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Rating action

Scope Ratings has today affirmed Türkiye's foreign-currency long-term issuer and senior unsecured debt ratings of B-. Türkiye’s long-term issuer and senior unsecured debt ratings in local currency are affirmed at B. The Outlooks on Türkiye’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 affirmation of Türkiye’s long-term credit ratings with Negative Outlooks reflects risks lingering on the nation’s credit profile post-elections, notwithstanding the policy normalisation initiated by minister of finance Mehmet Şimşek and central bank governor Hafize Gaye Erkan. Following years of unorthodox monetary policy, it will take time to fully restore the credibility, independence, and effectiveness of the Turkish central bank. In Scope’s opinion, the risk of policy reversal is meaningful, especially ahead of municipal elections scheduled for March 2024.

Furthermore, rebuilding external buffers and reducing the likelihood of a deeper balance of payment and/or financial crisis requires profound change in overall economic governance. Although the continuation of policy normalisation could generate significant benefits in the medium term, external risks are expected to remain prominent during the transition period due to negative net foreign-assets of the central bank and elevated sovereign foreign-currency exposure. Moreover, the policy normalisation exacerbates financial stability risks by weakening the nation’s banking-system resilience and its capacity to continually finance the sovereign, critically in foreign-currency. This creates an adverse equilibria under which the repayment capacity could rapidly weaken in case of policy inconsistency and/or a (confidence) shock.

The affirmation of Türkiye’s credit ratings acknowledges 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 and diversified economy, as well as comparatively strong medium-run growth potential. Yet, returning to more conventional policies is necessary as years of economic mismanagement have weakened Türkiye’s public finances and banking system.

The Negative credit 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 downgraded if, individually or collectively: i) macroeconomic stability is further undermined due to further deterioration in external accounts, more severe balance of payment pressures and/or a curtailed financial strength of the banking system; ii) the predictability of public policies further declines, exacerbating macroeconomic imbalances; and/or iii) severe domestic political pressure and/or an acute deterioration in security conditions and international relations accentuate market turbulence and external risk.

Conversely, the rating Outlook(s) could be revised to Stable if, individually or collectively: i) the process of policy normalisation is continued over the near- to medium-term, enhancing durably the predictability and effectiveness of public policies, while supporting greater confidence that real policy rates will be positive under a reasonable timeframe; and/or ii) external vulnerabilities are significantly reduced, due, for example, to a narrowing of current account deficits, improved capital inflows, and a sustained improvement in net international reserves.

Rating rationale

The first driver of the affirmation of Türkiye’s foreign-currency B- ratings with Negative Outlook reflects the uncertainty surrounding the continuity of policy normalisation in the longer run, given recent track record of loose and unorthodox policies.

Following general elections in May 2023, the central bank raised its one-week repo auction rate by 900 basis points, from 8.5% to 17.5% as of end-July^1,2, its highest level since September 2021. Real policy rates consequently increased from more than minus 30% to around minus 20% over the period. The rise in real policy rates has also been supported by the continuous decline in inflation to 38.1% YoY in June 2023, from 85.9% in October 2022, thanks to large base effects and lower energy prices. The forward guidance points to a monetary tightening process to be gradually strengthened, to reduce end-year inflation from 58% in 2023 to 33% in 2024 and 15% in 2025³. Moreover, the central bank has relinquished control over the lira, which depreciated by more than 30% against the US dollar since end-2022, at around TRY/USD 27 as of end-July, one of the weakest performances among emerging markets.

In addition, the central bank announced the simplification and the improvement of the existing micro- and macroprudential framework⁴, among which the “securities maintenance regulation” – compelling banks to hold lira-denominated bonds in addition to required reserves for foreign-currency deposits. The central bank also introduced selective credit tightening measures, among which a 2.5% limit on growth of lira denominated commercial loans, and a 15% reserve requirement on foreign-currency protected lira accounts. These currently have an outstanding balance close to TRY 3,000bn as of mid-July, or about USD 110bn (around 11% of GDP). Finally, the central bank announced the appointment of three deputy governors, supporting the strengthening of the governance under governor Hafize Gaye Erkan.

Nonetheless, challenges remain salient following years of unconventional policy, making any normalisation process complex to operate. Real policy rates remain negative and among the lowest across emerging markets, as inflation runs nearly 8 times the central bank target of 5% over the medium-term. Moreover, negative real rates are likely to persist as financial stability risks prevent the central bank from drastically tightening funding conditions in response to high inflation. In addition, near-term monetary policy challenges could become even more acute⁵ as the declining inflation trajectory may be reversed by the revalorisation of minimum wages and pensions; the rise in tax and regulated prices; the lira depreciation feeding-through domestic prices via a higher import bill; and a potential unsterilised compensation by the central bank of losses related to foreign-currency protected deposit accounts. Finally, the appointment of new central bank governor weeks after President Recep Tayyip Erdoğan’s re-election illustrates the heavy politicisation of the monetary financial institution and the risk of political interference around inflation targeting.

Overall, the policy normalisation initiated after the general elections – which may be positive in the long run if irrevocably and sustainably pursued – is balanced by the high uncertainty around the continuity of the process enhancing the predictability and effectiveness of the central bank. In Scope’s opinion, near-term costs attached to monetary policy tightening and lira depreciation, President Erdoğan’s stated preference for low interest rates, as well as unsuccessful attempts to reintroduce more conventional policy in the recent past, increase the risk that the current policy stance may be reversed or watered down, for example, ahead of municipal elections in March 2024.

The second driver of the affirmation of Türkiye’s foreign-currency B- ratings with Negative Outlook reflects exposure to a deeper currency and/or balance of payment crisis as rebuilding external buffers and improving foreign-currency supply will require continued policy normalisation initiated post elections.

Türkiye’s vulnerability to a more severe currency crisis results from intense pressure on the lira amid narrow policy options to cope with an adverse scenario. External gross financing needs are projected to increase to almost USD 280bn in 2023 or 27% of GDP, against less than USD 240bn in 2022, driving strong demand for foreign-currency and pushing the lira to record lows. Yet, the capacity of the central bank to counter an intensification of downward pressure on the lira is hindered by financial stability risks associated with more sizeable policy rate hikes and critically low foreign-exchange reserves. Swap-corrected net foreign assets, including the government’s short-term foreign-currency swap liabilities with domestic banks, which are excluded from central bank foreign-currency liability data, reached a record-low of minus USD 73bn in May 2023, before recovering modestly around minus USD 60bn in June.

Moreover, as captured by the negative net reserve stock, the central bank is still highly dependent upon continued forex supply and roll-over of existing foreign-currency swap arrangements with the resident banking sector. However, the net foreign asset position of Turkish banks declined to TRY 34.9bn in May 2023 from TRY 96.9bn in October 2022, before recovering to TRY 105.7bn in June 2023.

Furthermore, Türkiye’s vulnerability to a deeper balance of payment crisis is underpinned by rising external gross financing needs. The current account deficit has reached USD 60bn on a 12-month basis as of end-May 2023 and is projected at USD 55bn or 5.7% of GDP this year, up from USD 48bn or 5.4% last year. This results from a worsening trade deficit, close to USD 120bn on a 12-month basis as of end-June 2023, driven by a surge in gold imports. In addition, external debt repayments amount to around USD 221bn in 2023, including USD 166bn for short-term debt, which is 153% of the central bank’s gross official reserves as of end-June. Central government debt accounts for 25% of total external debt as of end-March 2023⁶ and is exclusively long-term. Yet, repayments are projected to rise from USD 6.4bn in 2023 (as of June) to USD 17bn in 2024 and USD 20bn in 2025, or almost 40% of the central bank reserves.

Moreover, 50% of central government debt stock is denominated in foreign-currency, which amplify its vulnerability to valuation effects caused by the lira depreciation. Excluding the central bank, the rest of short-term external payments are mostly owed by non-financial institutions (33% of total) and local banks (39%). The roll-over ratio of non-financial institutions returned below its 5-year moving average since February 2023, although the one of local banks is in line with its long-term trend. Banks’ foreign-currency liquid assets are also sufficient to cover short-term foreign-currency external debt⁷.

Finally, Türkiye’s external vulnerability is rooted in strong pressure on foreign-currency supply. The central government has a long record of drawing foreign-currency from the domestic sector – issuing local law but foreign-currency-denominated debt, almost exclusively to domestic banks. Yet, 80% of central government borrowing between January and May 2023 consists of domestic borrowing, exclusively denominated in lira, reflecting shrinking foreign-currency supply. Additionally, net capital inflows remain positive on a 12-month basis although FDI are modest relative to volatile flows, as recorded in net errors and omissions. Drawing foreign-currency from international capital markets is also constrained by rates on Eurobonds issued in January 2023 (USD 2.75bn, 9.75%), March 2023 (USD 2.25bn, 9.5%) and April 2023 (USD 2.5bn, 9.3%)⁸. Lastly, securing bilateral support – via direct loans, currency swaps, energy trade agreement or investment – is intertwined with the government’s ability to leverage the country’s influence in geopolitical negotiations and to reassure foreign investors about the overall economic governance in the long-run. In July, investors from the Gulf Cooperation Council pledged investment of more than USD 50bn.

The third driver of the affirmation of Türkiye’s foreign-currency B- ratings with Negative Outlook reflects vulnerability to financial stress as monetary policy tightening and the simplification of prudential rules affect the banking-system resilience.

The gradual approach taken by the central bank during June and July monetary policy committees, with policy rate hikes below market expectations, illustrates the sensitivity of the domestic financial sector to inconsistency around the calibration and/or sequencing of policy normalisation. As the banking system holds nearly 76% of the government domestic debt (around USD 100bn), monetary policy tightening could generate sizeable losses for banks’ security portfolios because of their exposure to fixed rate local currency government bonds, with average time to maturity of 5 years. Policy normalisation could also lead to a deterioration in asset quality should households and corporates experience difficulties to withstand higher policy rates and selective credit tightening.

Moreover, the lira depreciation amid pressure on net foreign asset position of local banks could push them to access foreign-currency liquidity parked at the central bank, mostly in the form of foreign-currency swaps, either to repay external liabilities or foreign-currency deposit withdrawal in a stress scenario. However, their ability to access this liquidity – more than half of USD 74bn foreign-currency liquid assets⁷ – is uncertain as it would pressure central bank reserves. Periods of exchange rate sell-off also raise demand for foreign-currency deposits, at risk of disproportionately affecting financial-system liabilities due to the lower albeit persistent discrepancy between the share of banking deposits (43% of total as of mid-July) and funding in foreign-currency and that of loans in foreign-currency (33%). Finally, the simplification of prudential rules and selective credit tightening are constrained by altered transmission channels and distortions resulting from unconventional policy. Deposit and lending rates have diverged from central bank funding since end-2021, while the weighted average rate on TRY deposits exceeds since early 2023 the weighted average interest rate on commercial loans.

Despite outstanding credit weaknesses, Türkiye’s foreign-currency B- ratings benefit from multiple credit strengths such as moderate levels of government debt, a resilient banking sector, as well as a large and diversified economy.

Central government debt levels are moderate relative to indicative rating peers and forecasted to rise from 35% of GDP in 2023 to around 43% by 2028. The interest burden is also modest albeit rising, from 8% of net revenues to more than 13% over the period. In addition, the adverse consequences of unconventional monetary policy on the sovereign balance sheet are eased by the rise of revenues set in the Supplementary Budget Law of July 2023, among which higher VAT and corporate tax⁹, the transfer to entire transfer to the central bank of the foreign-currency protected deposit scheme, including the part run by the Ministry of Treasury and Finance⁹, and the recapitalisation of State-owned banks by the Turkish sovereign wealth fund¹⁰. However, government debt is on an upward trajectory and interest expenditures are exposed to inflation-linked bonds. The fiscal outlook is also vulnerable to a more accommodative stance should the authorities further raise spending to ease the near-term cost of policy normalisation, among which higher inflation and economic slowdown, and/or to mitigate the consequences of February earthquake. As part of the Supplementary Budget Law, the net debt utilization has tripled to support reconstruction efforts⁹. In the long run, the debt trajectory remains vulnerable to unconventional policy, including a reversal or narrowing of the ongoing normalisation process.

Furthermore, the banking system has demonstrated its robustness and ability to operate in a challenging environment. Capitalisation ratios remain at comfortable levels with Tier 1 capital adequacy standing at 15.4% of risk-weighted assets as of Q2 2023, which is higher than the 15.2% ratio as of Q2 2022 and the 2010-2019 average. Moreover, public banks can count on the regular support from the Türkiye’s sovereign wealth fund that injected TRY 111.7bn (around USD 5.8bn) into three state-owned banks in March 2023¹⁰. Robust asset quality also supports the resilience of local banks with non-performing loans declining to 1.6% of aggregate loans as of end-June 2023, after reaching highs of 5.4% as of end-2019. Moderate debt levels of households and non-financial corporates, standing respectively at 11% and 52% of GDP in Q1 2023, further mitigate risks. Besides, non-financial corporates’ net forex position improved to minus USD 86bn as of April 2023, from a 2018 peak of minus USD 195bn.

Finally, Türkiye’s diversified economy (nominal GDP of about USD 890 bn in 2022) is projected to grow at 3.0% in 2023 after 5.6% in 2022, below its economic growth potential estimated at 3.9%. Domestic demand benefits from credit and fiscal stimulus introduced ahead of general elections, with lira lending growing by 82% YoY on average in H1 2023. The reconstruction efforts will also boost economic activity thanks to foreign aid and large multiplier effects. However, monetary policy tightening and inflationary pressure weigh on the near-term economic outlook. In 2024, the GDP growth rate is projected to increase modestly at 3.3% given the uncertainty around the continuity of policy normalisation. In the longer run, a below-potential growth rate of 3.5% over 2025-27 balances the vulnerability to deeper external and/or financial crisis with core credit strengths such as its customs union with the European Union, a diversification of trading partners, and favourable demographic trends.

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 Türkiye. Türkiye 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 Türkiye, no relative credit strength has been identified. 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 external shocks; ix) banking sector oversight; x) financial imbalances; xi) environmental factors; and xii) governance factors.

Combined relative credit strengths and weaknesses generate a three-notch downside adjustment and indicate B- / B long-term ratings for Türkiye. An extraordinary two-notch downside adjustment is applied across of foreign- and local-currency long-term ratings to account for significant weaknesses in macro-financial management and high economic imbalances. A further one-notch downside adjustment is applied for foreign-currency issuer and senior unsecured long-term ratings to account for high balance of payment risks.

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 25% weighting in the quantitative model (CVS).

Environmental factors are explicitly considered in the ratings process via an environment sub-category of the ESG sovereign risk pillar. The CVS considers Türkiye’s comparatively low level of carbon intensity per unit of output against that of peers. Nevertheless, exposure to natural disasters is considered high as the country is exposed to natural risks such as earthquakes and landslides. Moreover, Türkiye has middle-of-the-range scoring as compared with ratings peers on an ecological footprint of consumption compared with available biocapacity. Although Türkiye issued its first green bond in April 2023⁸, the country ranks 172 of 180 nations on the 2022 Environmental Performance Index of Yale University¹¹, among the lowest in Eastern Europe, reflecting deep challenges on natural resources protection and climate change mitigation. This drives Scope’s ‘weak’ qualitative assessment.

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, especially among women and youth, and a comparatively high level of income inequality. Unemployment rates are high although in line with that of rating peers. However, the old-age dependency ratio compares favourably against that of indicative peers, and demographic growth is positive. Progress has also been made in the reduction of absolute poverty and improvements of education, which supports Scope’s ‘neutral’ qualitative assessment.

Under governance-related factors, Türkiye scores weakly relative to OECD rating peers according to the World Bank’s Worldwide Governance Indicators under the CVS – with performance on voice and accountability, rule of law, control of corruption, regulatory quality, and government effectiveness having declined over a last decade. Furthermore, in the qualitative assessment, Scope evaluates ‘governance factors’ as ‘weak’ compared with Türkiye’s indicative rating peers.

Rating committee
The main points discussed by the rating committee were: i) domestic economic risk; ii) public finance risk; iii) external economic risk; iv) financial stability risk; v) ESG-related risk; and vi) rating peers.

Rating driver references
1. Central Bank of the Republic of Türkiye, Press Release, June 2023               
2. Central Bank of the Republic of Türkiye, Press Release, July 2023
3. Central Bank of the Republic of Türkiye, Speech, July 2023
4. Central Bank of the Republic of Türkiye, Press Release, June 2023
5. Central Bank of the Republic of Türkiye, Inflation Report, July 2023
6. Ministry of Treasury and Finance (of Turkey), Public Debt Management Report June 2023
7. Central Bank of the Republic of Türkiye, Financial Stability Report, May 2023
8. Ministry of Treasury and Finance, Press Release, April 2023 
9. Central Bank of the Republic of Türkiye, Inflation Report, July 2023
10. Türkiye Wealth Fund, Press Release, March 2023
11. Yale University, Environmental Performance Index 2022

Methodology
The methodology used for these Credit Ratings and Outlooks, (Sovereign Rating Methodology, 27 September 2022), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The model used for these Credit Ratings and Outlooks is (CVS Model version 2.1), available in Scope Ratings’ list of models, published under 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.

Solicitation, key sources and quality of information
The rated entity and/or its agents did not participate in the ratings process. 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 Ratings and Outlooks and the principal grounds upon which the Credit Ratings and Outlooks are based. Following that review, the Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and Outlooks are UK-endorsed.
Lead analyst: Thomas Gillet, Director
Person responsible for approval of the rating: Alvise Lennkh-Yunus, Executive Director
The Ratings/Outlooks were first assigned by Scope in January 2003. The Ratings/Outlooks were last updated on 11 March 2022.

Potential conflicts
See www.scoperatings.com under Governance & Policies/Regulatory 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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