Fitch Ratings has affirmed Turkey's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'BB' with a Negative Outlook, the rating agency said on May 3.
The rating agency placed Turkey at BB/Negative, two notches below investment grade, together with Guatemala and Vietnam. Moody’s Rating Services rates Turkey at Ba3/Negative, three notches below investment grade, together with Bangladesh, Bolivia and Vietnam, while Standard & Poor’s rates Turkey at B+/Stable, four notches below investment grade, together with Kenya and Greece.
Turkey's rating and Negative Outlook reflected weak external finances, manifest in its large external financing requirement, low foreign reserves as well as a high net external debt, high inflation, a track record of economic volatility, and political and geopolitical risks, Fitch observed.
The rating is supported by strong public finances, a large and diversified economy with a vibrant private sector, and GNI per capita and human development indicators above the medians in Turkey’s peer group.
The country’s economy is adjusting to a sharp depreciation of the lira in 2018, which stemmed from the materialisation of external financing vulnerabilities, aggravated by political and geopolitical developments, the rating agency noted.
The rapid correction in the current account deficit was seen as a necessary step on the path towards rebalancing and stabilisation. However, significant uncertainties remained around the outlook for an economic recovery and inflation, economic policy implementation, and the impact on the public finances and banking sector, Fitch said.
The external sector remains a major credit weakness. There has been a significant adjustment of the current account, driven by import compression and supported by services exports and underpinned by the floating exchange rate. On a rolling six-month basis, the current account posted a surplus of $2.7bn at end-February, compared with a deficit of $32bn a year earlier.
FX reserves fell ahead of elections
Gross foreign exchange reserves (including gold) rose by $7bn in the first two months of 2019, but fell to $96.3bn in March ahead of the end-of-month local elections, with the decline particularly sharp in net terms to around $28bn, “possibly reflecting efforts to keep the exchange rate stable ahead of the polls”.
“Market concerns about the reserves position appear to have contributed to a renewed fall in the lira, which could add to dollarisation pressures,” Fitch said.
Fitch forecasts weak domestic demand and a further improvement in services exports to underpin a current account deficit of 0.7% of GDP in 2019 (the smallest figure since 2002), less than projected net FDI inflows (1.2% of GDP).
“Gradual private sector deleveraging should also continue”; at end-February, the external debt rollover by banks was 80% and 93% for the non-bank private sector on a rolling six-month basis, reflecting reduced demand for FX as well as higher borrowing costs.
“Nonetheless, the external financing requirement will remain large due to private sector debt repayments,” Fitch added.
“Vulnerable to global investor sentiment”
The rating agency estimated Turkey’s total external financial requirement (including short-term debt) at $173bn in 2019, down from $212bn in 2018. “The financing requirement means Turkey will remain vulnerable to global investor sentiment and financial conditions, domestic political and economic policy uncertainty and a pronounced deterioration in relations with the US,” it said.
“Fiscal performance has been hit by the weak economy,” Fitch also observed. In Q1, the central government deficit was TRY36.2bn (0.8% of projected full-year GDP) up from TRY20.4bn a year ago, despite a TRY42.9bn jump in non-tax revenues due to the early payment of the central bank dividend.
“Pre-election stimulus measures affected both tax revenues (up only 5.8%) and primary expenditure (up 33.5%),” the agency added.
The government did not revise its fiscal targets (notably a 2019 deficit of 1.8% of GDP) or include new measures in its updated economic reform plan, despite the tough first quarter and an optimistic growth assumption of 2.3%.
Fitch assumes policy will be tightened as the election-related stimulus rolls off and other consolidation measures are implemented, but forecasts that the targets will be missed with a central government deficit of 2.4% of GDP in 2019 (general government deficit of 3.1%).
“A rebound in the economy will lift revenues in 2020, narrowing the general government deficit to a forecast 2.7% of GDP.”
“The moderate level of gross general government debt (GGGD) is forecast to remain a key rating strength.”
Fitch expects GGGD/GDP to rise to 31% at end-2019 from 30.4% at end-2018 owing to the widening of the fiscal deficit and assuming 0.5% of GDP support for state banks. This is well below the forecast median for 'BB' peers of 45.1%. GGGD/GDP is expected to decline to 30.2% in 2020.
Fitch's projections do not include further sovereign support for the banks.
“Exchange rate volatility poses a risk to debt dynamics,” Fitch said; 47% of central government debt was FX-denominated at end-February.
“Various discretionary policy measures were implemented ahead of local elections in March”, the rating agency added.
Risk of “distortions”
“While the government has fiscal space for counter-cyclical policies, the nature of some measures, notably interventions in the food retail market and ramped-up lending by state banks and reported pressure on private sector pricing policy risk creating distortions if maintained and raise questions over the broader policy stance,” Fitch said.
“The new economic reform plan published shortly after the elections did not refer to these policy measures and lacked detail, but did provide approximate timelines for individual initiatives,” it noted, adding: “Some of the structural measures in the plan have been welcomed by the private sector, particularly reforms to the insolvency process and politically difficult pension and severance pay reform.”
The post-election period could be more conducive to economic reform. A start could be made on tackling long-standing structural weaknesses, although Fitch remains cautious about the prospect of meaningful progress.
“Tough operating conditions continue to put pressure on the banking sector,” it added.
NPLs (loans overdue by 90+ days, solo basis) were 4.1% in April, up from 3% at end-2017; Stage 2 loans—which could migrate to NPLs in the course of the loans season—rose to 11.7% in February from 4.4% at end-2017, albeit partly reflecting IFRS9 implementation.
“Downside risks to asset quality remain significant given operating environment pressures,” the rating agency said.
Capital adequacy above requirement
Capital adequacy remains above the regulatory requirement, at 16.4% at end-March. Fitch's stress tests showed that pre-impairment profit and capital buffers provide a significant cushion against a potential marked deterioration in asset quality, a weakening in profitability and potential Turkish lira depreciation.
In April, the government injected TRY24bn of euro-denominated additional Tier 1 capital (equal to around 0.5% of GDP) into the state banks. This followed fairly rapid growth at these banks—in contrast to the rest of the banking sector—in Q1. Some private banks have also raised new capital.
“Refinancing risks for Turkish banks remain high following recent heightened market volatility and given the large stock of short-term external debt on banks' balance sheets (end-2018: $90bn on a remaining maturity basis),” Fitch said.
However, it estimated banks' total external foreign currency debt due within 12 months, net of more stable sources of funding, to be $40bn-$45bn compared with available foreign currency liquidity of $75bn-USD80bn.
“Turkey is undergoing a deep economic recession, but the economy seems to have bottomed after contracting 4% (non-annualised) in the second half of 2018, with net trade the main source of sequential growth,” Fitch said.
“Election-related temporary stimulus and rapid credit growth from state-owned banks have also contributed to the nascent Q1 recovery, pointing to a likely easing of momentum in Q2, particularly if accompanied by tighter fiscal policy,” it added.
In Fitch’s eyes, base effects mean that annual growth rates in Turkey will remain negative until Q4. It forecast that the Turkish economy will contract by 1.1% y/y in 2019.
The unemployment rate has risen rapidly. Growth should revive in 2020, but at a forecast 3.1% it will be below Fitch's estimate of trend growth (4.3%, recently revised down from 4.8%).
Average 2018-2020 growth of 1.5%
Average growth for 2018-2020 of 1.5% compares with an average for 2010-2017 of 6.8%.
Inflation has dipped from its peak, but remained elevated at 19.7% in March.
Weak domestic demand and base effects should put inflation on a downward path, but PPI remains high (29.6%) and “the impact of unwinding temporary tax and other price control measures is unclear”, Fitch said.
Fitch forecast that inflation would average 14.2% in 2019, the highest level of any sovereign rated above the 'B' category.
The policy rate was kept at 24% in April and is rising in real terms. “High dollarisation and the increased role of state bank lending and informal pressure on bank interest rates may be undermining transmission channels,” Fitch noted.
In Fitch's view, monetary policy credibility is weak in Turkey and potential mis-steps are a downside risk to the economic adjustment path.
Political and geopolitical risks weigh on Turkey's ratings, and World Bank governance indicators are below the 'BB' median. Tolerance of dissenting political views has reduced in the opinion of independent observers.
The opposition alliance won several key cities in local elections in March (the ruling AKP is contesting a narrow defeat in Istanbul), benefiting from the weak economy and a disciplined approach to the campaign. The elections completed a prolonged electoral cycle and the next polls are not scheduled for more than four years. Domestic security conditions have improved recently.
At times ‘volatile international relations’
In Fitch's view, geopolitical risks arise from Turkey's complex and at times volatile international relations. There are a number of pressure points in relations with the US, most particularly the government's planned purchase of the S-400 missile defence system from Russia; sanctions would be triggered by the arrival of the first S-400 missile components in the country.
Fitch's proprietary Sovereign Rating Model (SRM) assigned Turkey a score equivalent to a rating of 'BBB-’ on the Long-Term Foreign-Currency (LT FC) IDR scale.
However, Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its Qualitative Overlay (QO), relative to rated peers, as follows:
- 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, a weakening banking sector and the risk of developments in foreign relations that could impact financial stability.
The main factors that, individually, or collectively, could lead to a downgrade are:
- Failure to rebalance and stabilise the economy 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 increase in the government debt/GDP ratio to a level closer to the peer median.
- A serious deterioration in the domestic political or security situation or international relations.
The main factors that, individually, or collectively, could lead to a stabilisation of the Outlook are:
- A sustainable rebalancing of the economy evidenced by a reduction in the current account deficit and inflation that reduces external vulnerabilities
- A political and security environment that supports a pronounced improvement in key macroeconomic data
Fitch forecasts Brent Crude will average USD65/b in 2019 and USD62.5/b in 2020.