The Republic of Turkey (hereinafter, Turkey, or the country) has been assigned the following ratings:

• Long-term foreign currency credit rating at B+ and local currency credit rating at B+;
• Short-term foreign currency credit rating at B and local currency credit rating at B.

The outlook on the long-term foreign currency credit rating is Negative and local currency credit rating is Negative.

The Negative outlook assumes that the rating will most likely be downgraded within the 12 to 18-month horizon.

The COVID-19 crisis caused a deep contraction and placed a heavy burden on the country’s public finances. On the positive side, it is very likely that 2020 GDP growth is going to be better than that of most of the country’s peers, to a large extent due to aggressive domestic monetary stimulus. Nevertheless, credit expansion comes at the expense of the resilience of the economy, which had already been hampered by the 2018 currency crisis. In the Agency’s view, the resilience of the economy is constrained mainly by high FX exposure, limited international reserves and the low credibility of the central bank. These risks are reflected in the negative rating outlook.

Credit rating rationale

Sovereign model results (based on 2020 baseline scenario)

Assigned credit rating

* The BB Indicative credit rating was used to obtain the final credit rating, even though the core part of the rating model based on the 2020 baseline scenario put Turkey marginally at BB-. Given the extremely volatile economic environment, ACRA Europe sees a scenario in which the final 2020 and 2021 data might put the indicative rating at BB. The risks of a worse outcome are reflected in the negative outlook.

MACROECONOMIC SITUATION AND ECONOMIC POTENTIAL

Turkey has the 19^th largest economy in the world, with a strong manufacturing sector.

Turkey is a large emerging economy with an estimated GDP per capita of around 28,000 international dollars in 2020 (expressed in purchasing power parity standards). In nominal terms, Turkey’s economy was the 19^th largest in the world with GDP at around USD 760 bln. The economy is relatively well diversified, with manufacturing playing an important role. In 2019, the gross value added in manufacturing accounted for 18.3% of GDP. The openness of the economy is moderate with exports accounting for 32.7% of GDP in 2019. Exports are well diversified in terms of partners — in 2019, the three largest trading partners were Germany (9.2% of exports), the United Kingdom (6.2%), and Iraq (5.7%). In terms of products, the export structure is somewhat skewed towards the automotive industry, with an almost 16% share in exports.

The COVID-19 crisis is the second large shock to the economy within a short period of time.

Following a period of robust growth, the economy slowed markedly on the back of the 2018 currency crisis, which was triggered by high external imbalances and the delayed response of the Central Bank of the Republic of Turkey (TCMB). After increasing by 6.1% on average between 2013 and 2017, the economy only grew by 3% in 2018 and 0.9% in 2019. The gradual recovery from the currency crisis has been interrupted by the COVID-19 pandemic.

However, the economy is expected to contract only mildly in 2020 as Q3 GDP data has shown a V-shaped recovery — the economy grew 6.7% year-on-year following a 9.9% decline in the second quarter. The recovery is supported by robust credit growth fueling investment, which grew 22.5% year-on-year in Q3. Nevertheless, Q4 is likely to be weaker in light of new restrictions on movement and several central bank interest rate hikes. In December, the OECD projected the economy to contract 1.3% in 2020 before expanding by 2.9% in 2021.

Turkey has responded to the COVID-19 shock with aggressive monetary easing.

Inflation expectations remain weakly anchored. ACRA Europe expects inflation to remain elevated on the back of aggressive monetary easing, despite worldwide deflationary pressures stemming from subdued demand and the decline in oil prices. Credit growth has accelerated at a very strong pace: in Q4, the year-on-year change in loans stood at approximately 40%, up from 11% at the end of 2019. Thus, inflation remained in double-digits and even accelerated towards the end of the year. This pushed the annual average inflation rate above 12%. The recent interest rate hikes along with the subsequent stabilization of the lira exchange rate should ease inflationary pressures. However, the TCMB’s track record of prioritizing growth over its inflation target suggest that rapid disinflation is not a likely scenario.

From a long-term perspective, the growth potential of the economy is solid. It is supported mainly by positive demographic trends. The World Bank projects an increase of the working age population of more than 8% by 2040. In contrast, the growth potential is constrained by the underutilization of human capital: Turkey significantly lags behind its OECD peers in R&D spending, PISA scores, social mobility, and female labor force participation. Prior to the COVID-19 crisis, major international institutions projected the economy to grow by more than 3% annually in the coming decade and close to 2.5% in 2030–2060, which is solid for a country at Turkey’s level of GDP per capita.

PUBLIC FINANCE

The debt to GDP ratio is expected to exceed 40%.

As of September, the size of the announced fiscal package to counter the COVID-19 crisis stood at approximately USD 100 bln (13% of 2019 GDP). This fiscal support is predominately in the form of contingent liabilities (USD 81 bln of loan guarantees and extension of debt service payments by the public banks). Measures directly impacting the general government balance stood at USD 15 bln (2% of 2019 GDP), of which USD 10 bln are attributable to tax postponements and deferrals and USD 5 bln (0.7% of 2019 GDP) are attributable to direct fiscal support — inter alia, increased healthcare spending, increased social expenditures, and tax reductions.

These measures along with lower-than-expected tax collection and GDP will push the general government deficit to approximately 7% in 2020 and the debt to GDP ratio to 41.5% in ACRA Europe’s baseline scenario. An important factor behind the sizeable increase of the debt to GDP ratio from 32.6% is the revaluation of the FX-denominated debt due to the depreciation of the lira. Debt servicing costs are increasing significantly, in the first three quarters of 2020, the general government interest expenditures were up by 30% and are likely to surpass 3% of GDP.

Private sector purchases of government debt are not keeping pace with the increase in the debt stock.

Elevated financing needs are met almost exclusively in the domestic market. In January to November 2020, almost 98% of net borrowing was covered by domestic borrowing. However, the willingness of the private sector to hold government debt is not keeping up with the increase in the domestic debt stock. Thus, public institutions have to step in to keep borrowing costs favorable — the combined share of public banks and the TCMB in the domestic holders’ structure of central government debt stood at 42.6% in November 2020, up from 27.7% in 2019.

More than half of the government debt stock is FX denominated.

Lower confidence of domestic investors is also demonstrated by a further increase in FX domestic borrowing. The central government’s FX debt had increased almost 25% year-to-date by the end of November in dollar terms, while the share of FX debt in the total government debt had surpassed 57% (to a significant extent on the back of the depreciating lira). At the same time, the share of external debt has declined to 42.6%, pointing to increased domestic FX borrowing. External borrowing is far more constrained than domestic borrowing — the 5Y USD credit default swap stood slightly above 300 pts at the time of publishing this report, the highest among the G-20 emerging economies, except Argentina. Weakening market access has pushed the average time to maturity of the central government debt stock to 5.2 years, the lowest since 2013.

Gross international reserves can cover only around 60% of the FX government debt.

In ACRA Europe’s view, the risk of an outright default is contained in the short term, given the support from public institutions (the TCMB and public banks) and very strong coverage of the short-term external public sector debt service by international reserves (over 600% in November). Yet, from a longer-term perspective, relying on public banks and the TCMB for financing the government’s needs might lead to a pick-up in inflation and lira depreciation, and thereby further constrain the willingness of the domestic private sector to lend to the government in the local currency. A subsequent increased reliance on FX borrowing would further reduce the already weak coverage of the FX debt by international reserves (in November, reserves only covered approximately 60% of the central government FX debt), and thus, alleviate the risk of the inability to meet FX redemptions.

Public banks are expanding their lending at a strong pace.

The vulnerability of the banking system, which was elevated even prior to the COVID-19 crisis, has increased in light of the current economic uncertainty and a recent credit expansion supported by aggressive monetary easing. In November 2020, the year-on-year growth in loans of depository banks increased to 38.4% (in December 2019, it stood at 10.5%), led by state-owned banks (with a 43% share in deposit banks assets) with far higher risk tolerance than private banks with a year-on-year growth of 47.9%. In ACRA Europe’s view, this increases the risk of deterioration in the banking sector’s asset quality. Especially vulnerable are FX loans to the corporate non-financial sector, which has a wide negative gap between FX assets and FX liabilities (USD 157 bln, or 21% of 2019 GDP in October 2020).

The TCMB has no swap lines with major central banks.

FX risk is also elevated in the banking sector, where the FX share in total deposits stands at slightly above 55%. On the liabilities side, banks’ external debt (overwhelmingly FX denominated) maturing in the next 12 months stood at USD 83 bln in November, or 11% of 2019 GDP. In case of a substantial worsening of market conditions, some banks might encounter difficulties in refinancing their maturing external debts. Given the absence of swap lines with major central banks, in ACRA Europe’s view, the COVID-19 crisis has increased the risk of stress in the banking sector that might lead to bailouts using public resources.

PPP projects are a major source of non-financial sector contingent liabilities.

The government’s continent liabilities have also increased with respect to the non-financial sector. In Q3, COVID-19 related potential credit guarantees stood at USD 66 bln (8.7% of 2019 GDP). These come on top of the official non-financial sector contingent liabilities standing at USD 23 bln (3% of 2019 GDP) in Q3 2020. This figure, however, significantly understates the total extent of the non-financial sector’s contingent liabilities as it does not include the majority of the Ministry of Development’s PPP projects (with investment value at USD 78 bln, or 10.3% of 2019 GDP) and certain projects contracted by state-owned enterprises and municipalities.

EXTERNAL RISKS

The current account is deteriorating again.

ACRA Europe considers the external position of Turkey to be weak. Although the sharp depreciation of the lira has put an end to chronically high current account deficits, it has also significantly increased the external debt load in relation to GDP. International reserves have declined during the COVID-19 crisis and might prove insufficient to counter another sizeable external shock.

The current account balance turned positive in 2019 (1.2% of GDP according to the IMF), for the first time since 2001, mainly on the back of the deterioration of the goods balance. However, in 2020 the current account reverted back to negative figures on the back of a deep contraction in exports, while imports took a much smaller hit in light of the domestic stimulus. ACRA Europe expects a current account deficit of almost 4% GDP in 2020.

The gross external debt to GDP ratio has declined slightly since its Q2 2019 peak at 60.3%, mainly on the back of private banking sector external deleveraging. In Q3 2020, it stood at 59.1%. Nevertheless, it remains far above the 2019 emerging market G-20 countries’ average of 36%. The rollover ratio remains high — in November, external debt due in the next 12 months stood at USD 181 bln (42% of the total and 24% of GDP). Given the high share of the private sector in the short-term external debt (66%) and the very high share of the FX component in the total external debt (95%) along with uncertain market conditions, Turkey’s external position is vulnerable to rollover risk, especially in case of further strong selling pressure on the lira.

Reserve coverage ratios are low, net reserves are far below the headline figure.

The selling pressure on the lira has further drained Turkey’s international reserves. In November, they stood at USD 83 bln, down from USD 106 bln in December 2019. Thus, the reserve coverage of external debt has fallen further. In November, international reserves only covered 20% of the FX external debt and 46% of external debt maturing in the next 12 months. Moreover, the structure of reserves raises concerns about their immediate liquidity and long-term usability. A significant portion of the reserves comprises of gold (USD 40 bln) and banks’ required FX deposits held against their FX liabilities. At the same time, the gross reserves figure is also propped up by the TCMB’s FX swaps.

The lira exchange rate has stabilized on the back of the TCMB tightening. The one-week repo rate has been increased from 8.25% to 17%. After a strong hike of 475 bsp in November the year-to-date losses of the lira against the US dollar fell from around 30% to around 20% by the end of the year. However, given uncertain global economic conditions, low TCMB credibility and weak reserve coverage ratios, the vulnerability of the lira will remain elevated in the foreseeable future in ACRA Europe’s opinion.

INSTITUTIONAL FACTORS

Turkey’s governance framework is weak by global standards, with the main laggards being the Political Stability and Absence of Violence, and Voice and Accountability indicators.

Turkey’s institutional framework is deteriorating. The country’s average score for the World Bank’s Worldwide Governance has deteriorated substantially in recent years. Despite some improvement since the failed coup in 2016, the Political Stability and Absence of Violence indicator is by far the worst among the G-20 emerging economies. Its assessment is constrained by relatively frequent terrorist attacks and the country’s ongoing involvement in the Syrian conflict. The Voice and Accountability indicator is also well below the global average. Its deterioration over recent years can be attributed to the consolidation of power in the hands of President Erdoğan following the 2017 constitutional reform and an increased crackdown on the media and civil society.

Appendix 1. Comparative analysis of Turkey and the sample group

Comparison of macroeconomic and institutional indicators

* 2018 data was used for Mexico and Thailand

** At original maturity, excluding direct investments.

*** Indicates the extent of differences between the country’s trade structure and the average world indicator and ranges approximately from 0 (weak differences) to 1 (strong differences).

**** Assessment of effectiveness ranges from approximately -2.5 (weak) to 2.5 (strong).

Sources:  IMF, UNCTAD, World Bank

Appendix 2. List of material data sources

Appendix 3. Key indicators

Balance of payments, USD bln

Sources: IMF, TCMB

External position (assets and liabilities), USD bln

* At original maturity

** Excluding state-owned enterprises

Sources: IMF, Turkish Ministry of Treasury and Finance

Budget indicators, % of GDP

Source: IMF, Turkish Ministry of Treasury and Finance

Rating history

The rating was first released for distribution on January 18, 2019, with the last review on July 10, 2020.

Regulatory disclosure

ACRA Europe provided no additional services to the Turkish government. No conflicts of interest were discovered in the course of the sovereign credit rating assignment.

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