International credit ratings agency Moody’s has published on its website its Credit Opinion update report on Turkey’s rating downgrade to B2 from B1. The report is as follows:
“CREDIT OPINION Update
Government of Turkey – B2 negative
Update following downgrade to B2, negative outlook maintained
Our credit view of Turkey balances a large, diversified economy and moderate (but rising) levels of government indebtedness against heightened external vulnerabilities and a continued erosion of institutional strength and policy effectiveness. In response to the coronavirus outbreak, Turkey has further eased its fiscal and monetary policy stance. But measures to counteract the economic effects of coronavirus remain relatively small, and economic policy uncertainty persists. The central bank's foreign exchange reserve position has declined considerably, while external refinancing requirements remain high and costly. In spite of the decline in oil prices, the risk of a balance-of-payments crisis has thus become increasingly likely, exacerbated by elevated capital outflows.
Large and diversified middle-income country
Favourable demographics and diverse trade linkages
Moderate debt burden
Very low foreign exchange reserve position at the central bank
Economy's dependence upon foreign capital inflows and foreign investor confidence
Gradual erosion of institutional and governance strength
Persistently turbulent geopolitical environment
The negative outlook reflects the view that fiscal metrics could deteriorate at a faster pace than currently anticipated in the coming years. It also reflects the downside risks associated with the authorities’ inadequate reaction function, which makes Turkey more likely to suffer a full-blown balance of payments crisis in the coming years. Finally, it reflects elevated levels of geopolitical risk on several fronts—the relationship with the United States (US, Aaa stable), the relationship with the European Union (EU, Aaa stable), and tensions in the Eastern Mediterranean—that could be an accelerant for any crisis.
Factors that could lead to an upgrade
Given the negative outlook, a positive outlook or an upgrade is highly unlikely. However, the rating outlook could stabilise if fiscal and monetary policies become more coherent in preventing further exposure to a balance of payment crisis near term. External financial support could also be credit supportive, as would diminished tensions with the US and the EU. A determined set of economic reforms that address the economy's structural imbalances while capitalising on the country’s inherent strengths could lead to upward rating pressure over the medium term.
Factors that could lead to a downgrade
Turkey’s rating would likely be downgraded if there was an increasing likelihood that the current balance of payments pressures were going to deteriorate into a full-blown crisis. In such an event, the government could try to conserve scarce FX assets by imposing restrictions on foreign-currency outflows that affect sovereign creditors as well.
Detailed credit considerations
We assess Turkey’s economic strength as “baa2”, reflecting its large and diverse economy, its relatively high per-capita income and its youthful population, which underpin its positive but slowing growth potential. Conversely, our assessment also factors in the volatility of this growth given the low savings rate, persistently high inflation, and heightened structural growth constraints in the absence of long-delayed structural economic reforms. We adjust Turkey's economic strength score by three notches, to “baa2” from “a2”, to reflect our view that the economy is reliant on unsustainable credit creation and has structural issues related to productivity, economic complexity and lack of market flexibility that are not captured in the indicative factor score.
The score for Turkey’s institutions and governance strength is assessed as “b2”. In our view, policy predictability, the effectiveness of economic policymaking and the rule of law – important aspects of institutions and governance strength – have steadily eroded in recent years. Intense political pressure exerted on key regulatory institutions such as the central bank has persistently undermined their credibility. In turn, the central bank has rarely achieved its principal mandate, the 5% (± 2%) medium-term inflation target. Amendments to the constitution to concentrate powers within the presidency have come into effect following the June 2018 presidential election and have reduced the predictability of macroeconomic, civil, and foreign policies.
The score for Turkey’s fiscal strength is set at “ba1”, one notch lower than the initial score to reflect our view that fiscal metrics will deteriorate over the course of 2020 and that this deterioration will not be reversed over our forecasting horizon. Turkey's fiscal strength score reflects moderate but increasing deficits and debt levels compared to most similarly rated peers. Yet, the government's debt metrics are vulnerable to high inflation and currency depreciation given the increasing share of foreign currency-denominated and inflation-indexed debt in the government's total debt stock and have a marginally shorter debt maturity structure. In addition, we take into account off-balance sheet financial obligations, such as public-private partnerships.
Turkey's susceptibility to event risk score (which is on an inverse scale relative to other factor scores) is assessed as “b”, driven by the country’s exposure to external vulnerability and political risk.
Turkey’s external vulnerability risk is set at “b” in light of the heightened vulnerability stemming from the country's large external refinancing needs. Unusually weak domestic demand is flattering the headline current-account data, but in structural terms Turkey still has a weak current-account position, which is tied to the low savings rate, dependence on energy imports, and the high import content of Turkish exports. Adding to external vulnerabilities are the country’s weak level of foreign exchange assets relative to economy-wide foreign currency and external payments obligations. These vulnerabilities are exacerbated by capital outflows from Turkey and other emerging market countries, which are in-part related to the pandemic.
Turkey's political risk score is also set at “b”. Political tensions with the US government remain elevated due to Turkey having adopted Russia's (Baa3 stable) S-400 air-defence system, increasing the risk of renewed financial market stress and currency depreciation. In addition, geopolitical risks arising from disputes over gas exploration and sea borders in the eastern Mediterranean could also be an accelerant to any crisis.
We set Turkey's government liquidity risk at “ba”, reflecting higher risks for the cost and availability of funding. Although the government has relatively low gross borrowing requirements, non-resident participation in Turkey's domestic government debt market has fallen steeply due to market stress and political uncertainty. Domestic debt auctions are now focused mainly at primary dealers and state banks, reducing yields at the expense of marketable debt issuance.
Turkey’s banking sector risk is also assessed at “ba”. This reflects the system's reliance on short-term foreign-currency-denominated wholesale funding; asset quality concerns, though capitalization remains adequate; and the relaxation of regulatory standards, which lowers transparency and comparability to peers.
How environmental, social and governance risks inform our credit analysis of Turkey
Moody's takes account of the impact of environmental (E), social (S) and governance (G) factors when assessing sovereign issuers’ economic, institutional and fiscal strength and their susceptibility to event risk. In the case of Turkey, the materiality of ESG to the credit profile is as follows:
Environmental considerations are not material to Turkey’s credit profile, and the country has not been identified as being one of the sovereigns materially exposed to physical climate change risks. Turkey experiences some environmental pressures because of rapid population growth, which translated into industrialisation and rapid urbanisation. While this results into increased pollution and some degree of environmental degradation, these considerations are not material to Turkey’s credit profile.
Regarding social considerations, while Turkey is faced with labour market rigidities and low female participation rate, these credit features are mitigated by Turkey’s youthful population, which underpins its positive but slowing growth potential. In addition, we regard the coronavirus outbreak as a social risk under our ESG framework, given the substantial implications for public health and safety as well as the economic fiscal implications of the pandemic.
Our assessment of Turkey’s weak and deteriorating governance has been an important credit feature, which underpinned our decision to downgrade Turkey’s rating by multiple notches since the introduction of the presidential system in mid-2018. Since then, it has become frequent practice in Turkey for official decrees ordering sometimes significant changes in laws and practices to be no longer required to go through parliament to gain approval. These interventions have become more frequent since the 2018 market pressures. Moreover, the executive continues to undermine the independence of key institutions that meaningfully undermines those institutions' credibility and effectiveness.
All of these considerations are further discussed in the “Detailed credit considerations” section above. Our approach to ESG is explained in our report on How ESG risks influence sovereign credit profiles and our cross-sector methodology General Principles for Assessing ESG Risks.
On 11 September, we downgraded Turkey's government ratings to B2 and maintained the negative outlook, due to the recent deterioration in Turkey’s external fundamentals that make a balance of payments crisis more likely.
External vulnerabilities are increasingly likely to crystallise in a balance-of-payments crisis
The country's foreign-currency reserves, which have been dwindling downwards because of the central bank’s unsuccessful attempts to defend the lira since the beginning of 2020, are at the lowest level as a percentage of GDP that they have been since November 2005. Gross foreign-exchange reserves (excluding gold) are currently at $44.9 billion (as of 4 September), an over 40% decline since the beginning of the year.
Turkey has tried a number of measures to increase gross reserves—including a tripling of the country’s swap line with Qatar to $15 billion in May and increasing banks’ reserve requirements—but this amounts to an exceptionally low buffer when measured against upcoming external debt payments. We forecast that the country’s external vulnerability indicator (EVI), an indicator of the adequacy of foreign currency reserves to cover external debt repayments and non-resident deposits, will rise from 263% in 2019 to 409% in 2021, which represents heightened exposure to changes in international investor sentiment. In a crisis, the authorities could use the commercial banks' reserves of US$44 billion deposited at the central bank to repay maturing external debt, however such a situation would increase the risk that the government impose restrictions to safeguard its scarce FX assets. Some banks recently imposed fees for foreign-currency withdrawals.
If banks’ required reserves for TL and FX liabilities are netted out, net foreign-exchange reserves are now close to zero. Moreover, the reliance on swaps has grown at a very rapid pace in 2020. As of the end of July, the Turkish central bank had a $53 billion net short position in the swap market, up from $30 billion in March. In other words, all the commercial banks’ reserves at the central bank are insufficient to cover this short position if these swaps were not rolled over. Turkey does hold substantial gold reserves, and due to both increases in the gold price and an increase in gold volumes held, gold holdings are now broadly equal to FX reserves ($42.7 billion at the beginning of September).
The lower gross and net reserves go, the more likely it is that Turkey experiences a severe balance of payments crisis. In the past, when the economy came under pressure, Turkey's flexible exchange rate acted as a shock absorber that has insulated the real economy from macroeconomic shocks and allowed the country to muddle through without addressing its structural imbalances. More recently, the authorities have been unwilling to allow the lira to float freely because of the economic consequences of a weaker currency. The tourism industry, which is highly responsive to a more competitive exchange rate, would not benefit this year due to the pandemic.
Elevated levels of geopolitical risk could be an accelerant for a crisis
While geopolitical risk has increased in recent years, with Turkey's relationship with the US and EU deteriorating due to foreign policy disagreements on Syria, Libya, and the refugee crisis, tensions in the eastern Mediterranean have markedly risen in the past few weeks. This follows Turkey's more assertive behaviour around gas exploration in areas that Greece (B1 stable) regards as its own economic zone. Turkey has not signed up to the United Nations Convention on the Law of the Sea and therefore does not recognise the exclusive economic zone around the Greek islands.
The spat involves the presence of military ships from both countries, as well as from France (Aa2 stable), which is siding with Greece. France is calling for another round of EU sanctions on Turkey, on the grounds that it is violating Greece's territorial sovereignty. Other countries involved in the exploration of gas in the area include Egypt (B2 stable) and Libya, who have maritime agreements with Greece and Turkey respectively, and to a lesser extent Lebanon (C, no outlook).
In late August, Turkey announced gas finds in the Black Sea. While they could reduce Turkey's reliance on energy imports, and thus provide some support to the current-account balance, in our view they will not come on stream quickly enough to mitigate these broader risks to Turkey’s external accounts.
Fiscal buffers, which have been a source of credit strength for many years, are eroding
Over the last two years, Turkey's debt affordability has weakened markedly due to rising government debt levels as well as a weaker debt structure that renders the government’s finances more vulnerable to high inflation and currency depreciation. This prompted us to lower our fiscal strength assessment by two notches to “ba1” this summer. The fact that Turkey has had to contend with two crises since 2018 has taken a toll on the public finances even though the government’s fiscal response to the pandemic has been relatively modest. The weak growth performance and fiscal measures to manage the economic effects of the coronavirus will have a meaningful impact on the deficit in 2020, and we forecast that it will rise to 7.5% of GDP.
In addition to the widening primary balance, the depreciation of the lira and high inflation will contribute to an increase in the debt burden and higher interest payments on account of an increased reliance on domestic and floating-rate borrowing which comes at the expense of higher yields. We forecast the government debt burden to increase from 32.5% in 2019 to 42.9% in 2020 and the debt affordability ratio to deteriorate to 8.8% in 2020, up from 7.3% in 2019 and 5.8% in 2018. Under our baseline scenario, the return to growth after the economic shock of 2020 will not suffice to offset the impact on the upward debt trajectory, and we expect Turkey’s debt burden to increase to above 46% of GDP in the coming years.”
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