Moody’s Investors Service has upgraded its credit rating on Turkey by two notches to B1 from B3, while keeping the positive outlook, the rating agency said on July 19 following a scheduled review on the country.

Turkey currently has a B+/Positive rating, at four notches below investment grade, from Fitch Ratings, a B1/Positive, at four notches below investment grade, from Moody’s Investors Service and a B+/Positive, at four notches below investment grade, from S&P Global Ratings.

In December and September, S&P delivered two Turkey outlook upgrades. In January, Moody’s delivered an outlook upgrade. 

In March, Fitch delivered a one-notch rating upgrade. In May, S&P delivered a one-notch rating upgrade.

More upgrades will follow should Turkey’s monetary normalisation policy remain in effect.

Fitch has scheduled its next Turkey review for September 6. S&P has November 1 earmarked for a Turkey review while Moody’s has announced July 19.

U-turn to orthodoxy

The key driver behind the two-notch upgrade by Moody’s is Turkey’s return to orthodox monetary policy in the wake of the re-election of Turkish President Recep Tayyip Erdogan in May last year.

Inflationary pressures have eased while the credibility of the country’s monetary policy and confidence in the Turkish lira (TRY) have been enhanced.

Turkey's elevated external vulnerability is improving, while political risks remain a rating constraint.

The positive outlook reflects a balance of risks skewed to the upside.

Meanwhile, the level of dollarisation in Turkey remains high and confidence in the lira has not yet been fully restored, implying that the risk of a return to the previous policy settings, which used regulatory measures to suppress demand for hard currencies, remains significant.

Moody’s expects Turkey’s official inflation to fall to below the 45%-level by December from the 72% y/y recorded in June.

Importantly, there will be no repetition of the mid-year minimum wage hikes that happened in July 2023 and 2022, implying that wage developments are likely to support disinflation going forward, according to Moody’s.

The rating agency forecasts end-2025 official inflation at around 30%, compared to its expectation of 38% released in January, when it changed Turkey’s outlook to positive.

The sharp monetary tightening has also restored the attractiveness of the lira with deposit rates averaging close to 60% currently, Moody’s also noted, adding that the central bank has reduced the size of the protected deposit scheme (KKM) by around 50% to $62bn in early July compared to the peak of $128 bn in August 2023, without a material impact on financial stability.

Foreign investors have returned to the lira-denominated papers with cumulative capital inflows since July 2023 standing at around $12bn.

The official 12-month rolling current account deficit data released by the central bank stands at $25bn, 2% of the official GDP target for 2024, and down from $57bn, or 5% of the official GDP release, a year ago, according to Moody’s.

It should be noted that the retreat in the official current account deficit figures is mainly due to the shifting of gold imports from the foreign trade category to the net errors and omissions column after the Erdogan regime imposed a quota on gold imports.

Gold imports continue on an illegal basis, but they are not tracked under foreign trade but in errors.

Turkey’s foreign-currency reserves have, meanwhile, risen by about $33bn compared to the trough, which was registered in May 2023, the rating agency also observed.

External financing is again widely available for Turkish issuers, including banks and corporate issuers.

No full-blown BoP crisis

Earlier concerns over rising risks of a full-blown balance of payments (BoP) crisis, which triggered successive downgrades to the B3 rating level, have for now dissipated.

While Turkey's headline external financing needs remain at elevated levels, at over 20% of GDP, more than half is financed via stable funding sources, in particular trade credit and deposits place at both the central bank and in the banking system that have been resilient to repeated shocks.

External vulnerability risks remain significant though. In particular, Moody’s external vulnerability indicator, which compares external debt payments due with the level of reserves of the previous year, remains high at close to 280%.

The indicator has declined from a peak of 360% in 2021 and somewhat overstates the external risks, given that around half of the short-term external debt in the form of deposits and trade credit has consistently been rolled over and the central bank has large gold reserves at its disposal.

Politics remain a constraint

Political risks have declined, but remain a key rating constraint. The risk of a reversal of policy direction towards the previous unorthodox stance has declined since the municipal elections at end-March.

The next parliamentary and presidential elections are due a long time from now, in 2028, giving the authorities some time to bring inflation down to previous low levels, even at the cost of temporarily low economic growth.

However, a very sharp slowdown in growth coupled with rapidly rising unemployment could lead to political pressure for an early easing of the monetary policy stance.  

Moody’s expects that the authorities will maintain the tight economic policy stance for some time and that fiscal policy will be tightened significantly next year.

Macroeconomic stability and strengthened institutions may allow Turkey's underlying credit strengths such as its diversified and competitive economy and comparatively strong fiscal and debt metrics to come to the fore again.

Moody’s would be likely to consider such improvements as longlasting and sustainable if they were to be accompanied by a structural reduction in Turkey's dependence on energy imports.

Reforms to end the practice of the backward-indexation of wages would also be credit positive.

ESG remains negative

Turkey’s ESG credit impact score at CIS-4 reflects the overall negative impact of ESG factors, in particular still weak governance.

Turkey also has material exposure to a number of environmental and social risks, which are mitigated to some extent by reasonably strong balance sheets of the sovereign, banks and corporates.

Turkey has moderate exposure to environmental risks (E-3) across a range of categories, such as water supply, natural capital, and waste and pollution.

The country is vulnerable to water stress and it has experienced reductions in winter precipitation in the western part of the country over the past half century. This can impact the quantity and quality of water in Turkey's rivers, which are an important source of drinking water, irrigation and power generation.

Carbon transition risks are also material and reflect a relatively high share of coal and gas-fired energy generation.

Exposure to social risks is similarly moderate (S-3). While Turkey’s young population supports its demographic profile, youth unemployment is high, labour force participation is low and informal employment is widespread.

High inflation has eroded living standards, adding to social risks.

The overall provision of basic services such as safe drinking water and sanitation services to the population is uneven across the country and weaker than in many other OECD countries.

Governance risks remain a key risk to Turkey's credit profile (G-4), notwithstanding the decisive change in monetary policy, Moody’s said.

The quality of institutions weighs on overall governance. The overall G score given by the rating agency incorporates the recently improved score for policy credibility and effectiveness to reflect the continuing ability to maintain prudent fiscal policies despite a range of shocks.