russian further incursion in the Ukraine on global commodity prices as well as renewed supply-chain bottlenecks, Turkish inflation is seen further rising near term. Due to erosion in the independence of the central bank and a stated preference of President Recep Tayyip Erdoğan with respect to low interest rates, authorities’ policy one-week repo rate has, rather than being increased in response to inflation of nearly 11x central-bank objectives, been cut, from 19% to 14% since September 2021. Presently, real policy rates are -26.2% – the lowest of emerging markets – elevating risk to the currency and real economy should risk sentiment further wane with Turkish monetary policy, due to political influence, constrained in capacity to reinstate confidence in the economy via rates.
An important factor underlying price pressure has been weakening of the lira. The currency is currently 44% under September 2021 levels despite a FX sell-off near the end of 2021 easing after adoption of an extraordinary sleeve of countermeasures late December. Announced measures to date aid against selling pressure of the currency near term and are intended to encourage resident sector investment and savings in domestic currency. These include most importantly a scheme to protect lira deposits against forex losses alongside steps to support exporters from forex volatility and eliminate withholding taxes as regards investment in sovereign lira notes. In January 2022, further capital controls were detailed requiring transfer of 25% foreign-exchange revenues of exporters to lira. However, these actions are unlikely over a long run to be sustainable or prevent severe currency crisis. Instead, Scope views the lira savings scheme as gradually sacrificing one of Turkey’s outstanding significant credit strengths – the health of the sovereign balance sheet – in order to temporarily slow lira declines while retaining accommodative monetary policy settings.
The Turkish central bank has made direct interventions in the exchange rate since December 2021, complementing actions of state-owned banks further propping up lira. However, such actions undermine the nation’s contemporary floating exchange rate framework – historically a core credit strength – while curtailing an outstanding stock of state FX resources. Gross official reserves (including gold) stand circa USD 110.3bn as of 6 March 2022, moderately under a 21 November 2021 level of USD 128.4bn. However, following deduction of use of short-term FX swap liabilities1 with domestic banks that are currently being excluded from central bank FX liability data, swap-corrected net foreign assets are of a record-low USD -58.3bn in February 2022, declining from a level of USD 18.5bn as of year-end 2019 (and USD 56.2bn as of 2011 peaks). As represented by the negative net reserve stock, the Turkish central bank is dependent (increasingly) upon continued forex supply from and roll-over of existing FX swap arrangements with the resident banking sector – intensifying a sovereign-bank nexus and raising risk of severe currency crisis were Turkish banks to face future limitation in capacity to supply foreign currency.
While Turkey’s gross reserves cover circa 90% of short-term external debt (from late 2020 lows of 61%), around USD 20bn of such reserves are denominated in less liquid Qatari rial and Emirati dirham, reflecting swap arrangements with these governments. Importantly, Turkey’s access to foreign currency via international official channels has been constrained during recent currency crises, increasing risk of potential bottlenecks affecting resilience during future adverse scenarios. Instead of dependence on more restricted Eurobond market access to raise foreign currency, the central government has relied on drawing foreign currency from the domestic sector – issuing over USD 30bn in local law but foreign-currency-denominated debt, almost exclusively to domestic banks. This is alongside the resident sector holding 50% of international Eurobond debt.
Central government debt is 67% denominated in foreign currency as of January 20222, with this FX share having risen sharply from 27% as of mid-2013 – amplified by valuation effects on the state’s foreign-currency liabilities due to lira depreciation. Scope envisions increase of the government debt ratio to 65.0% of GDP by 2026, from 42.0% in 2021 (and against 27.4% as of a 2015 low). This assumes general government deficits of an average of 5.9% of GDP during 2022-26 – staying more elevated than pre-crisis. 10-year lira borrowing costs have risen to 25.7% at time of writing, from 10% in January 2020 – affecting average interest costs of the debt portfolio. Under an adverse scenario of severe lira crisis (assuming currency depreciation of 44% and 35% in years 2022 and 2023 in this stressed scenario), general government debt rises to 80.3% by 2026. As Turkey’s debt continues dollarisation, supportive factors contributing to anchoring debt sustainability such as mitigation of a rising debt ratio vis-à-vis structurally elevated inflation (repressing a formerly largely domestic-currency denomination of government debt) attenuate in comparative significance. Instead, the pace of increase of the debt ratio is expected to accelerate moving ahead due to compounding effects of lira depreciation on a growingly foreign-currency structure of the debt as well as due to interlinking of lira loss with budgetary compensation after December policy announcements.
Over an immediate future, Turkish state-owned and private-sector banks hold available dollars to swap with the central bank and activate for currency-market intervention or loan to the government. Still, residents’ foreign-exchange deposits at local deposit-taking lenders declined USD 22bn from December peaks to USD 189bn as of 28 February, constraining banking-system foreign-currency resources. The current account recovered in 2021 to 1.9% of GDP, from 5.0% of GDP during 2020, as goods and tourism services exports recovered. However, the trade deficit sharply reversed over an initial two months of 2022 amid increase of energy as well as grain imports. Contrary to central bank expectation for a current-account surplus this year, Scope sees the current-account balance reversing sharply to significant deficit of circa 8% of GDP in 2022 – driven by rise of global energy and commodity prices.
The possibility of more severe crisis is likely to interact over a forthcoming period with institutional and political challenges ahead of scheduled 2023 presidential and parliamentary elections. While multiple scenarios are outstanding surrounding the elections, Scope considers it unlikely President Erdoğan relinquishes power easily after elections are held, even should current opinion polls be confirmed. The President currently lags significantly behind under polling to potential presidential candidates of main opposition Republican People’s Party. The possibility of less democratic avenues being exercised to hold to power after 2023 alongside scenarios of civil instability, disputed election outcomes and further weakening of Turkish institutions could exacerbate existing vulnerabilities from an inadequate economic policy framework and adverse market sentiment. At the same time, there are upside scenarios after the election of change of government and policy direction, after a presumed initial period of instability, under which Turkish democratic institutions and economic policies are eventually re-strengthened.
Turkey’s sovereign credit ratings consider geopolitical concern(s) such as confrontations with the United States and the NATO alliance over activation of Russian S-400 missile defence systems, engagement in conflicts in Syria and Libya, as well as tension around gas exploration and pipeline construction in the eastern Mediterranean. These events amplify market instability, weigh on government expenditure, constrain options with respect to access to multilateral and bilateral financing during crises and brought sanctions such as those from the European Union and the United States. Current war in Ukraine risks growing financial-market spill-over to vulnerable economies such as that of Turkey, but also might present an opportunity for rapprochement with the West, with the government closing Bosphorus and Dardanelles straits limiting passage of some Russian vessels to the Black Sea.
Despite outstanding credit weaknesses, Turkey’s credit ratings benefit from multiple credit strengths such as a large and diversified economy, a resilient banking sector, and still moderate levels of government debt.
Turkey’s diversified economy (nominal GDP of circa USD 805bn in 2021) is expected to grow an under-consensus 2.3% during 2022 before 2.4% in 2023, after growth of a robust 11% in 2021. Alongside recovery of domestic demand as well as of external demand, this economic outlook has been underpinned by accommodative credit conditions, with lira lending to the domestic economy of a robust 22.1% YoY as of Feb-22. Scope estimates comparatively strong economic growth potential of Turkey of 3.9%. Nevertheless, proclivity of the Turkish economy for increasingly frequent economic crisis is expected to constrain realised growth, with Scope assuming below-potential growth of 2.5% over 2024-26. Customs union with the European Union and a diversification of trading partners remain credit strengths.
Tier 1 capital adequacy of the banking system, while recently reinforced, had declined to 14.4% of risk-weighted assets as of Q3 2021, from 16.4% at Q2 2020 – amid depreciation in lira and effects on the lira-equivalent value of foreign-currency loans. Due to an increasing discrepancy between the share of bank deposits and funding in foreign currency (58%) and that of loans in foreign currency (39.5%), periods of FX sell-off increasingly disproportionately affect financial-system liabilities and capital cushions. Turkey’s sovereign wealth fund recapitalised the three largest state-owned banks via TRY 48.6bn (or USD 3.3bn) of capital injection in February. Non-performing loans declined to 3.2% of aggregate loans as of January 2022, after reaching highs of 5.7% in December 2019. Overall, the resilience of the Turkish banking system remains a vital credit strength. Turkey benefits, moreover, from moderate non-financial corporate debt, of 64.8% of GDP in Q3 2021, declining from 77% as of Q3 2020.
Finally, Turkish sovereign debt levels remain moderate under an international comparison. Although on an increasing trajectory, central government debt amounts currently to 38% of GDP – below that of most indicative sovereign peers, allowing the government some time to amend weaknesses of an underlying policy framework. The Turkish sovereign wealth fund held USD 33.5bn of equity as of end-2018, although funds have instead been activated for the recapitalisation of state-owned banks. The central bank has revived purchases of government bonds during 2022 to ease rising borrowing costs – with aggregate central bank holdings of presently circa 0.7% of GDP (4.5% of outstanding domestic debt securities). The central bank’s securities portfolio can increase to 5% of assets. While expansion of quantitative easing purchases may support local bond yield dynamics, such purchases are likely to facilitate currency weakness and accelerate inflation. Exit of international investors has curtailed a share of domestic debt (denominated mainly in lira) held by non-residents to only 3% from 20% as of late 2017 – meaning that, near term, there is likely to be reduced selling pressure affecting 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 ‘bbb-’ for the Republic of Turkey. Turkey receives no positive adjustment under the reserve currency adjustment. As such, a ‘bbb-’ 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, no relative credit strengths are signalled under the QS. The following relative QS 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 external shocks; ix) banking sector oversight; x) financial imbalances; and xi) institutional and political risks.
Combined relative credit strengths and weaknesses generate a three-notch downside adjustment and indicate BB- long-term ratings for Turkey. The lead analyst has recommended a further two-notch downside rating adjustment of foreign- and local-currency long-term credit ratings to account for significant weaknesses in macro-financial management, such as with respect to central bank policy setting. Finally, 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 as well as resilience of the domestic banking system and capacity to supply liquidity to the sovereign in lira.
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 significant 20% weighting in the quantitative model (CVS). Under governance-related factors, Turkey scores weakly according to the World Bank’s Worldwide Governance Indicators under the CVS, lagging behind scoring of OECD peers – with performance on voice and accountability, rule of law and control of corruption having declined significantly over a last decade. Furthermore, in the Qualitative Scorecard (QS)’s complementary governance assessment, Scope evaluates ‘institutional and political risk’ as ‘weak’ as compared with that of Turkey’s sovereign peer group based on analyst qualitative assessment. Turkey’s governance challenges contribute to downgrade of long-term ratings to B in local currency and B- in foreign currency.
Socially related factors are captured under the sovereign methodology in the CVS via accounting for the economy’s comparatively low rate of labour force participation against that of economies in a ‘bbb-’ CVS indicative peer group, as well as comparatively high level of income inequality (as captured via a ratio of the income share of the 20% of persons with the highest household incomes to the 20% of persons with the lowest household incomes). Turkey’s healthy old-age dependency ratio compares well, however, against that of indicative sovereign peers. In addition, a medium level of GDP per capita (estimated of USD 9,407 in 2021) but high unemployment (11.4% in January 2022, with 11.7% seen in 2022 (average) before 12.2% in 2023) of the Turkish economy under international comparison are evaluated via the CVS. Increases of the society’s working-age population (+0.4% per annum over 2022-26, although moderating from an annual average of 1.6% over a previous decade) support economic potential. Progress has been made in the reduction of absolute poverty and improvements of education. However, there has been weakening in government commitment to market-oriented reform, with declining sustainability with respect to the economic growth framework. As such, social factors are also considered in a QS evaluation with assessment of ‘neutral’ on ‘social risks’ against the nation’s sovereign peers.
Environmental factors are explicitly considered in the ratings process via an environment sub-category of the ESG sovereign risk pillar. Here, the CVS considers Turkey’s comparatively low level of carbon intensity per unit of output against that of peers. Moreover, risk to Turkey’s sovereign ratings from exposure to natural disasters is considered low according to the 2021 World Risk Index although Turkey is nevertheless exposed to natural risks such as earthquakes, floods and landslides. Finally, Turkey has middle-of-the-range scoring as compared with ratings peers on an ecological footprint of consumption compared with available biocapacity. The nation ranks 99th of 180 nations on the 2020 Environmental Performance Index of Yale University – with improvements in scoring on air quality, pollution emissions and agricultural sustainability over a previous 10 years but declines in scores on ecosystem services, health of fisheries and climate change.
Environmental risks are likewise considered via the QS, under which the Agency has assigned an evaluation of ‘neutral’ against the nation’s sovereign indicative peer group.
The main points discussed by the rating committee were: i) external sector stability; ii) monetary policy and inflation; iii) fiscal policy; iv) structural economic policies; v) institutional risk and elections; vi) geopolitics; vii) resilience of the banking system; viii) FX exposures of the economy; ix) spill-over from the Russia-Ukraine crisis; x) foreign- vs local-currency credit risk; and xi) peers considerations.
Rating driver references
1. Central Bank of the Republic of Turkey
2. Ministry of Treasury and Finance (of Turkey), Public Debt Management Report February 2022
The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology: Sovereign and Public Sector’ 8 October 2021), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.
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