Fitch Ratings has revised its outlook on Turkey's Long-Term Issuer Default Ratings (IDRs) to ‘Negative’ from ‘Stable’ and affirmed the IDRs at 'BB-', three notches below investment grade, it said in an August 21 statement.

The revision results from Fitch’s second and last scheduled rating review for Turkey in 2020. Moody’s Investors Service’s second Turkey review is scheduled for December 4 while S&P Global Ratings has completed its scheduled reviews for Turkey this year. On July 24, S&P affirmed Turkey at 'B+/Stable', four notches below investment grade.

Moody’s previously scheduled a Turkey sovereign rating review for June 5 but that date was put back. In its latest rating action on Turkey, in June last year, Moody’s issued a downgrade to B1, four notches below investment grade, with a negative outlook.

Moody’s on June 15 downgraded Turkey’s flag carrier, Turkish Airlines, to B3/Negative, six notches below investment grade. It also sees Turkish lenders at six notches below investment grade with negative outlooks.

A depletion of Turkey’s foreign exchange reserves, weak monetary policy credibility, negative real interest rates and a sizeable current account deficit partly fuelled by a strong credit stimulus have exacerbated external financing risks for Ankara, Fitch noted in its August 21 statement.

Political pressures, the limited independence of the Central Bank of the Republic of Turkey (CBRT) and a track record of being slow to respond to events, increase the risk that policy is tightened insufficiently, contributing to further external imbalances, market instability, and a more disorderly adjustment, it added.

Large interventions

There have been large currency interventions to defend the lira, which has depreciated 16% against the USD since March on the back of net capital outflows and a worsening trade deficit, Fitch noted.

Gross FX reserves (including gold) at the CBRT fell to $88bn in mid-August from $106bn at end-2019. This was despite a $41bn boost from additional FX swaps (to end-June) as a result of regulatory limits on banks dramatically shrinking the offshore lira swap market and a $10bn increase in the swap line with Qatar, the rating agency also said.

Gross reserves minus swaps have fallen more sharply, from $87bn at end-December to $29bn, “which better highlights the underlying trend”, Fitch said.

Net reserves (net of FX claims, mainly from Turkish bank placements) minus swaps are negative at $30bn, it added.

Fitch “places more emphasis in its analysis on Turkey's gross FX reserves, which is the input to its Sovereign Rating Model and aligns with the fact that the private sector accounts for most of Turkey's large external financing requirement”.

However, “the large contribution of swaps to gross reserves creates a greater risk if they are not rolled over”.

CBRT's resulting net short FX position also exposes it to balance sheet risk, with the potential for losses due to lira depreciation to further weigh on confidence in the currency, Fitch assessed.

“FX interventions have weakened policy credibility. Turkey's prior long-standing commitment to a floating exchange rate was a supportive factor for its rating and facilitated the economic adjustment since the lira crisis in mid-2018, but this has been damaged by the scale of interventions this year,” it also said.

“The sharp fall in real interest rates, from a peak of 8.3% (ex-post, policy rate) in June 2019 to minus 3.5% (or to minus 1.5% using 12-month inflation expectations), has further weakened disinflation prospects and monetary policy credibility,” the rating agency said.

Official “inflation remains high”, at 11.8% in July, and has averaged 11.7% in 2015-2020 compared with the 'BB' median of 3.4%.

Use of rate corridor

CBRT has started to tighten liquidity, with the average funding rate increasing to 9.4%, and Fitch anticipated further use of the interest rate corridor (overnight rate of 9.75% and late liquidity window of 11.25%) before any change to the main policy rate.

Fitch forecast an increase in the policy rate to 9.25% at end-2020.

However, “the policy reaction function is unpredictable, and there is a risk that tightening will be insufficient to stabilise the external position”.

The current account balance deteriorated to a deficit of USD20bn in H1 from a surplus of USD9bn (1.1% of GDP) in 2019.

This is driven by strong credit growth and the collapse in tourism, according to Fitch.

Fitch forecast a full-year current account deficit of 3.2% of GDP in 2020.

The government's coronavirus response focused heavily on credit stimulus but the authorities have signalled a tightening partly by adjusting the asset ratio regulation on banks that incentivises lending.

The Turkish economy has a long-standing close correlation between stronger economic activity, high loan growth and an increasing current account deficit, and it is unclear how the authorities view such trade-offs, with the risk of a build-up over time of unsustainable credit levels, exacerbating external imbalances, Fitch also said.

The external financing positions of the banking and corporate sectors account for 42% and 35%, respectively, of Turkey's $190bn external financing requirement over the next 12 months, according to the agency.

Banks' external financing requirements fell to $79bn at end-June, from $102bn at end-1H18, and $35-40bn “when more stable sources of funding are excluded”.

Banks have foreign-currency liquidity of $75bn at end-June, of which Fitch estimated 54% was swaps largely undertaken with CBRT.

Orderly FX deleveraging

Banks' orderly FX deleveraging has continued, with a 74% rollover rate in June (on a rolling three-month basis), and the average price for the eight syndicated loans since the coronavirus shock was marginally lower than in Q4 2019.

FX-adjusted foreign currency bank deposits were still growing, by 7% y/y in July, the banking sector deposit dollarisation ratio remains high, at 50% in June (51% at end-2019), compared with the 'BB' median of 25%, “representing a risk to external finances should there be a loss of depositor confidence”, Fitch said.

The corporate sector has also continued to deleverage, with the overall net FX position falling to USD165bn in May from USD187bn a year earlier.

Of the USD67bn of corporate external debt due over the next 12 months, trade credits, which carry little rollover risk, make up USD47bn.

The sharp fall in domestic borrowing costs has contributed to a recent reduction in the corporate external debt rollover rate, to 60% in June (three-month, rolling) while it has also “added to the pressure on the balance of payments and CBRT reserves”.

Fitch said it expected the Turkish economy to contract by 3.9% in 2020.

“There is continued speculation about an early election”, but Fitch saw this as less likely in the near term and remained doubtful that there was a compelling motivation, despite reported strains within the coalition and the potential for a steady erosion of support to opposition parties.

Fitch expected US sanctions to be advanced against Turkey, and “it remains unclear the extent to which they will be broadened from implementation of CAATSA [Countering America’s Adversaries Through Sanctions Act] measures”.

‘Risk of Syria escalation’

In Syria, the ceasefire Turkey agreed with Russia on military operations in Idlib region was unlikely to hold in Fitch’s view, and “there is a risk of an escalation, heightened tensions with Russia, and adverse spill-overs, compounded by the likely further displacement of Syrians”.

Military operations in Libya have stepped up since Fitch’s last review in February, adding to risks to relations with Russia.

Fitch continued to view the US court case against Turkish state lender Halkbank for Iran sanctions evasion as of lower impact but still with the potential to damage investor sentiment.

The government's direct fiscal response to the coronavirus shock was “moderate”. The central government deficit widened to 5.2% of GDP (annualised) in January-July. Fitch forecasts the general government deficit will move up to 6.5% of GDP in 2020 from 3.3% in 2019. “There is particular uncertainty around the forecast partly given the lack of clarity over the unwinding of fiscal measures,” it said.

Fitch forecast that general government debt would increase from 33% of GDP at end-2019 to 40% at end-2020, 7pp higher than forecast in its last review in February.

“There has been an increase in contingent liability risks, mainly from the banking sector,” Fitch said. Other direct government guarantees currently total close to 5% of GDP, in addition to which the ratings agency estimated contingent liabilities from public-private partnerships of a similar magnitude.

“Turkish banks' credit profiles remain under pressure from exposure to macro and lira volatility. Regulatory forbearance is providing an uplift to asset quality and capital metrics,… and refinancing risks also increase with a weakening of investor sentiment,” Fitch said.

Fitch said it expected a marked weakening in underlying asset quality, given the recessionary environment, exposure to vulnerable sectors such as tourism, and the recent rapid growth in lending particularly unsecured retail.

Risks to capitalisation were significant given pressures on asset quality and the currency, according to the ratings agency.