Fitch Revises Turkey's Outlook to Negative; Affirms at 'BB-'
Thu 02 Dec, 2021
HIGH
The central bank's premature monetary policy easing cycle and the prospect of further rate cuts or additional economic stimulus ahead of the 2023 presidential election have led to a deterioration in domestic confidence, reflected in a sharp depreciation of the Turkish lira, including unprecedented intra-day volatility, and rising inflation. These developments create risks to macroeconomic and financial stability and could potentially re-ignite external financing pressures.
After the 2018 and 2020 crises, Turkey enters this new period of stress from a vulnerable position, with a high degree of uncertainty regarding the economic authorities' policy reaction function, high external financing requirements, deteriorating inflation dynamics and weakened external buffers.
The central bank lowered its main policy rate to 15% in November (cutting by a total of 400bp since September) despite rising inflation (19.9% yoy in October) and the tightening of external financing conditions. As a result, real rates ex-post have fallen deep into negative territory (-4.9%) from 2.75% in March, weakening domestic confidence and increasing demand for FX. The central bank has repeatedly changed its policy guidance in recent months from a commitment to maintaining positive real rates to focusing on core inflation dynamics, and more recently on narrowing the current account deficit. Fitch considers that the recently announced central bank intervention in the FX market, if sustained, will not by itself address the main causes behind the depreciation pressures and risks further undermining the already weak central bank international reserves' composition.
The lira has depreciated by 46% against the US dollar since the beginning of the year and 38% since September, including days of large intra-day volatility. Negative real rates, the absence of policy guidance, statements by government officials arguing for a weaker lira as part of an economic development strategy and rising inflation and inflation expectations will maintain pressure on the currency.
We forecast inflation to reach 25% by end-2021 and remain one of the highest among rated sovereigns, averaging 20% in 2022-2023. A weaker lira, high international commodity prices and rising inflation expectations create upside risks to our inflation projections. According to the central bank's latest survey, median 12-month inflation expectations have increased by 350pp to 16% since August and 540bp since the beginning of the year.
There is a high degree of uncertainty regarding the timing and type of policy response due to the public statements of government authorities, including the president, in favour of low rates and a weaker lira, and the increased visibility of political interference in the central bank decisions and management. Maintaining a deeply negative real policy rate could further undermine domestic confidence, increasing risks for financial stability, for example if depositor confidence is shaken, and potentially jeopardise the until now resilient access of banks and corporates to external financing.
Moreover, the focus of the government on supporting faster commercial credit growth, a key rationale behind the easing cycle in Fitch's view, and the prospect of significant real wage increases for 2022 could reverse the improvement in the current account (forecast to halve to 2.5% of GDP in 2021) and increase external financing pressures. External debt maturing over the next 12 months amounts to USD168 billion (end-September), with the majority related to banks and corporates. Mitigating factors include a record of continued access to external financing through periods of stress and reduced private sector external leverage.
MEDIUM
The proximity of the 2023 electoral cycle will have an impact on policy direction and expectations of economic actors, in Fitch's view. The president has re-emphasised his opposition to high interest rates despite the fall in the lira and his influence on monetary policy has become more visible. Additional monetary easing or economic stimulus may risk exacerbating macroeconomic instability, which seems to have damaged government support in 2020, and creating risks to social stability and increased political polarisation.
We forecast general government debt to increase significantly to 47% of GDP in 2021, driven mostly by the lira depreciation, up from our August forecast of 39% but still below the forecast 58% of GDP 'BB' median. The fiscal deficit is likely to outperform peers and the government's 2021 revised fiscal target of 3.5% of GDP, and we forecast that the deficit will remain below rating peers in 2022-2023. Debt dynamics will remain vulnerable to increased currency risks, as 60% of central government debt was foreign currency linked or denominated in October 2021, up from 39% in 2017. Government debt amortisations are manageable, averaging 2.5% of GDP in 2022-2023 and the sovereign has a record of access to external bond markets despite repeated periods of stress in recent years.
Although GDP growth is strong relative to peers, including 1.8% of GDP in 2020 and Fitch's forecast of 10.5% in 2021, GDP per capita in US dollar terms has deteriorated since 2013, falling by almost USD4,000 to a forecast USD8,500 in 2021, due to the multi-year weakening of the currency, putting additional downward pressure on Turkey's credit profile. There is a is high degree of uncertainty regarding our 3.5% growth projection for 2022. Stimulus from the recent monetary policy easing and additional credit support measures announced will be balanced by the reduced impact of monetary policy on local financing costs, deterioration in consumer and investor sentiment, and the negative impact of a weaker exchange rate, including reduced consumer purchasing power.
Turkey's 'BB-' IDRs also reflect the following key rating drivers:-
Turkey's ratings reflect weak monetary policy credibility, high inflation, low external liquidity in the context of high financing requirements and geopolitical risks. These credit weaknesses are set against low government deficits and debt and a record of strong growth performance and structural indicators, such as GDP per capita and Human Development, relative to rating peers.
External financing pressures eased in 2021 due to a narrowing current account deficit, moderately higher international reserves, and banks and corporates' uninterrupted access to sufficient external finance to roll-over large debt payments.
International reserves have recovered due to strong export revenues, net external borrowing and the increase of the FX swap with China and a new one with South Korea, as well as USD6.4 billion IMF SDR allocation. We forecast reserves to reach USD119 billion at end-2021, but decline in 2022-2023 to USD111 billion, given continued current account deficits and financial dollarisation, and the limited upside for portfolio inflows, in our view.
Turkey's reserve buffers, at 4.8 months of current external payments in 2021, are low compared with 6.6 months for the 'BB' median, and relative to the country's large external financing requirement, high deposit dollarisation and the risk of changing investor sentiment. In addition, the underlying position of international reserves remains weak. Net reserves (net of FX claims, mainly from Turkish bank placements) reached USD25 billion in mid-November (still considerably below the USD41.1 billion at end-2019), and reserves net of FX swaps with local banks remain negative.
The banking system has demonstrated resilience to financial market stress, most recently in March, although risks to banks' Standalone Credit Profiles remain significant. The relative stickiness of deposits 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 foreign currency debt, in particular when adjusting the latter for more stable sources of funding such as intra-group facilities and parent funding.
Nevertheless, the banking sector remains vulnerable to exchange-rate volatility due to the impact on capitalisation, asset quality, refinancing risk (given short-term foreign-currency financing) and high deposit dollarisation (56% including precious metals). The banking sector has increased its exposure to the sovereign both through government debt holdings (71% of domestic debt) and FX swaps with the central bank.
Geopolitical risks will remain elevated, but existing sanctions have so far had a limited impact on the economy. In addition to the tensions created by Turkey's purchase of Russian-made S-400 missiles, and US cooperation with Kurdish forces in Syria, the relationship with the US has several potential flash points. Similarly, relations with the EU remain complex, including issues related to Cyprus, and operations in northern Syria, Libya and the sale of arms to Ukraine could represent additional sources of tension with Russia.
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. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Turkey has a medium WBGI ranking at 37, reflecting a recent track record of peaceful political transitions, a moderate level of rights for participation in the political process, moderate but deteriorating institutional capacity due to increased centralisation of power in the office of the president and weakened checks and balances, uneven application of the rule of law and a moderate level of corruption.
RATING SENSITIVITIES
Factors that could, individually or collectively, lead to negative rating action/downgrade:
-Macro: A policy response that fails to ease or exacerbates macroeconomic and financial stability risks such as an inflation-exchange rate depreciation spiral or weaker depositor confidence.
-External Finances: Re-intensification of balance of payments pressures, including a sustained reduction in international reserves, deterioration of the current account balance or reduced access to external financing, for example due to further loss of investor confidence in light of economic policy measures
-Structural features: A serious deterioration in the domestic political or security situation or international relations that severely affects the economy and external finances.
-Public finances: A marked worsening in the government debt/to GDP ratio or broader public sector balance sheet.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
-Macro: A credible and consistent policy response that stabilises confidence and reduces macroeconomic and financial stability risks, for example by reigning in inflationary pressures.
- External Finances: A reduction in external vulnerabilities, for example evident in a sustained improvement in the current account balance, stronger external liquidity position and reduced dollarisation.
- 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.
