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

DBRS, Inc. 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 well-capitalized banking system, all of which enhance the resilience of the economy to adverse shocks. The rating strengths are countered by several challenges, including large external imbalances driven by low domestic savings and structural bottlenecks that impede higher productivity and greater utilization of labor resources. Political uncertainty domestically and geopolitical risks stemming from events in neighboring countries 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 external accounts are gradually rebalancing amid lower oil prices and moderate domestic demand. However, in the context of monetary policy normalization in the U.S., economic fragility in Europe and geopolitical concerns in the Middle East, Turkey’s large external financing needs pose substantial near-term risks.

The ratings could experience downward pressure if (1) insufficient policy action is taken to reduce the current account deficit, (2) the commitment to price stability and sustainable public finances materially weakens, or (3) a sharp reduction in capital inflows has severe effects on the economy and the financial system. DBRS does not see upside pressure on the ratings in the near term.

The ratings are supported by the size and diversity of the Turkish economy. Turkey is an upper-middle income country with nominal GDP of approximately $800 billion. Real GDP expanded at an average annual rate of 4.1% over the last decade, led by large contributions from capital and labour. Favorable demographics should continue to support the growth outlook. The population of Turkey is the youngest in Europe and the number of working-age persons is projected to grow more than 20% from 2012 to 2030.

Consistent primary surpluses have strengthened the public sector balance sheet. Public debt declined from 78% of GDP in 2001 to 33% in 2014, a moderate level compared to other BBB rated sovereigns. Sound debt management has also reduced exposure to exchange rate and interest rate risks. Of the central government debt, two-thirds is denominated in local currency and the average time to maturity has been extended to 6.5 years.

Turkey’s banking system remains well-capitalized despite bouts of market volatility over the last two years. The capital adequacy ratio for the sector is above 15%, 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 $176 billion net foreign exchange exposure in April 2015. In an adverse scenario characterized by higher interest rates, currency depreciation and slower economic growth, bank profitability and asset quality could deteriorate.

Notwithstanding the credit strengths, Turkey’s large external financing needs pose substantial risks. The current account deficit is gradually adjusting even as problems in Iraq and Russia have dampened export growth. However, the external gap remains large and the quality of foreign funding is poor. Moreover, the international environment is characterized by rising geopolitical risks, a fragile recovery in Europe, and expectations of higher interest rates in the United States. 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.

Policy space to respond to a shock has also narrowed. Monetary policy action is constrained by above-target inflation expectations and pass-through effects from exchange rate depreciation. On the fiscal side, the government has maintained primary surpluses, but non-interest spending has increased at strong pace and the fiscal position could deteriorate as economic activity shifts towards exports, which are less revenue-intensive.

In addition, growth prospects are relatively weak due to macroeconomic imbalances and structural constraints. One major challenge is the low savings rate. Over the last six years, Turkey’s national savings averaged less than 14% of GDP, a very low level given the country’s investment needs. Other important structural impediments include restrictive labor and product market regulations, which hamper the economy’s productivity performance. Boosting domestic savings and improving productivity will likely depend on supply-side reforms.

Turkey faces the uncertain prospect of a coalition government following the June 2015 general elections. Regardless of the outcome of coalition negotiations, DBRS believes current macroeconomic policies will be largely maintained. Consensus on broader economic reforms, however, are less likely. Recent statements by party leaders suggest that the most likely partnership – if one is formed – is a grand coalition between the Justice and Development Party (AKP) and the Republican People’s Party (CHP). If a coalition agreement is not reached by mid-August, early elections will likely be called for November 2015.

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 Turkish Statistical Institute, Central Bank of the Republic of Turkey, Undersecretariat of Treasury, Ministry of Development, IMF, World Bank, The Conference Board Total Economy Database 1990-2015, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating 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: Alan G. Reid
Initial Rating Date: 23 May 2013
Most Recent Rating Update: 28 July 2014

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