International credit ratings agency Fitch Ratings has affirmed Turkey’s credit rating at “BB-“, but has revised up its outlook from negative to stable.
Fitch’s action report explaining the reasoning behind its revision is as follows:
“KEY RATING DRIVERS
The revision of the Outlook reflects the following key rating drivers and their relative weights:
HIGH
Turkey's return to a more consistent and orthodox policy mix under a new economic team has helped ease near-term external financing risks derived from last year's falling international reserves, a high current account deficit and deteriorating investor confidence. Monetary policy has been significantly tightened, international reserves have stabilised and the Turkish lira has appreciated by 18% against the US dollar since early November.
Under its new leadership, the central bank has simplified monetary policy by reverting to a single policy interest rate (one-week repo rate) to improve transparency and predictability, strengthened its communication strategy and stepped-up its tightening cycle by increasing policy rate rates by 675bp in November-December. The real policy rate (adjusted for 12-month inflation expectations) increased to 6.8% in February 2021 compared with -1.55% in August. Authorities have also reversed previous regulatory measures to rein in rapid credit growth.
The central bank current policy settings are aimed at achieving sustained disinflation (reaching its inflation target of 5% in 2023), a reversal in dollarization and rebuilding FX reserves. Fitch considers that rebuilding policy credibility will take time, given limited central bank independence, exemplified by the sacking of two of its governors since July 2019, and a recent track record of delayed response to mounting macroeconomic pressures or premature policy easing.
In line with its intention to strengthen inflation targeting credentials, the central bank has renewed its previous long-standing commitment to a floating exchange rate, after large scale interventions in 2020. The change in investor sentiment and domestic actors has led to significant lira appreciation, lower risk premium and some net capital inflows.
International reserves have stabilised and recovered slightly. Gross FX reserves (including gold) have increased from a low USD86.7 billion in November to USD95.6 billion in early February, still below the USD105.7 billion at the end of 2019. Nevertheless, the underlying position of international reserves remains weak. Net reserves (net of FX claims, mainly from Turkish bank placements) rose to USD15.3 billion in early February (still considerably below the USD41.1 billion at end-2019). Reserves net of FX swaps with local banks remain negative.
Turkey's reserve buffers, at 4.5 months of CXP cover compared with 5.3 months for the 'BB' median, are low relative to the country's large external financing requirement, high deposit dollarization and the risk of changes investor sentiment. In the absence of shocks, and assuming the continuation of the current policy settings, we forecast international reserves to increase gradually to USD104 billion in 2021 and USD110 billion in 2022. Upside risks to this forecast are dependent on net capital inflows or a quicker-than-expected reversal in deposit dollarization.
Turkey's 'BB-' IDRs also reflect the following key rating drivers:
The rating is supported by Turkey's moderate levels of government and household debt, large and diversified economy with a vibrant private sector, and GDP per capita and Ease of Doing Business indicators that compares favourably with 'BB' medians. Set against these factors are Turkey's weak external finances, a track record of economic volatility, high inflation, increased dollarization and political and geopolitical risks.
Public finances continue to be a key rating strength. Stronger than expected revenues and a modest anti-crisis package (2.5% of GDP) resulted in a central government deficit of 3.5% of GDP in 2020. At the general government level, Fitch estimates that the deficit reached approximately 4.5% of GDP, significantly below the 8.5% estimated for the 'BB' median, assuming moderate deficits at the local government, social security and unemployment insurance fund close to the projections under the 2021-2023 National Economic Programme.
The Ministry of Finance and Treasury has also announced it may lower its 2021 budget target to 3.5% from 4.3% of GDP in 2021, partly to support the disinflation process. The combination of slower revenue growth due to cooling economic activity and the use of some of the available fiscal space to provide additional support to cushion the economic and social impact of the pandemic will result in a 3.9% central government deficit in 2021 and 3.7% in 2022, according to our projections. The general government deficit will then decline to 4.1% of GDP in 2021 and 3.9% in 2022, still below the projected 5.7% and 4.3% 'BB' median.
Government debt rose by 7pp to 40% of GDP in 2020, 20pp below the estimated 'BB' median 2020 estimate. High nominal GDP growth and lower primary deficit will underpin a modest decline to 37% by 2022. However, currency risk has increased (56% of central government debt was foreign currency linked or denominated at end-2020, up from 39% in 2017). Turkey's debt management strategy aims at strengthening domestic debt composition in terms of costs, duration and currency taking advantage of improved confidence and macroeconomic stability prospects.
Inflation averaged 11.7% in 2015-2020, compared with the 'BB' median of 3.4% and we expect the disinflation process to be gradual. Despite high real rates and the lira appreciation, cost pressures, higher commodity prices including food, still high inflation expectations and a 21% increase in the minimum wage will maintain inflation in double digits in 2021, in our view. We forecast that inflation will decline to 11.0% at end-2021 and 9.2% at end-2022, compared with the current central bank forecast of 9.4% and 7%, respectively.
After a strong sequential recovery in 3Q20, the economy has likely maintained positive growth momentum despite the tightening of anti-pandemic measures, thus resulting in a full-year growth of 1.4% in 2020. Although a strong carry-over effect will lead to a full year growth of 5.7%, domestic demand will slow down in 1H21. We expect the economy to benefit from the vaccination drive and easing of restrictions domestically and abroad later in the year and forecast GDP growth of 4.7% in 2022.
Recent polls show that the support for the ruling AKP and its coalition partner, the MHP, has come under pressure, partly reflecting the negative economic impact of the pandemic and financial stress. Fitch considers that the sustainability of the current orthodox policy mix and implementation of reform measures, such as those expected to be announced by the government in the near term, will also be influenced by the proximity of the 2023 general elections.
Sanctions and other geopolitical risks continue to weigh on Turkey's rating with the potential to impair investor sentiment and external finances. In December 2020, the US applied limited sanctions (against Turkey's defence procurement agency) under the Countering America's Adversaries Through Sanctions Act (CAATSA) due to the 2019 purchase of the S-400 Russian missile system. While we expect sanctions to remain narrow in scope and not significantly impact the Turkish economy, this issue will likely remain a source of tension in addition to US cooperation with the Kurdish People's Protection Units (YPG) in Syria.
The EU issued personal sanctions against Turkish officials involved in natural gas prospecting in the Eastern Mediterranean. Although Turkey has withdrawn its exploration ship and announced its willingness to improve relations with the EU, a sustainable improvement in relations remains uncertain. In addition to operations in Northern Syria and Libya, Turkey has supported for Azerbaijan in the Nagorno Karabakh conflict, which could represent an additional source of tension with Russia.
Fitch forecasts the current account deficit to narrow to 2.9% in 2021 and 2.1% in 2022, from a high 5.3% of GDP in 2020, reflecting slower domestic demand and reduced gold imports, both supported by our expectation of a tight monetary policy stance and improved confidence. The recovery in external demand and the tourism sector will benefit export of goods and services, albeit at a more gradual pace.
We forecast external financing requirements (current account balance plus private and public debt amortizations), at 83% and 65% of international reserves in 2021 and 2022, respectively, remaining higher than peers driven by the private sector. However, the external financing positions of the banking and corporate sector have remained resilient throughout periods of stress since the 2018 crisis and maintained relatively comfortable roll-over rates in 2020.
Credit growth has decelerated markedly since mid-2020, declining to 18% yoy (FX adjusted) and 0.8% on a 13-week annualised basis, reflecting the tightening in financial conditions, phasing out of credit stimulus largely intermediated by state-owned banks and changes to regulations that previously incentivised lending. Slowdown in credit growth to more sustainable levels, including consumer credit, is key to support disinflation and reduction of the current account deficit.
The banking system has demonstrated relative resilience to the Covid-19 pandemic shock and financial markets' stress in 2020. Both capitalisation (capital adequacy ratio at 18.8% end-2020) and asset quality (non-performing loans (NPL) at 4.1% end-2020) metrics have benefited from regulatory forbearance expected to remain in place until mid-2021 and the Credit Guarantee Fund' stimulus. However, Turkish banks continued to provision against loans in 2020 as if there was no regulatory forbearance. Fitch expects a further moderate increase in NPL, partly reflecting the still high Stage 2 loans and loan seasoning risks amid waning government stimulus and the higher interest rate environment. We also believe the share of restructured loans could further rise.
The banking sector is vulnerable to exchange rate volatility due to the impact on capitalisation, asset quality, refinancing risk (given short-term foreign-currency financing) and high deposit dollarization (54% including precious metals). The relative stickiness of deposits in the Turkish banking system during periods of stress in recent years is a supportive factor for the rating. In addition, the banking sector's available foreign currency liquidity is sufficient to meet its short-term external debt, in particular when adjusting the latter for more stable sources of funding
ESG - Governance: Turkey has an ESG Relevance Score (RS) of 5 for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Turkey has a low WBGI ranking at the 39th percentile.
RATING SENSITIVITIES
The main factors that could, individually or collectively, lead to positive rating action/upgrade are:
- External Finances: A reduction in external vulnerabilities, for example evident in a sustained reduction in the current account deficit, stronger external liquidity position and reduced dollarization.
- Macro: A sustained decline in inflation and a rebuilding of monetary policy credibility, which could cause the removal of the -1 QO notch on Macroeconomic Policy and Performance.
- Structural: A reduction in geopolitical risks for example from the conflict in Syria, and from US sanctions, which would cause the removal of the -1 QO notch on Structural Features.
The main factors that could, individually or collectively, lead to negative rating action/downgrade:
- Macroeconomic policy and performance & External finances: Re-intensification of balance of payments and macroeconomic stability risks, including sustained erosion of international reserves or severe stress in the corporate in banking sector, for example due to weaker investor confidence as a result of premature monetary easing
- Structural features: A serious deterioration in the domestic political or security situation or international relations that severely affects the economy.
- Public finances: A marked worsening in the government debt/to GDP ratio or broader public balance sheet.
SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)
Fitch's proprietary SRM assigns Turkey a score equivalent to a rating of 'BBB-' on the Long-Term Foreign-Currency (LT FC) IDR scale.
Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to SRM data and output, as follows:
- Macroeconomic policy and performance: -1 notch, to reflect weak macroeconomic policy credibility and a recent track record of delayed response to mounting macroeconomic pressures or premature policy easing.
- External finances: -1 notch, to reflect a very high gross external financing requirement, low international liquidity ratio, and risks of renewed balance of payments pressure in the event of changes in investor sentiment.
- Structural features: -1 notch, to reflect the risk of developments in geopolitics and foreign relations, including sanctions, that could impact economic stability as well as downside risks in the banking sector due to significant reliance on foreign financing and high financial dollarization.
Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM
ESG CONSIDERATIONS
Turkey has an ESG Relevance Score of 5 for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch's SRM and are highly relevant to the rating and a key rating driver with a high weight. Turkey faces geopolitical risks and security threats and is involved in conflicts in neighbouring countries.
Turkey has an ESG Relevance Score of 5 for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in Fitch's SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight.
Turkey has an ESG Relevance Score of 4 for Human Rights and Political Freedoms as the Voice and Accountability pillar of the World Bank Governance Indicators are relevant to the rating and a rating driver.
Turkey has an ESG Relevance Score of 4 for International Relations and Trade. Bilateral relations with key partners have been volatile, including threats of US sanctions and periodic tensions with the EU. This turbulence hurts investor confidence, brings risks to external financing and can impact trade performance and is a rating driver for Turkey.
Turkey has an ESG Relevance Score of 4 for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver for Turkey, as for all sovereigns.
Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity(ies), either due to their nature or to the way in which they are being managed by the entity(ies).”