Update: And to round out the triumvirate, Moody’s just joined S&P and Fitch in the Turkey downgrade party…
Moody’s downgraded Turkey’s long-term foreign debt rating to Ba3 from Ba2. Additionally, Moody’s shifted the outlook to negative from watch negative.
The key driver for today’s downgrade is the continuing weakening of Turkey’s public institutions and the related reduction in the predictability of Turkish policy making.
That weakening is exemplified by heightened concerns over the independence of the central bank, and by the lack of a clear and credible plan to address the underlying causes of the recent financial distress, notwithstanding recent statements by the government.
The tighter financial conditions and weaker exchange rate, associated with high and rising external financing risks, are likely to fuel inflation further and undermine growth, and the risk of a balance of payments crisis continues to rise.
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Just hours after Fitch fired off the latest rating agency warning shot against Turkey, warning that the actions Erdogan has undertaken so far are “insufficient to restore policy credibility”, traders were keenly looking at the scheduled update of S&P’s BB- rating of Turkey, which with an “outlook negative” would most likely be a downgrade.
Sure enough, moments ago Standard and Poors announced that it had cut Turkey by one notch, from BB to B+, citing its expectation “that the extreme volatility of the Turkish lira and the resulting projected sharp balance of payments adjustment will undermine Turkey’s economy.”
It gets worse, as S&P admits that it “forecasts a recession next year. Inflation will peak at 22% over the next four months, before subsiding to below 20% by mid-2019.” Furthermore, the rating agency anticipates that “2019 will be the first year since 2009 in which nominal credit growth will be less than inflation, implying a major shift in real domestic financing conditions.“
As expected, at the basis of the decision is the collapse in the lira:
The weakening of the lira is putting pressure on the indebted corporate sector and has considerably increased the funding risk for Turkey’s banks. We expect these economic and financial shifts will have implications for public finances, resulting in a rise in the government’s still-moderate debt ratio, and increasing the risk of contingent liabilities rising in the banking sector. Despite heightened economic risks, we believe the policy response from Turkey’s monetary and fiscal authorities has so far been limited.
S&P explains its rationale as follows:
Institutional and Economic Profile: The economy is set to contract in the aftermath of the recent extreme lira volatility
- Turkey has experienced extreme currency volatility with limited policy response so far.
- We now expect the economy will contract by 0.5% in real terms in 2019, underpinned by declining consumption and falling investment. Our forecast assumes, however, that banks are still able to successfully refinance existing foreign debt stock over the next three years.
- Turkey’s institutional environment remains weak, with limited checks and balances in place. Decision-making is centered around President Erdogan following the transition to an executive presidential system in June 2018.
Over the last two weeks, Turkey has experienced substantial local-currency volatility, following a long period of accumulating macroeconomic imbalances and overheating. Since the beginning of the year, the lira has dropped 38% against the U.S. dollar, of which almost half has taken place in the last two weeks. Meanwhile, inflation reached nearly 16% year-on-year in July.
We forecast an economic recession as a result of exchange rate depreciation and volatility, as well as a likely reduction in foreign financing inflows in the months ahead. According to official estimates, Turkey’s economy grew by 7.4% year-on-year in the first quarter of 2018. However, in recent months signs of a slowdown in domestic demand have become increasingly evident. Combined with the expected sharp balance-of-payments adjustment, we foresee a hard landing for the Turkish economy.
Elevated inflation brought about by the pass-through from exchange-rate depreciation will erode real incomes, depressing private consumption. We expect consumption growth will decelerate to 3.4% this year before posting a 1.7% decline in 2019. This compares to an average annual growth rate of over 5% over the last five years.
More significantly, we expect investments–a traditional driver of the Turkish economy–will shrink by 6% in real terms in 2019. Although the potential for fiscal policy to support public investments remains unclear, several factors combine to foretell a particularly weak outlook for Turkey’s private
The economic outlook is pretty ugly:
Overall, we expect the Turkish economy will experience a hard landing with real GDP contracting by 0.5% in 2019 before rebounding gradually. This is a milder adjustment compared to past financial crises in Turkey–output contracted by 6.0% in 2001 and 4.7% in 2009. Although our forecast remains uncertain, we believe that in contrast to 2009 external demand will hold up relatively well for Turkey’s newly competitive merchandise and services exports, which should provide support.
In a new twist, S&P also covered Turkey’s ongoing diplomatic spat with the US…
There are also substantial risks stemming from Turkey’s international relations. Turkey’s relations with the U.S. have continued to deteriorate throughout 2018, culminating in the introduction of sanctions against two Turkish government ministers at the beginning of August. We understand that risks of further sanctions remain: points of contention include Turkey’s continued detention of a U.S. citizen; its alleged role in allowing Iranian counterparties to evade American sanctions; and its purchase of S-400 surface-to-air missiles from Russia. In early August, U.S. President Donald Trump announced tariffs on aluminium and steel exports from Turkey to the U.S., while Turkey retaliated by hiking tariffs on a range of American consumer goods.
… and regional security:
Regional security also remains precarious. Apart from geopolitical repercussions, any deterioration could substantially impact tourism flows. This could be the case, for example, if tensions in Syria escalated or there was an increased domestic terrorist threat.
As for capital controls…
Although still not our base case, we consider that the likelihood of the introduction of capital controls in Turkey has increased. Consequently, we have revised our transfer & convertibility assessment–which measures the likelihood of a sovereign introducing restrictions on FX access for nonsovereign issuers’ debt service–downward to ‘BB-‘ from ‘BB+’. That said, the Minister of Finance has so far publicly ruled out this option.
Finally, the outlook:
We could lower our ratings on Turkey if we see an increasing likelihood of a systemic banking crisis with the potential to undermine the country’s fiscal position. Key indicators of this could include a rise in corporate loan book default rates, difficulties rolling over banks’ foreign funding, or domestic deposit withdrawals. We could also lower the ratings if Turkey’s economic growth turned out to be materially weaker than we currently project, with a deeper recession taking place over the four-year forecast horizon.
We could consider an upgrade if the government successfully devises and implements a credible economic adjustment program that bolsters confidence, stabilizes balance-of-payments flows, and brings inflation under control.