Rating Action Commentary
ֳ Revises Turkey's Outlook to Stable; Affirms at 'BB-'
Fri 01 Nov, 2019 - 5:05 PM ET
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Turkey - Rating Action Report
ֳ - London - 01 Nov 2019: ֳ has revised the Outlook on Turkey's Long-Term Foreign-Currency Issuer Default Rating (IDR) to Stable from Negative, and affirmed the IDR at 'BB-'.
Key Rating Drivers
The revision of the Outlook reflects the following key rating drivers and their relative weights:-
MEDIUM
Turkey has continued to make progress in rebalancing and stabilising its economy, leading to an easing in downside risks since our previous review in July. The current account balance has improved, FX reserves have edged up, economic growth has continued, inflation has fallen and the lira has held up despite large cuts in interest rates, buoyed by more supportive global financing conditions and the recent US announcement on removal of Syria-related sanctions.
Turkey's current account balance strengthened to a surplus of USD5.1 billion in the 12 months to August, from a deficit of USD57.9 billion in May 2018, and its external financing requirement has continued to ease somewhat. The rollover rate for the non-bank private sector was a robust 97% on a rolling 12-month basis to mid-August, while banks' demand for FX has reduced in line with a fall in FX lending (of 6% in the year to mid-October) and some drawdown in their sizeable foreign currency liquidity.
Nevertheless, Turkey's gross external financing requirement remains large and a source of vulnerability - ֳ forecasts it at close to USD170 billion (including short-term debt) for 2020. The majority of the current account adjustment has come from import compression (although exports have also grown) and ֳ expects some widening of the current account balance as domestic demand recovers, with deficits of 0.3% of GDP in 2019, 0.9% in 2020 and 1.8% in 2021 - but still well below the 2018 deficit of 3.5%.
The exchange rate has been relatively stable in the face of 10pp of policy interest rate cuts by the Central Bank of Turkey since July, depreciating 0.5% against the US dollar and trading within the range of 5.48-5.92. Exchange rate effects have been the main driver of a fall in inflation, to 9.3% in September from 16.7% in July. Gross foreign exchange reserves are up USD8.1 billion in the year to September and by USD3.9 billion since July, to USD101.1 billion.
Turkey's 'BB-' IDRs also reflect the following key rating drivers:-
Turkey's rating is supported by its large and diversified economy with a vibrant private sector, GNI per capita that compares favourably with 'BB' medians and moderate levels of government and household debt. Set against these factors are Turkey's weak external finances, high inflation and a track record of overshooting inflation targets and of economic volatility. Political and geopolitical risks also weigh on Turkey's ratings, with the capacity to disrupt economic adjustment, and raising concerns about government effectiveness and policy predictability in an environment where checks and balances have been eroded.
Turkey's track record of high and volatile inflation, weak monetary policy credibility and limited central bank independence heighten the risk of renewed macroeconomic instability. Following July's dismissal of the central bank governor for failing to following government instruction on interest rates, there has been an overhaul of senior officials at the central bank, and the main policy rate has been cut to 14% from 24%. This comes against a backdrop of President Erdogan regularly expressing unorthodox views on the relationship between interest rates and inflation.
ֳ forecasts that inflation will remain relatively high at 12% at end-2020 and 10% at end-2021, compared with the central bank forecast of 5.4% (and well in excess of the current 'BB' median of 3.4%). Market inflation expectations have remained sticky at 9.8% in two years' time, although are partly adaptive. Combined with Turkey's large external financing requirement and susceptibility to shocks, this may make it challenging to substantially reduce the main policy rate without risking renewed currency depreciation that could increase stresses on corporate and bank balance sheets.
We have maintained our GDP growth forecast of 3.1% for 2020 as rising disposable incomes support consumption, and 3.6% in 2021 as lower financing costs and some recovery in confidence also feeds through to investment growth. This is below our assessment of Turkey's trend rate of growth of 4.3%, and similar to the peer group median (average 3.3% in 2020-2021). Our 2019 GDP forecast has been revised up 0.8pp since our last review to -0.3% on the back of stronger 2Q outturns. The return to mild growth so far this year has been driven by net trade and supported by fiscal easing (as well as state bank credit stimulus) which will provide less support from 4Q19.
Geopolitical risks continue to weigh on Turkey's rating. Last week the US president announced the removal of sanctions relating to Turkey's military offensive in north-east Syria. This came after the agreement struck between Turkey and Russia on the removal of the Kurdish YPG from a 30km buffer zone that the two countries will jointly patrol. In our view, the US position also makes it more likely that the implementation of US sanctions triggered by delivery of S400 missile components from Russia will be on the lighter side of those set out in the legislation, and potentially subject to a lengthy delay. Nevertheless, this week the US House of Representatives passed a new bipartisan bill threatening new sanctions on Turkey, and US policy in these areas has the potential to change quickly. We do not expect Turkey's operation in Syria to have a significant impact on credit fundamentals in the absence of a more far-reaching conflict.
ֳ forecasts an increase in the general government budget deficit to 3.3% of GDP in 2019, from 2.4% last year, reflecting weak economic activity and counter-cyclical fiscal measures, particularly in 1Q. The deficit is contained by an estimated 0.5% of GDP improvement in the local government balance, and by the transfer of half of the central bank's contingency reserve, also equivalent to 0.5% of GDP. ֳ then expects a broadly flat general government balance, with deficits of 3.3% in 2020 and 3.1% in 2021, marginally above the government targets. We consider that the government views its central government deficit target of less than 3% of GDP as an important policy anchor and would likely adopt new, one-off measures to limit budget shortfalls that arise for example from GDP growth undershooting the 5% target. ֳ forecasts general government debt will increase to 32.5% of GDP at end-2021 from 30.1% at end-2018, but still well below the 'BB' median of 46.7%. There has also been a steady increase in contingent liabilities, albeit from a low base.
ֳ does not anticipate a marked acceleration of structural reforms under the New Economy Programme (NEP), despite the conducive electoral cycle (with no national elections now due until 2023). The NEP retains a number of structural measures that have been welcomed by the private sector such as enhancing the insolvency process, reforming the pension system, and cutting corporation tax. However, the ambitious 5% GDP growth target and some ongoing measures to stimulate state bank lending could signal a prioritisation of short-term growth over more difficult structural reforms with a longer planning horizon. ֳ views the macroeconomic forecasts underpinning the NEP as highly optimistic. Turkey has never previously sustained a combination of strong GDP growth, low inflation and current account close to balance.
Banking sector metrics remain under pressure from the challenging operating conditions. The announced classification of TRY46 billion of loans as NPLs is reported to take the NPL ratio to 6.3% by year-end, from 5.0% in September and 3.9% at end-2018. ֳ expects a further increase partly reflecting the still-high Stage 2 loans (estimated at around 12%). Loan growth has been muted, despite some pick-up since July to near 5% (FX-adjusted). Credit growth has been largely driven by state banks, resulting in erosion of their capital and profitability buffers. However, sector capital adequacy (18.4% total capital ratio in September) remains comfortably above minimum regulatory requirements and has been supported by additional Tier 1, Tier 2, issuance and foreign currency deleveraging. Pre-impairment profit continues to provide a buffer to absorb credit losses, and banks' funding costs which have already started to decline should further benefit from the lower policy interest rate.
Sovereign Rating Model (SRM) and Qualitative Overlay (QO)
ֳ's proprietary SRM assigns Turkey a score equivalent to a rating of 'BBB-' on the Long-Term Foreign-Currency (LT FC) IDR scale.
ֳ'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 and low international liquidity ratio.
- 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 foreign relations that could impact economic stability.
ֳ'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. ֳ'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.
RATING SENSITIVITIES
The main factors that may, individually, or collectively, result in positive rating action are:
- A sustained decline in inflation, a rebuilding of monetary policy credibility and a track record of greater macroeconomic stability.
- A reduction in external vulnerabilities, for example evident in a sustained current account close to balance, a stronger external liquidity position and reduced dollarisation.
- An improvement in governance standards or reduction in political risk.
The main factors that may, individually, or collectively, result in negative rating action are:
- Disruption to the path of economic stabilisation and rebalancing that is consistent with lower inflation and external vulnerabilities.
- Heightened stresses in the corporate or banking sectors potentially stemming from a sudden stop to capital inflows or a more severe recession.
- A marked worsening in the government debt/GDP ratio or broader public balance sheet.
- A serious deterioration in the domestic political or security situation or international relations.
Key Assumptions
ֳ forecasts Brent Crude to average USD65/b in 2019 and USD62.5/b in 2020 and USD60.0/b in 2021.
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 ֳ'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 ֳ'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 voice and accountability is reflected in the World Bank Governance Indicators that have the highest weight in the SRM. They 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 trade 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.
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PARTICIPATION STATUS
The rated entity (and/or its agents) or, in the case of structured finance, one or more of the transaction parties participated in the rating process except that the following issuer(s), if any, did not participate in the rating process, or provide additional information, beyond the issuer’s available public disclosure.