DBRS Confirms the Republic of Turkey at BBB (low), Stable Trend

DBRS, Inc. (DBRS) has confirmed the Republic of Turkey’s long-term foreign currency issuer rating at BBB (low) and the long-term local currency issuer rating at BBB. The trend on both long-term ratings is Stable. DBRS has also confirmed the short-term foreign currency issuer rating at R-2 (middle) and the short-term local currency issuer rating at R-2 (high). The trend on both short term ratings is Stable.

The confirmation reflects Turkey’s large and diverse economy, moderate levels of public debt and solid banking system. In addition, economic growth over the last decade has been strong, underpinned by macroeconomic stability, employment growth and labor productivity gains. These strengths counter Turkey’s rating constraints, which include large external imbalances, low domestic savings, and structural bottlenecks that impede higher productivity and greater utilization of labor resources. Political risks domestically and in neighboring countries such as Iraq also weigh on the ratings.

The Stable trend reflects DBRS’s view that Turkey has space to manage near-term economic challenges. Fiscal accounts post a primary surplus, private sector leverage has increased but remains at moderate levels, and the banking system has adequate capital buffers. Moreover, the economy appears to be rebalancing as domestic private sector demand moderates and net exports benefit from a weaker currency and strengthening demand from Europe. However, in the context of monetary policy normalization in the U.S. and intensifying geopolitical risks, Turkey’s reliance on short-term external financing poses substantial near-term risks.

The trend could be changed to Positive if external imbalances are reduced in a durable manner, the domestic savings rate increases, and fiscal discipline is maintained. Conversely, the ratings could experience downward pressure if (1) insufficient policy action is taken to sustainably reduce the current account deficit, (2) a sharp and protracted reduction in capital flows has severe effects on the economy and the financial system, or (3) the commitment to sustainable public finances materially weakens.

The ratings are supported by the size and diversity of the Turkish economy. Real GDP expanded at an average annual rate of 4.9% over the last decade. As a result, Turkey is an upper-middle income country with nominal GDP of over $800 billion and a population of 75 million. Demographic trends in Turkey support the country’s growth prospects. The working age population is projected to grow nearly 20% from 2012 to 2030.

Consistent primary surpluses and sound debt management have also strengthened the public sector balance sheet. Public debt declined from 78% of GDP in 2001 to 36% in 2013, a moderate level compared to other BBB rated sovereigns. At the same time, the share of central government debt denominated in local currency increased from 62% in 2005 to 69% in May 2014, the share with fixed rates climbed from 50% to 64%, and the average time to maturity increased from 2.9 years to 6.0 years. As a result, public debt is less exposed to exchange rate and interest rate risks.

Turkey’s banking system remains strong and resilient despite bouts of market volatility over the last two years. The capital adequacy ratio for the sector is above 16%, the quality of the capital is strong, and non-performing loans are less than 3% of total loans. Although banks’ external obligations have increased substantially, their net foreign exchange exposure remains modest. On the other hand, the rapid expansion of credit over the last decade raises some concern over loan quality. Furthermore, banks are indirectly exposed to exchange rate risk through the corporate sector, which had a $170 billion net foreign exchange exposure in April 2014. In the context of higher interest rates, currency depreciation and slower economic growth, bank profitability and asset quality could weaken.

Notwithstanding Turkey’s credit strengths, large external financing needs and reliance on short-term funding pose substantial risks. External imbalances are gradually adjusting as exports to Europe strengthen and domestic demand moderates. Excluding the gold balance, the current account narrowed from 9.1% of GDP in 2011 to 6.4% in the first quarter of 2014. However, the external gap remains large and the quality of foreign funding is poor. In the event of an adverse shock or sharp tightening in global financial conditions, net capital inflows could stop or even reverse. The resulting adjustment would likely have strong negative effects on growth.

In addition to external vulnerabilities, the Turkish economy faces several structural challenges. First and foremost, Turkey’s low savings rate presents a major obstacle to strong and balanced economic growth. Over the last five years, national savings averaged less than 14% of GDP, a very low level given the country’s investment needs. In the absence of higher domestic savings, it could be difficult for Turkey to sustain strong growth without excessively relying on foreign savings.

Restrictive labor and product market regulations could also constrain labor participation and productivity growth. Turkey's labor market is characterized by high structural unemployment, low participation and high informality. A number of rigidities in the market, such as the high tax wedge on labor and strict employment protection rules, discourage formal job creation and limit the movement of labor to more productive sectors of the economy. Poor education outcomes also point to the need to upgrade the technical capacity of the workforce. Furthermore, insufficient competition in key non-tradable sectors, such as electricity and telecommunications, keeps business costs high and adversely affects international competitiveness.

Inflation has been persistently high and will likely surpass the inflation target in 2014 for the fourth straight year. Moreover, inflation expectations over the next 12 months reached 7.3% in July 2014. With inflation well above the target and inflation expectations trending upwards, DBRS believes there is limited space to provide monetary support if the economic outlook weakens.

In addition, heightened political uncertainty and mounting geopolitical risks could increase foreign funding challenges. Results from the March 2014 municipal elections reconfirmed that the Justice and Development Party (AKP) and Prime Minister Erdoğan continue to enjoy widespread public support. The AKP hopes to build on this success in Turkey’s first direct presidential elections in August 2014 and the next parliamentary elections in 2015. Although the AKP looks well-positioned ahead of the general elections, slower-than-expected economic growth and intra-party tensions could broaden support for the opposition and increase political uncertainty. Rising geopolitical risks are also a source of concern. Instability in Iraq could weaken demand for Turkish exports, generate higher oil import prices and add to inflationary pressures, thereby dampening growth prospects and complicating efforts to narrow the current account deficit.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales.

The sources of information used for this rating include the Central Bank of Turkey, Ministry of Finance, Turkstat, IMF and Haver Analytics. DBRS considers the information available to it for the purposes of providing these ratings was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Michael Heydt
Rating Committee Chair: Roger Lister
Initial Rating Date: 23 May 2013
Most Recent Rating Update: 23 May 2013

For additional information on this rating, please refer to the linking document under Related Research.