International credit ratings agency Fitch Ratings has affirmed Turkey’s credit rating at “BB-“, but has revised down its outlook from stable to negative.
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:
A depletion of foreign exchange reserves, weak monetary policy credibility, negative real interest rates, and a sizeable current account deficit partly fuelled by a strong credit stimulus, have exacerbated external financing risks. Political pressures, the limited independence of the Central Bank of the Republic of Turkey (CBRT), and a track record of being slow to respond to events, increase the risk that policy is tightened insufficiently, contributing to further external imbalances, market instability, and a more disorderly adjustment.
There have been large currency interventions to defend the lira, which has depreciated 16% against the US dollar since March on the back of net capital outflows and a worsening trade deficit. Gross FX reserves (including gold) fell to USD88.2 billion in mid-August from USD105.7 billion at end-2019. This is despite a USD40.5 billion boost from additional FX swaps (to end-June) as a result of regulatory limits on banks dramatically shrinking the offshore swap market and a USD10 billion increase in the swap line with Qatar. Gross reserves minus swaps have fallen more sharply, from USD87.3 billion at end-December to USD29.3 billion, which better highlights the underlying trend. Net reserves (net of FX claims, mainly from Turkish bank placements) minus swaps are negative at -USD30.2 billion.
Fitch places more emphasis in its analysis on Turkey's gross FX reserves, which is the input to our Sovereign Rating Model and aligns with the fact that the private sector accounts for most of Turkey's large external financing requirement. However, the large contribution of swaps to gross reserves creates a greater risk if they are not rolled over. CBRT's resulting net short FX position also exposes it to balance sheet risk, with the potential for losses due to lira depreciation to further weigh on confidence in the currency.
FX interventions have weakened policy credibility. Turkey's prior long-standing commitment to a floating exchange rate was a supportive factor for its rating and facilitated the economic adjustment since the lira crisis in mid-2018, but this has been damaged by the scale of interventions this year.
The sharp fall in real interest rates, from a peak of 8.3% (ex-post, policy rate) in June 2019 to minus 3.5% (or to minus 1.5% using 12-month inflation expectations), has further weakened disinflation prospects and monetary policy credibility. Inflation remains high, at 11.8% in July and has averaged 11.7% in 2015-2020 compared with the 'BB' median of 3.4%. CBRT has started to tighten liquidity, with the average funding rate increasing to 9.4%, and we anticipate further use of the interest rate corridor (overnight rate of 9.75% and late liquidity window of 11.25%) before any change to the main policy rate. We forecast an increase in the policy rate to 9.25% at end-2020 and 10.25% at end-2021, with inflation ending both years at 10.5%. However, the policy reaction function is unpredictable, and there is a risk that tightening will be insufficient to stabilise the external position.
The current account balance deteriorated to a deficit of USD19.7 billion in 1H20 (USD13.7 billion seasonally adjusted/4.1% of GDP annualised, USD12.1 billion excluding gold), from a surplus of USD8.7 billion (1.1% of GDP) in 2019. This is driven by strong credit growth, a shallower recession in Turkey than its main trading partners, and the collapse in tourism, with some offset from low energy prices (the impact of the oil price decline to our forecast of USD35 a barrel in 2020 would be sufficient to offset a near 50% fall in net tourism receipts). Fitch forecasts the current account will improve in 2H20 as credit growth moderates and external demand strengthens, with a full-year deficit of 3.2% of GDP. We project the current account narrows to 2.4% of GDP in 2021, helped by recovering tourism, followed by 2.8% in 2022 partly due to high inflation gradually eroding competitiveness gains.
Loan growth has accelerated sharply, to 25% at end-July (33% on a 13-week annualised basis) and to 36% in state banks, driven by consumer credit growth of 48%. The government's coronavirus response focussed heavily on credit stimulus, and the expanded Credit Guarantee Fund (CGF) has accounted for 47% of the increase in lending since end-March but this is now reducing. The authorities have also signalled a tightening partly by adjusting the asset ratio regulation that incentivises lending. Alongside higher effective interest rates, we expect nominal credit growth to ease to closer to 15% in the near term. However, the Turkish economy has a long-standing close correlation between stronger economic activity, high loan growth and an increasing current account deficit, and it is unclear how the authorities view such trade-offs, with the risk of a build-up over time of unsustainable credit levels, exacerbating external imbalances.
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 and political and geopolitical risks.
The external financing positions of the banking and corporate sectors have remained resilient. These account for 42% and 35%, respectively, of Turkey's USD190 billion external financing requirement over the next 12 months. Banks' external financing requirements fell to USD79 billion at end-June, from USD102 billion at end-1H18, and USD35 billion-USD40 billion when more stable sources of funding are excluded. Against this banks have sufficient foreign-currency liquidity of USD75 billion at end-June (of which we estimate 54% is swaps largely undertaken with CBRT).
Banks' orderly FC deleveraging has continued, with a 74% rollover rate in June (on a rolling three-month basis), and the average price for the eight syndicated loans since the coronavirus shock was marginally lower than in 4Q19. Foreign currency bank deposits are still growing, by 7% in July (yoy-FX adjusted) and overall deposit growth has increased 5pp since March to 25%. The relative stickiness of deposits in the Turkish banking system during periods of stress in recent years is a supportive factor for the rating. However, the banking sector deposit dollarisation ratio remains high, at 50% in June (from 51% at end-2019), compared with the 'BB' median of 25%, representing a risk to external finances should there be a loss of depositor confidence.
The corporate sector has also continued to deleverage, with the overall net FX position falling to USD165 billion in May from USD187 billion a year earlier. Of the USD67 billion of corporate external debt due over the next 12 months, trade credits, which carry little rollover risk, make up USD47 billion. The sharp fall in domestic borrowing costs has contributed to a recent reduction in the corporate external debt rollover rate, to 60% in June (three-month, rolling). While this has added to the pressure on the balance of payments and CBRT reserves, it has improved the funding profile of the corporate sector.
Fitch forecasts the economy contracts by 3.9% in 2020, with private consumption leading the recovery from a fall in 2Q20 GDP of around 10%. There has been a broad-based lifting of lockdown measures, helped by Turkey's moderate incidence of COVID-19 cases. We forecast GDP growth of 5.4% in 2021 and 4.6% in 2022 also supported by recovery in investment and tourism, and the boost to net exports of the 10% real effective exchange rate depreciation since end-2019, partly offset by a somewhat weaker credit stimulus. These are above Turkey's trend rate of growth, which we estimate at 4.3%, and compare favourably with the 'BB' median GDP forecasts of 4.8% in 2021 and 3.9% in 2022.
The coronavirus shock has set back the already limited structural reform prospects, and there has been further postponement of pension and severance pay measures. There is continued speculation about an early election, but we think this is less likely in the near term and remain doubtful there is a compelling motivation, despite reported strains within the coalition and the potential for a steady erosion of support to opposition parties.
We view overall geopolitical risk as similar to our last review in February. US sanctions are expected to be advanced, and it remains unclear the extent to which they will be broadened from implementation of CAATSA measures. In Syria, the ceasefire agreed with Russia on military operations in Idlib region is unlikely to hold in our view, and there is a risk of an escalation, heightened tensions with Russia, and adverse spill-overs, compounded by the likely further displacement of Syrians. Military operations in Libya have stepped up since our last review, adding to risks to relations with Russia. We continue to view the US court case against Halkbank, and potential EU sanctions for gas drilling in Cyprus, as lower impact but still with the potential to damage investor sentiment.
The government's direct fiscal response to the coronavirus shock was moderate, totalling close to 2% of GDP, and focussed on employment support, tax deferrals, and a doubling of the CGF limit (costing 0.5% of GDP, on top of which there was a capital injection into three state-owned banks also totalling 0.5% of GDP). The central government deficit widened to 5.2% of GDP (annualised) in 7M20, from 2.9% in 2019, driven by higher expenditure, with revenues/GDP broadly unchanged. Fitch forecasts the general government deficit increases to 6.5% of GDP in 2020, from 3.3% in 2019, before narrowing to 4.5% in 2021 and 4.0% in 2022. There is particular uncertainty around the forecast partly given the lack of clarity over the unwinding of fiscal measures.
Fitch forecasts general government debt increases from 32.8% of GDP at end-2019 to 39.5% at end-2020, 7.2pp higher than forecast at our last review. General government debt is then projected to stabilise, ending 2022 at 38.8% of GDP, still well below the current 'BB' median of 59.4%. There has been an increase in contingent liability risks, mainly from the banking sector. Other direct government guarantees currently total close to 5% of GDP, in addition to which we estimate contingent liabilities from public-private partnerships of a similar magnitude.
Turkish banks' credit profiles remain under pressure from exposure to macro and lira volatility. Regulatory forbearance is providing an uplift to asset quality and capital metrics, but is due to fall away from end-2020, and refinancing risks also increase with a weakening of investor sentiment. The sector non-performing loan ratio was 4.4% at end-June and Fitch estimates Stage 2 loans at 10%-11%. We expect a marked weakening in underlying asset quality, given the recessionary environment, exposure to vulnerable sectors such as tourism, and the recent rapid growth in lending particularly unsecured retail. The common equity Tier 1 ratio (including forbearance) increased to 15.2% at end-June (from 14.2% at end-2019), but risks to capitalisation are significant given pressures on asset quality and the currency (we estimate a 10% lira depreciation erodes capital ratios by 40bp).
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 WBGI ranking at the 38th percentile.
SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)
Fitch's proprietary SRM assigns Turkey a score equivalent to a rating of 'BB+' on the Long-Term Foreign-Currency (LT FC) IDR scale.
In accordance with its rating criteria, Fitch's sovereign rating committee decided not to adopt the score indicated by the SRM as the starting point for its analysis because the SRM output has migrated from 'BBB-' to 'BB+', but in our view this is potentially a temporary worsening.
Assuming an SRM output of 'BBB-', in accordance with its rating criteria, 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 rated peers, as follows:-
- Macroeconomic policy and performance: -1 notch, to reflect weak macroeconomic policy credibility and coherence and downside risks to macroeconomic stability.
- External finances: -1 notch, to reflect a very high gross external financing requirement, low international liquidity ratio, and risks of greater external imbalances resulting in a disorderly adjustment.
- Structural features: -1 notch, to reflect an erosion of checks and balances and institutional quality, downside risks in the banking sector and the risk of developments in geopolitics and foreign relations that could impact economic stability.
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.
The main factors that could, individually or collectively, lead to negative rating action/downgrade:
- External Finances and Macro: More acute external financing risk, for example due to policy settings that result in greater external imbalances, unsustainable credit growth, and higher inflation, or severe stresses in the corporate or banking sectors.
- Public Finances: A marked worsening in the government debt/GDP ratio or broader public balance sheet.
- Structural: A serious deterioration in the domestic political or security situation or international relations.
The main factors that could, individually or collectively, lead to positive rating action/downgrade:
- External Finances and Macro: Greater confidence in the sustainability of the external position, particularly if reforms raise domestic savings, reduce dollarisation and make GDP growth less dependent on credit growth and external borrowing.
- Structural: An improvement in governance standards, political or 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.
- Macro: A sustained decline in inflation and a rebuilding of monetary policy credibility, which would cause the removal of the -1 QO notch on Macroeconomic Policy and Performance.
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).”