Moody’s Investors Service has stripped Turkey of its investment grade status, cutting its long-term issuer and senior unsecured bond ratings to ‘Ba1’ from ‘Baa3’ in another blow to an economy hit by terrorist attacks and a failed coup attempt. 

Moody’s cited in its statement published on September 23 two reasons for the downgrade: the increase in the risks related to the country’s sizeable external funding requirements and the weakening in previously supportive credit fundamentals, particularly growth and institutional strength. The outlook on the ratings was kept at stable because Turkey’s headline fiscal metrics are still favourable, Moody’s said.

The rating cut from Moody’s leaves Fitch Ratings as the only major rating agency to keep Turkey at investment grade. Standard & Poor’s already downgraded Turkey’s ratings into high yield status in the wake of the failed July 15 coup attempt. In August, Fitch affirmed the country’s long-term foreign and local currency issuer default ratings (IDR) at ‘BBB-’, the lowest investment grade, but it downgraded the outlook to negative from stable.

Moody’s expects the slow deterioration in Turkey’s credit profile to continue over the next two to three years. “Growth will slow over the coming years, as constraints on the externally-funded, consumption-fuelled economy emerge, the reform agenda slows further and the investment climate remains weak,” it said in a statement on its website.

Turkey’s $720bn economy slowed in the second quarter of this year and is showing signs of further weakening: industrial production contracted sharply in July and the PMI index fell in August to its lowest level since early 2009. The government is responding to the slowing growth by announcing a set measures aimed at boosting domestic demand. Consumer loan repayment period will be extended to 48 months from the current 36 months, while the limit for credit card instalments will be increased to 12 months from nine at present. Credit card debts will also be restructured.

The other macroeconomic indicators are not very promising either. The jobless rate rose to a four-month high of 10.2% in June and consumer confidence is now dwindling while inflation remains high. The current account deficit, the economy’s traditonal Achilles’ heel, is declining but is still large, making Turkey dependent on foreign capital inflows.  

JP Morgan estimated in July that the removal of the country from investment grade could trigger forced selling of around $9bn-10bn worth of Turkish bonds. “I think this number is too high, as much will have already left/reduced given the nervousness over this move since the ratings were put on negative ratings watch back in July,” Tim Ash of Nomura International commented after Moody’s downgrade.

Normally a central bank is expected to raise rates to attract foreign capital when the country goes through such difficult times (ie, a failed coup attempt, weak growth, a civil war across the border, and domestic security risks), but Turkey’s central bank is moving in the opposite direction. It once again reduced its overnight lending rate by 25bp to 8.5% this month.

Elevated risks

“Turkey continues to operate in a fragile financial and geopolitical environment and that its external vulnerability has risen, both over the past two years and more recently as a result of unpredictable political developments and volatile investor perception,” Moody’s said in the statement, adding that this has credit implications for Turkey given its strong dependence on foreign capital.

The risk of a sudden, disruptive reversal in foreign capital flows, a more rapid fall in reserves and, in a worst-case scenario, a balance of payments crisis has increased, according to the rating  agency. According to Moody’s’ calculations Turkish corporate, banking and government sectors need to repay approximately $156bn in external liabilities this year and together with the current account deficit, this amounts to an estimated 26% of GDP in 2016 and in 2017, exposing the country to sudden shifts in investor confidence.

“The erosion of Turkey’s institutional strength has negative implications both for the level of growth in the coming years and for the implementation of the structural changes the government has identified are needed to deliver balanced, sustainable growth and relieve external pressures,” it said.

Moody’s expects real GDP to grow at an average of 2.7% over the 2016-19 period, while its current account deficit forecasts for 2016 and 2017 stand at 4.3% and 4.0% of GDP, respectively.

Downgrade angers politicians

Senior Turkish politicians have criticised Moody’s downgrade, arguing the decision was biased and ignored solid economic fundamentals. “Just two days ago, Moody’s said Turkey has overcome the shocks from the failed coup attempt – what changed in two days?” Prime Minister Binali Yildirim scolded on September 24. “We don’t think these assessments are unbiased. They wanted to create a perception of the Turkish economy.”

Echoing Yildirim, Deputy Prime Minister Mehmet Simsek and Economy Minister Nihat Zeybekci pointed to the sound foundations of the economy and dismissed Moody’s concerns, while pledging more reforms. “In an environment of a global economic slowdown, the Turkish economy grew by 3.9% in the first half of the year,” Zeybekci wrote on Twitter.

“Speeding up the structural reforms and maintaining the fiscal discipline will be our best response to the rating agencies,” Simsek tweeted.

In an interview with Bloomberg last week ahead of Moody’s decision, President Recep Tayyip Erdogan said he doesn’t care if Turkey’s rating gets downgraded to junk. “They [rating agencies] are making mistakes and they are doing it intentionally. Turkey’s economy is strong,” he told Bloomberg.

Tim Ash, who also disagrees with Moody’s rating move, said: “I guess these kind of comments are meant for the domestic audience, and to deflect any domestic political criticism/blame for the downgrade”. These kind of comments damage Turkey's credibility externally and particularly in the eyes of investors, he added.

According to Ash, there will be a move weaker on September 26 morning in the Turkish lira and yields, but he does not think the rating move will create new and big systemic risks for Turkey. “We will see the loss of some cross-over money, but more dedicated EM money will be pulled back in by better valuations.”

The lira extended losses early on September 26, trading down around 1.5%, while credit default swaps had widened by around 20bp and yields by 38bp.