S&P keeps Turkey rating steady, warns of downside risks
The brief report issued by the agency did highlight some room for improvement, but mainly gave voice to downside risks. …
The brief report issued by the agency did highlight some room for improvement, but mainly gave voice to downside risks. Turkey’s ratings outlook will crystalize after 31 March 2019 municipal elections, when economy czar Albayrak is expected to launch a stability and reform program. Whether such a program will meet creditors’ growing concerns, solve the deepening bad loans problem or have sufficient time to be implemented, given Turks’ notoriously short patience with recessions remains to be seen.
Below are highlights from S&P comments
Ratings rationale: Weak institutions, economic slump and fiscal space
Our ratings on Turkey remain constrained by its weak institutions. There are limited checks and balances between government bodies, raising questions about Turkey’s ability to address the challenging environment for its financial sector and broader economy. Following the June 2018 elections, power remains firmly in the hands of the executive branch, with future policy responses difficult to predict.
As capital inflows into Turkey dried up last year, the lira weakened substantially and the historically high current account deficit was forced into surplus. Imports fell notably as domestic purchasing power reduced in foreign currency terms.
Despite the current account shifting into surplus, we believe Turkey’s balance-of-payments risks remain elevated and therefore constrain the sovereign ratings. This is principally due to the need to refinance a high stock of external private sector debt, which we estimate amounts to about 40% of 2018 GDP. The repayment schedule for this debt is front-loaded with almost half maturing in the next 12 months. We consider this a risk given what we view as only limited foreign exchange reserves at the Central Bank of the Republic of Turkey (CBRT).
The ratings remain supported by Turkey’s comparatively low net general government debt burden, thanks to past economic policies. We think the government still has some fiscal flexibility that should help absorb the consequences of an ongoing economic adjustment. Nevertheless, a combination of support for public-private partnerships, weaker economic growth, and possible external deleveraging in the private sector could rapidly erode what today appears to be a sound public balance sheet.
— We expect the Turkish economy to contract by 0.5% this year, although there are major uncertainties surrounding this forecast.
— Weak growth dynamics are mainly due to domestic demand. Both consumption and investments will reduce while net exports make a positive contribution to growth.
— Turkey’s institutional environment remains weak, with limited checks and balances. Turkey is gearing up for the March 2019 local elections and we don’t expect any reform or policy initiatives until these are over.
Slow recovery, but hope for 2020 and beyond
Our base-case economic scenario, described above, is largely unchanged from six months ago and remains subject to considerable uncertainty. We currently project output contraction to be much milder than the 5% recession Turkey experienced in 2009. This is because, unlike 2009, external conditions are broadly favorable this time around with Turkey’s trade partners forecast to continue growing. Net exports have so far supported economic dynamics, cushioning subdued domestic demand. Should growth in Europe decelerate or trade wars escalate materially, the adjustment for the Turkish economy could prove more painful.
We also see some potential upside stemming from a more consistent government policy response to Turkey’s economic challenges. This could happen after the March 2019 local elections.
Beyond 2019, we believe Turkey’s growth prospects could improve. We note that Turkey’s economy is large and diverse, characterized by a highly flexible SME sector, a strategic geographic location, and a young and growing population.
Some export-oriented sectors, particularly tourism, have been doing well recently because of competitiveness gains due to the weaker lira.
Nevertheless, we expect recovery from the current downturn to be slower compared to pre-2018 growth rates. In our view, absent substantial reform momentum coupled with reduced political uncertainty, faster recovery will be difficult to achieve.
Turkey’s institutional arrangements have eroded substantially in recent years and are a major constraint for the sovereign ratings. In last year’s June presidential and parliamentary elections, the president and the Adalet ve Kalkinma Partisi (AKP)-led coalition secured a victory that was the final chapter in Turkey’s transition to an executive presidential system. As a consequence, we expect the executive branch will dominate future decision-making, sidelining the few checks and balances that had remained in place, including, by potentially increasing, off-balance-sheet financial activities.
In our view, this high centralization of power has left Turkey ill-prepared to deal with the fallout from last year’s balance-of-payments shock.
Turkey has been in a constant electoral cycle over the last three years and remains so: local elections are coming up in March 2019.
Political outlook still murky
We continue to see risks stemming from Turkey’s international relations. Even though interactions with the U.S. have improved following the earlier release of a detained U.S. citizen, multiple points of contention remain. U.S. policy toward Turkey has also become less predictable than in the past. Tensions between the two countries include Turkey’s alleged role in allowing Iranian counterparties to evade American sanctions including by using state-owned financial institutions, the Turkish government’s decision to purchase S-400 surface-to-air missiles from Russia, and its open support of the regime of Venezuelan President Maduro, whom the U.S. has openly denounced.
Regional security also remains a concern. Apart from geopolitical repercussions, any deterioration could decrease tourism flows. This could happen if tensions in Syria were to escalate or if there was an increased domestic terrorist threat, for instance, due to Turkish military operation against the YPG in Syria.
Question marks on banks
We previously highlighted downside risks to banks’ foreign debt refinancing (see “Turkey Long-Term Foreign Currency Rating Lowered To ‘B+’ On Implications Of Extreme Lira Volatility; Outlook Stable,” published Aug. 17, 2018).
Positively, and in line with our base case, banks were able to roll over much of their external debt coming due last autumn, even though the cost has risen substantially. According to CBRT estimates, the rollover ratio declined to 80% by the end of last year. That said, we understand that some banks did not refinance maturing debt, not because they lost market access but because credit demand was rapidly declining and the outlook for lending was weakening.
We currently expect some deleveraging in the banking sector in 2019 with an external debt rollover ratio of 80%-90% for the rest of the year. Downside risks remain, for example if domestic residents lose confidence in the financial system or if foreign financing dries up, significantly reducing rollover ratios. If this happens, Turkey’s economic adjustment will likely be more pronounced than the 0.5% output contraction we are currently projecting.
The exchange rate would then likely further correct, while consumption and investment would sharply decline.
We view the CBRT’s buffers to counter a potential deterioration in balance of payments as limited. Although headline foreign exchange reserves amounted to
US$93 billion at the end of 2018 (12% of GDP), a large proportion pertains to the CBRT’s liabilities in foreign currency to the domestic banking system.
This reflects the required reserves on banks’ foreign-exchange deposits as well as liabilities under the reserve option mechanism. The latter allows commercial banks to maintain some of their required reserves related to Turkish lira deposits in foreign currency. Excluding these, we estimate the CBRT’s net reserves are a much smaller, US$40 billion (5% of GDP).
Relatively robust fiscal position, but
In contrast to the balance of payments, Turkey’s fiscal position remains supportive of the sovereign ratings. Historically, the government ran recurrent fiscal deficits, but these have been contained, averaging only slightly higher than 1% of GDP over the last five years. We estimate that last year’s deficit was 2.5% of GDP, lower than we previously forecast. We expect a mild widening of the deficit this year, mainly due to weaker economic growth.
Nevertheless, shortfalls will remain contained at below 3% of GDP over the forecast horizon. Consequently, net general government debt should hover around 25% of GDP, which compares well globally.
Beyond the headline figures, Turkey’s underlying fiscal position has somewhat deteriorated in our view. We note that last year’s stronger fiscal outturn was bolstered by a series of one-off revenue measures including the tax amnesty and the introduction of permission for citizens to opt out of military service, for a fee. This trend has continued in 2019. For example, the CBRT decided to bring forward the payment of a large dividend (1% of GDP). The CBRT made a profit in 2018 because foreign-exchange reserves were revalued in local currency terms, owing to the lira’s depreciation. We also see risks from various potential government off-balance-sheet commitments, such as those stemming from public-private partnerships (PPPs). We understand the PPPs are administered by different government bodies and there are no consolidated published statistics. It is, however, unlikely that the maximum theoretical government exposure to PPPs and guarantees extended exceeds 10% of GDP.
Despite the aforementioned risks, the government still has policy space to leverage the public balance sheet if needed, in our view. Such a need could arise, for example, if the government were called to support parts of the banking system through recapitalizing individual institutions or undertaking a broader sector clean-up by moving nonperforming assets to a “bad bank.” In our view, risks to the stability of the Turkish banking system have risen substantially over the last 12 months. These stem from more difficult domestic and foreign financing conditions, and a likely deterioration in asset quality.