Turkey Outlook Upgraded at S&P

S&P upgraded Turkey’s outlook from negative to stable with a maintain a credit rating of BB which is two notches below the investment grade, citing government policy gradually refocusing on measures to reduce external vulnerabilities. Here we list key takeaways from the report:

  • Accepting that it would have a minimal impact, mandatory enrollment of employees aged under 45 in the Private Pension System is considered as an indicator of positive intent.
  • Attempts to cut the bill for imported energy are important to the credit rating agency regarding the external balances.
  • S&P believes that the government’s reform agenda also targets improving educational standards, increasing labor market flexibility and female participation in the workforce, and reducing the size of Turkey’s sizable informal economy, however, the implementation of this ambitious program of reforms competes to some extent with the president’s intention to bring about constitutional change with the end goal of achieving an executive presidency
  • S&P has lowered its estimate of Turkey’s gross external financing requirement for 2016-2019 to close to 170% of current account receipts plus usable reserves, from close to 185%, largely due to the lengthening average maturity of Turkish external debt (which we believe is very important).
  • S&P views Turkey’s banking system as generally well capitalized and supervised, noting the size of state-owned banks being relatively large and foreign currency funding represent risks (if their hedges do not hold, due to counterparty risk, or because of the second-round effects of the large open foreign exchange position in the corporate sector on banks’ asset quality).
  • S&P could lower its ratings if Turkey’s fiscal performance and debt metrics deteriorate beyond expectations, or if political uncertainty contributed to further weakening in the investment environment or tightening global policy rates intensified balance-of-payment pressures.
  • S&P could raise its ratings if sustained rebalancing of the source of economic growth led to much lower external borrowing needs.

The following shows the changes in S&P Global’s estimates on Turkey for the 2016-2019 period.


Turkey: Outlook Revised to Stable at S&P

Standard & Poor’s revised its outlook Turkey to stable from negative and affirmed its BB+ FC and BBB- LC sovereign credit ratings after the close of the market on Friday. The action was a positive surprising as it came amid concerns around Turkey’s political outlook taken to a higher level with the ouster of PM Ahmet Davutoglu. The credit rating agency downgraded sovereigns such as Poland, citing risks related to institutional stability.

The change at the top of the government should not be a game changer for Turkish politics in the short-term since Davutoglu had mostly felt into line with President Erdogan during his tenure. Still, this would keep Turkey’s governance mechanism open to dispute and harm Turkey’s accession process to the European Union while negotiations over visa-free pass going on which was supposed to mark a milestone in the history of country. Also, one would expect that steps toward a constitutional reform are to be taken faster than expected.

Turning back to the upside revision of S&P, the action has been primarily driven by a change in S&P’s assessment for Turkey’s debt burden as the credit rating agency believes that risks to the roll-over of its external debt have moderated. Having said that, the economic performance of the country has proven to be resilient by posting a higher-than-expected GDP growth of 4% despite to a number of challenges including, the busy electoral calendar in 2015, the end of the peace process with the PKK, heightened regional instability, and weak investor sentiment toward emerging markets.

Interestingly, S&P does not see eventual constitutional reform leading significant policy changes such as intensification of intervention in the independence of Turkish central or nationalization of private sector banks. Since, we don’t even have any draft that frames a new constitution, it is hard to predict the implications for the economy. But for instance, in case of a completed transition towards a presidential system, most certainly only the President will be in charge of assigning the Central Bank Governor. This the most controversial point made in the S&P’s Turkey release.

Putting it in a nutshell, below is the comparison of the estimates of the credit rating agency in November 2015 and May 2016 which, in our view, is useful to understand the underlying dynamics of S&P’s rating process.

Turkey - S&P EstimatesThe next report will be released on November 4, 2016.

Turkey’s Resilience to a Fed Rate Hike

The effects on emerging markets of unconventional monetary policies implemented by some advanced economies have been a focus of debate. The policy of so-called quantitative easing that the central banks in advanced economies embarked on has increased capital flows to emerging markets. However, as these policies are scheduled to end in the near future and advanced economies are beginning to normalize their monetary policy, we are watching episodes of volatility in global financial markets. For emerging markets improving macroeconomic and financial policy frameworks and developing the financial system is crucially important for intermediating capital flows in a stable and efficient manner.

The quantitative easing had spillover effects on emerging markets through many transmission channels. The compressed term premium of assets in advanced economies increased the demand for all substitute assets including emerging market assets, as investors turn to riskier assets in search of higher expected risk-adjusted returns.

At this juncture, with the European Central Bank now embarking on its own quantitative easing, it is reasonable to ask whether we should expect to see similar on net flows into emerging markets. It is absolutely supportive of capital flows into emerging markets, but the impact will be relatively muted compared to what occurred under the US Federal Reserve quantitative easing. Investors in European assets will face strong incentives to re-balance on non-European assets. However, the small capitalization of European market compared to the United States implies that magnitude of this reallocation will be limited by comparison. Not surprisingly, we have observed a remarkable weakness in capital inflows to emerging markets following the Federal Reserve entering a tightening path despite the European Central Bank injecting liquidity to the market in order to overcome the stagnation across the continent.

By quadrupling their short-term external debt stock in 5 years of quantitative easing, Turkish banks have benefited a lot from the unconventional wave in the world of monetary policy. Analyzing the data with a timeline of the US Federal Reserve’s quantitative easing timeline clarifies the borrowing dynamics of Turkish financial institutions.

Turkey - Banks Short-Term External Debt Stock

In a previous post, we pointed the sluggish credit growth in Turkey and whether it is a cause for concern around Turkey’s growth. The economic activity in the country had been fueled by the fast loan growth such that Turkish central bank turned negative on increasing lending amid qualms about the signs of possible overheating and implied a policy to keep the loan growth rate at a targeted level of 15%. Meanwhile, lending growth in the country had been increasingly dependent on external financing due to mainly two reason. First, eased borrowing conditions in the global due to aforementioned reasons had encouraged the bank in Turkey for external financing. Second, the multi-purpose monetary policy expectedly failed the lower the inflation rates below the targeted level and consequently the deposit growth considerably slowed because of offering a negative return in real terms.

Turkey - Loan and Deposit Growth and Reliance on External Financing

So, within a higher interest environment across the global markets where Turkish lira depreciates against the US Dollar, Turkish banks are expected to deleverage voluntarily. Considering the decreasing roll-over ratios, this might be already underway. On May 8, Standard & Poor’s, the credit rating agency, pointed the issue resulting lower real GDP growth while it cut Turkey’s notch by one level in local currency terms. The agency’s real GDP projections are 3.0%, 3.2%, 2.8% and 2.5% in 2015, 2016, 2017 and 2018, respectively. Additionally, below is its expectations for Turkey’s external financing needs over the course of next four years. It is not even worth to mention that these seem as downside risks to the ratio outlook.

Turkey - External Financing Needs Expectations

The challenge going forward will be achieve a solid foundation for sustained growth amid an international climate dominated by short-term interest rates. Specific to Turkish banking universe, the central bank began paying interest on lira-denominated reserve requirements which was the latest move Governor Erdem Basci to try to boost economic growth without monetary policy easing. However, given the industry has lacked a sufficient deposit growth for a while, with strengthening competition among banks this would result in higher interest rates in Turkish deposit market leading higher funding costs. Following that, the move may cause credit expansion slowing further rather than mitigating the effects of the US Federal Reserve fallout. This is likely to be the key theme in fixed income markets where the high interest rates are here to stay for a while.

Turkey is to face a number of economic challenges once the political turmoil is over and this time it will not easy to blow the clouds away.