When Moody’s cut Turkey’s credit rating to junk status on September 23 there were fears it would trigger a wild sell off of Turkish assets and send the lira tumbling.

Stocks did fall more than 4%, the lira weakened about 1%, and the yield on the two-year benchmark note increased to 9% on September 26 from Friday’s 8.7%. But, that was it: no panic sell-off and no massive outflow from Turkish assets followed.

The fall-out from the downgrade was also short-lived. The main stock exchange index, the BIST-100, recovered in the following days and the lira reversed some of its losses. The Treasury’s debt auctions attracted strong bids, underlining investors’ continuing interest (and confidence) in Turkish assets despite the failed coup attempt in July.

The downgrade was actually Turkey’s second since the botched putsch. Standard & Poor’s cut the country’s rating shortly after the coup attempt. Fitch is now the only major rating agency to keep Turkey at investment grade. Fitch’s next review is expected in early 2017.

The rating agency cited 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, notably growth and institutional strength.

Predictably, top government officials question Moody’s motives, dismissing the rationale behind the rating cut. According to deputy premier Numan Kurtulmus this was a politically motivated decision, while other senior ministers, including deputy premier Mehmet Simsek, the economy tsar, pointed to the strong macroeconomic fundamentals, lashing out at the rating agency for poor judgement.

Prime Minister Binali Yildirim asked, “what changed in two days?” compared to the rating agency’s earlier comments that the impact of the coup had dissipated.

Half full or half empty?

The downgrade has triggered a debate among Turkey commentators and analysts as to whether the move was justified, and over its likely impacts in the short to medium term.

Certainly Turkey’s $720bn economy is facing challenges and headwinds. GDP growth slowed in the second quarter. The engine of growth, private consumption, is losing steam. Household consumption, which accounted for nearly 70% of national income, increased by 5.2% y/y in Q2, weakening from the 7.1% y/y rise in the first three months of the year.

The government is responding to the slowing growth and weaker consumption appetite by announcing a set of measures to boost demand at a time when inflation still hovers above 8%. The central bank is supporting the government’s efforts to revive the economy through rate cuts.

But the main concern is Turkey’s heavy dependency on foreign funds to plug its current account deficit, the economy’s Achilles’ heel.

Some analysts had previously suggested that Moody’s action could trigger capital flight. 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.

In response to such claims, deputy premier Nurettin Canikli argued that a possible rating downgrade had already been priced in, that’s why the market reaction has been rather muted. The government does not plan specific measures after Moody’s downgrade, Canikli added.

From the external funding perspective, the junk grade will probably make life a little more difficult for Turkish corporates and banks as they will face higher borrowing costs. Moody’s estimates that 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. This large external funding need exposes the country to sudden shifts in investor confidence, according to the rating agency.

Relentlessly bullish Tim Ash at Nomura downplays such fears. “Turkey downgrade – what downgrade?” asked Ash when the markets recovered from Monday’s volatility and the Treasury’s debt auctions saw strong demand. “Ok, fortunate this all happened in a liquid EM market, but still...Turkey is proving durable.” The real story is how limited the sell-off has been, according to Ash.

“Many investors have been waiting for the downgrade to create value to buy back into Turkey - so these same investors don't see fundamental and systemic risk in Turkey or much less so than Moody's evidently,” Ash said in an emailed commentary on September 26. “Just to highlight the strengths again - sound public finances, strong demographics, pro-business culture, diversified export structure, strong banks, et al, plus and as a reflection of all the above a durability of growth.”

However, for those on the more pessimistic side argue that what really matters is not the immediate market reaction but the underlying growth dynamics.  “The loss of the country’s investment grade status caused a small and short-lived sell-off in local financial markets, but perhaps more importantly it shifted investors’ attention to the health of the economy,” claim the analysts at Capital Economics. “The past month has bought plenty to worry about on this front.”

Lessons learnt?

In a similar vein, Morgan Stanley analysts see Moody’s action as a structural downgrade not a cyclical one. They think the macro implications should be limited in the short term, yet some structural issues may be lurking beneath the surface for both growth (through a higher cost of borrowing creating pressure on consumption and investment) and the public finances (through a combination of price, currency and economic growth effects). Morgan Stanley expects $2bn-$3bn of forced selling.

Morgan Stanley underline the potential risks from the downgrade but also point to the country’s strengths, which can help it weather the fall-out from losing the investment grade. Ammunition to provide more support through macro-prudential measures and strong public finances are likely to minimise the repercussions of the downgrade, they say.

At the end of the day, they think the glass is still half-full, pointing to the fact that Moody’s kept Turkey’s outlook stable. The investment bank urges the authorities to focus more on structural reforms to maintain the investment grade from Fitch.

It looks like those warnings are not falling to deaf ears in Ankara. “Turkey will draw lessons from the credit downgrade and is already tackling some of the challenges highlighted by the agency, including structural reform and improving the quality of its institutions, Finance Minister Naci Agbal told Reuters on September 28.

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

Key as to whether Turkish market durability endures is the policy reaction, according to Ash.  “Rating agency bashing will go down badly with markets and investors, and it would be much healthier all around if Turkish policy makers reacted by rolling out a credible reform programme, and the central bank should be part of that programme.”