Turkey: Moody's downgrades credit rating due to balance of payments risk

International credit rating agency Moody's Investors Service further lowered Turkey's credit rating as balance-of-payments risks escalate and officials have turned to unorthodox policies to stabilize the lira and rebuild foreign reserve buffers. The agency downgraded Turkey's credit rating from B2 to B3 and changed its rating outlook from negative to stable. Moody's pointed to the possibility that Turkey's current account deficit will likely exceed previous expectations by a large margin, increasing the need for external financing as global financial conditions tighten.

Highlights from Moody's rating evaluation;

·        Authorities are increasingly forced to resort to unorthodox measures to stabilize the currency and restore currency buffers.

·        Moody's estimates that the country's current account deficit will be close to 6% of gross domestic product this year, three times higher than expected before the Russian invasion of Ukraine.

·        Moody's said that Turkey's foreign reserves are also in focus, as energy import prices remain high and tourism and export revenues decrease. Although foreign exchange reserves excluding gold reached $67.7 billion at the beginning of August, the rating agency pointed out that they were in decline for most of the year.

·        Currency remains under pressure, indicating continued high inflation in the coming months. According to the latest estimates of Moody's, consumer price inflation will still hover around 70% at the end of the year.

·        Moody's stable outlook on Turkey's rating reflects its view that the country has 'relatively low external debt and moderate refinancing needs' for 2022 and the remainder of 2023.

As an important instability factor, inflation stands out as the main factor that negatively affects credibility. Inflation fell from below 20% in October last year, then rose to 79.6% in July and is now among the highest reported globally. Authorities have taken a number of measures since the beginning of the year to stabilize the currency, rebuild the central bank's low foreign exchange reserve buffer and, more recently, contemplate a 'soft' landing in the economy with credit growth prevailing. New measures, such as the obligation of exporters to convert 40% of their export earnings into lira at the CBRT, and the ban on banks to extend loans to companies with significant foreign currency assets, are announced more frequently than ever and are becoming unusual. Measures taken so far have not been successful in stabilizing the currency and significantly increasing the CBRT's foreign exchange buffers. Other measures focus on directing loans to specific sectors and activities, such as exporting companies and investment loans rather than consumption. There are early signs of a slowdown in credit growth. Moreover, bank loan rates have risen to over 30% in recent weeks, significantly above the CBRT's policy rate of 14%, which will help reduce loan demand.

However, in Moody's view, increasingly complex regulatory and macroprudential measures are unlikely to be effective in restoring some degree of macroeconomic stability and help reduce inflation sustainably. Moody's expects a gradual economic slowdown in the second half of this year and next year, while the rating agency forecasts real GDP growth of 4.5% and 2% for 2022 and 2023, respectively. The global environment has become significantly more challenging as financial conditions have tightened globally and Turkey's main export markets in Europe are facing a slowdown in growth due to an energy crisis and ongoing supply chain challenges. A sharp slowdown will adversely affect the labor market, the strength of public finances, and increase social and political risks. If the economy slows sharply—important for the private sector as the main borrower abroad—external refinancing options may become more limited. At the same time, it is unclear whether there is political acknowledgment that the Turkish economy should slow down, especially in light of the upcoming elections, which should be held by June 2023 at the latest.

Price growth in Turkey has hit double digits almost continuously since the beginning of 2017, but this year it reached the highest level in a quarter century due to rising commodity costs and the central bank's reluctance to raise interest rates. The lira, which has been in a continuing decline after a deep depreciation in the last two months of last year, lost more than 25% of its value against the dollar in 2022 and performed the worst among 23 other emerging market currencies tracked in the same category.

Moody's expects a significant weakening in Turkey's public finances this year. While public finances, supported by the doubling of government revenues due to high inflation, remained solid in the first half of the year, budgetary pressures are likely to increase significantly in the last months of the year. The cost of the deposit protection scheme to the Treasury is rising, with Moody's estimating the full-year cost at around 2.2% of GDP, based on the rating agency's exchange rate estimates. As of June, the Treasury paid 0.3% of GDP. Similarly, the cost of inflation-indexed debt held mostly by domestic banks has increased significantly, and Moody's estimates that high inflation will add about 1.2% of GDP in interest payments this year compared to 2021. The budget deficit, expected at around 4.5% of GDP, also reflects the slowdown in the economy, higher wages and the public sector pension bill, and earlier tax cuts. Debt solvency is deteriorating rapidly and the ratio of interest payments to income is expected to reach 10.2% this year, the highest level since 2010 and in the coming years.

On the balance of payments and international reserves; Turkey's external position is under more pressure than expected, mainly as a result of rising energy prices pushing up already high inflation and increasing external financing needs. Falling foreign exchange reserves are another pressure point. While strong tourism and goods export performance will generate significant foreign exchange revenues, these inflows will start to slow in the autumn and net energy imports will likely remain very high. At this point, Moody's expects the pressure on the exchange rate and the CBRT's foreign exchange buffer to increase again. With the help of a large inflow tied to a major energy project, foreign exchange reserves recently rose to $67.7 billion as of early August (excluding gold reserves worth $40.8 billion). However, despite the introduction of a deposit protection scheme aimed at encouraging depositors to move away from TRY deposits and foreign currency deposits, and despite the obligation for exporters to convert 40% of their exports, reserves have been falling for most of the year. Net reserves are negative up to $50 billion, excluding reserves borrowed in exchange with banks and required reserves from banks.

External financing needs are large this year, about $250 billion, or 34% of GDP; half of this is short-term debt, typically in the form of converted deposits such as commercial loans or non-residential deposits in the banking system. Moody's estimates trust-sensitive external refinancing needs to be around $128 billion, or 17% of GDP, with the majority of these needs being met by the private sector. In contrast, the government has only one external bond maturity left for $2.5 billion in September plus $3.2 billion in interest and loan repayments in July-December, which can be met from approximately $11 billion in foreign exchange deposits at the CBRT.

As the reason for the rating outlook to be stabilized; Despite the expected increase in the budget deficit, the government's debt burden will remain modest this year compared to its peers below 40% of GDP (general government level). The central government's external debt stock is low, less than 20% of GDP. While government debt is highly subject to currency depreciation (about 67% of the central government's outstanding debt stock is denominated or denominated in foreign currencies as of June 2022), strong nominal GDP growth is still helping to largely offset the currency's depreciation. should continue. Despite the huge depreciation last year, the debt ratio increased by only 2.4 percentage points of GDP. The government borrows predominantly domestically, in a profile where borrowing costs are extremely negative in real terms and more than three-quarters of the debt is held by incumbent banks. Foreign investors own only 1% of domestically issued debt as of June, limiting the impact of further loss of foreign investor confidence.

Banks and companies, the main borrowers abroad, have been able to rollover debts that were due during previous periods of financial stress and have faced no difficulties so far this year and have well-protected foreign exchange positions that provide a cushion against future periods.

Factors that may be subject to an increase in grade or outlook:

·        The rating may be raised if Turkey's policy makers refocus on reducing inflation through decisive and clear monetary policy actions that restore confidence in the CBRT.

·        An improvement in Turkey's external competitiveness and economic resilience, and a sustained reduction in external imbalances would also be positive for the rating.

Factors that could be subject to a downgrade in grade or outlook:

·        The rating is likely to be further lowered if authorities resort to more stringent policy measures that increase the risk of a banking crisis or payment default by large corporations.

·        Further material deterioration in the external balance would also be negative and would be evidence that inflation remains persistently high, indicating a further increase in social risks.

·        In addition, a serious political crisis that causes acute economic and financial disruptions after the next elections will also negatively affect the credit rating.

Credit Rating Profile:

·        Turkey is rated B by Fitch Ratings and B+ by S&P Global Ratings.

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