DBRS Confirms Republic of Turkey at BB (high), Negative Trend

DBRS, Inc. has confirmed the Republic of Turkey’s long-term foreign currency issuer rating at BB (high) and the long-term local currency issuer rating at BBB (low). DBRS has also confirmed the short-term foreign currency issuer rating at R-3 and the short-term local currency issuer rating at R-2 (middle). The trend on all ratings is Negative.

The Negative trend reflects downside credit risk associated with the deterioration in the rule of law and elevated geopolitical tensions, all in the context of Turkey’s large external financing needs. Reduced external funding poses clear risks to the macroeconomic outlook. The fallout of the July 2016 failed coup attempt and the upcoming constitutional referendum has led to an increase in political uncertainty. This could divert political attention from the much-needed structural reform agenda, which is important to boost national savings and reduce external imbalances. In addition to domestic political uncertainty, geopolitical risks stemming from events in neighboring countries also weigh on the ratings.

Turkey’s large external financing is a key source of vulnerability. Growth has been primarily driven by domestic demand, and despite the recent revision in Turkey’s national account statistics (savings are now estimated at 27% of GDP v/s 14.5% as per the old series), growth has come at the expense of high current account deficits. Moreover, structural energy imbalances and dimming prospects for tourism are likely to keep the current account deficit elevated. Increasing external indebtedness of non-financial corporates has added to the buildup of imbalances. Gross external debt rose to US$416 billion (49% of GDP) in the third quarter of 2016. Consequently, taking into account Turkey’s current account deficit and maturing liabilities of the public and private sector, Turkey faces a high annual external financing requirement of 25% of GDP. Although banks and corporates have demonstrated resilience since 2011, given the relatively low level of net foreign exchange reserves, sudden stops or a reversal in net capital inflows could have negative effects on the economy.

The government response to the failed coup attempt in July 2016 has increased political uncertainty. The widespread suspension or removal of judges, academics, journalists, civil servants including one-third of the staff of the banking and supervisory agency, in addition to military suspects, raises concerns about the rule of law. In addition, the erosion of institutional checks and balances could weaken policy predictability and investor sentiment. The upcoming referendum on a new Constitution replacing the existing parliamentary system of government with an executive presidency adds to the political uncertainty.

Policy space to respond to a shock has also narrowed. Monetary policy action is constrained by above-target inflationary expectations and the pass-through effects from exchange rate depreciation. On the fiscal side, there is some room for easing as the government has been maintaining primary surpluses. However, non-interest spending has increased at a strong pace indicating the need for a medium term fiscal consolidation strategy. 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 recent years, policymakers have acknowledged the need to rebalance the economy, increase domestic savings, and remove structural bottlenecks to boost productivity. The government’s Action Plan based on the Priority Transformation Programs of the National Development Plan (2014-18) aims to boost savings in the pension system, increase labor market flexibility, and pursue education and taxation reform. While some measures have been passed, such as the automatic enrollment in private pension schemes, attention to the reform agenda could be diverted by domestic political developments.

Despite the vulnerabilities, Turkey’s ratings are supported by several credit strengths, including the economy’s size and diversity. Turkey is an upper-middle income country with nominal GDP of US$874 billion and a population of 78 million. Real GDP growth has averaged 5.9% since 2003, supported by favorable demographics and capital accumulation. 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.

Turkey has also made significant progress in the area of public finances. Consistent primary surpluses have strengthened the public sector balance sheet. The general government debt-to-GDP ratio has declined by more than one-half, from 74.3% of GDP in 2001 to 30% in 2016. Turkey has improved its debt profile in terms of composition and maturity, reducing the sensitivity of the debt stock to liquidity, interest rate and exchange rate risks. Of the central government debt, two-thirds is denominated in local currency and the average time to maturity has been extended to 6.3 years. However, Turkey remains exposed to lower investor risk appetite, as 17.3% of government debt is held by non-residents.

Turkey’s banking system remains well-capitalized despite bouts of market volatility over the last three years. The capital adequacy ratio for the sector is 16%, the quality of the capital is strong, and non-performing loans account for 3.4% of total loans. Although banks’ external obligations have increased substantially, they have a neutral net foreign exchange position. However, banks are indirectly exposed to exchange rate risk through the corporate sector, which had a $212 billion net foreign exchange exposure in October 2016. In an adverse scenario characterized by higher interest rates, currency depreciation and slower economic growth, bank profitability and asset quality could deteriorate.

RATING DRIVERS
DBRS is concerned about the possibility of a further deterioration in Turkey’s governance indicators and the weakening of the macro-policy framework, as that could lead to less predictability in policy making and undermine Turkey’s resilience to shocks. The ratings could be lowered further if (1) our assessment of Turkey’s institutional quality continues to weaken, or (2) if economic and financial sector fundamentals deteriorate further, and result in a sharp reduction in capital inflows. On the other hand, the trend could change to Stable, if institutional quality concerns subside, and policy actions are taken to facilitate a smooth macroeconomic rebalancing.

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. These can be found at http://www.dbrs.com/about/methodologies.

The sources of information used for this rating include Central Bank of the Republic of Turkey, Ministry of Finance, Undersecretariat of Treasury, Turkish Statistical Institute, International Monetary Fund, World Bank, Haver Analytics, and DBRS. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.
This rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities.

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: Rohini Malkani, Senior Vice President
Rating Committee Chair: Roger Lister, Chief Credit Officer, Global Financial Institutions Group and Sovereign Ratings
Initial Rating Date: 23 May 2013
Most Recent Rating Update: 21 July 2016

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