Prepare to be harangued with tales of international conspiracies from newly-minted Sultan Recep Tayyip Erdoğan.
Turkey has been a case study this year in what not to do if you’re concerned about preserving a veneer of legitimacy with the financial community.
To be clear, no one was under the impression that the Turkish central bank was actually “independent”. Erdogan is an autocrat and as Nigel Rendell, a senior analyst at Medley Global Advisors, who spoke to Bloomberg via e-mail for a piece dated Tuesday put it, “if we look back and ask who’s stood up to Erdogan and come off better, it’s a short list – in fact, it’s a list with no names.”
Right. Actually, if you made a list of people who have stood up to Erdogan and then tasked a super computer to cross-check that list against a list of people who are both alive and not in prison, the only name you’d come up with is Fethullah Gulen, who Erdogan will eventually get his hands on even if Michael Flynn has to kidnap him in the middle of the night (allegedly).
Well, Erdogan is no fan of higher interest rates. In fact, the principle dictate of Erdogan-o-nomics is that higher rates cause inflation, an axiom so completely at odds with real economics that trying to wrap your head around it is an exercise in abject futility.
Turkey, like Argentina, was one of the wobbliest dominoes in the frontier/emerging market complex and so, when the dollar started to rally thanks to an unapologetic Fed, the lira went into something akin to a death spiral as bad fundamentals conspired with external pressure from hawkish U.S. monetary policy to create a currency crisis.
Amid the lira plunge, Erdogan decided to bring forward a landmark election that would consolidate virtually all power in a new executive presidency by 18 months. Although Turkish assets initially rallied on the announcement (presumably because getting the vote out of the way would remove “uncertainty”) but the lira would quickly plunge anew.
Although the central bank deployed an emergency LLW hike, simplified monetary policy, delivered a hike to the one-week repo rate and continued to insist that they retained their independence, the writing was on the wall: Erdogan would commandeer monetary policy once he emerged victorious from the (rigged) election.
And even if the writing wasn’t on the wall, Erdogan made sure that everyone knew what was going to happen.
Days after calling interest rates “the mother and father of all evil” during a speech to the business community in Ankara, he delivered a truly hilarious deadpan interview with Bloomberg, during which he made it abundantly clear that while short-term measures might be necessary to shore up the flagging currency, after the elections he would lower rates.
This week, the market’s worst fears were realized when he put Berat Albayrak (his son-in-law) in charge of the economy, one of a series of appointments and an alarming (if predictable in character) move from the perspective of the investment community.
Erdogan left no room for Mehmet Simsek, whose presence was one of the only things the market was still hanging its hat on. Here are some passages from a Goldman note out Friday:
The cabinet reshuffle comes at a challenging time for the Turkish economy, following the sharp FX adjustment in May, soaring inflation and a widening current account deficit. The decision also follows President Erdogan’s repeated calls for lower interest rates and a more active role in monetary policymaking. Financial markets responded negatively to the news, with the Lira depreciating by almost 6% and 10-year yields increasing by around 100bp.
In past research we have linked the volatility of Turkish asset prices to the government’s pro-growth bias in economic policy, where tight monetary policy has largely been countered by expansive fiscal and quasi-fiscal policies. In light of the significant personnel change in Turkey’s economic policy team, the coming period will be crucial in communicating a joint policy framework for rebalancing the economy, facilitating a domestic slowdown, bringing inflation down to a more manageable rate and demonstrating fiscal restraint, while also bringing the current account deficit down towards a more sustainable level.
Failure to do so in a timely and decisive manner risks deterring investors at a time when Turkey is dependent on external financing to the tune of just under 30% of GDP each year, is running a year-to-date current account deficit of 6.5% of GDP, and where the quality of financing has deteriorated towards capital flows that could reverse at relatively short notice. The fragility of Turkey’s funding position presents clear risks for its banking sector and raises the possibility of both sharp FX adjustments and a harder-than-expected landing.
Given all of this, it comes as no surprise that on Friday, Fitch downgraded Turkey, and cut the outlook to negative from stable.
Factors influencing the decision include the country’s large external financing needs, soaring inflation and, of course, Erdogan himself and his outlandish economic “theories.” Here’s Fitch:
Notwithstanding the simplification of interest rate setting around the one week repo rate announced in June, monetary policy credibility has been damaged by comments by President Erdogan suggesting a greater role of the presidency in setting monetary policy after the elections. Subsequent amendments to the central bank’s articles of association appear to strengthen the president’s influence, notably over key appointments.
The lira fell to a session low on the news.
You can expect Erdogan to use this as fodder for more bombastic rhetoric that explicitly blames foreign interests for the country’s FX crisis.
Now would be a good time for Berat Albayrak to say something reassuring to markets.
Of course he won’t. Because after all, it’s important to stay in the good graces of one’s in-laws – especially when one of those in-laws is a ruthless dictator.
Fitch Ratings-London-13 July 2018: Fitch Ratings has downgraded Turkey’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘BB’ from ‘BB+’. The Outlook is Negative.
A full list of rating actions is at the end of this rating action commentary.
KEY RATING DRIVERS
The downgrade of Turkey’s IDRs and Negative Outlook reflects the following key rating drivers and their relative weights:
Fitch believes downside risks to macroeconomic stability have intensified owing to the widening in the current account deficit (CAD), more challenging global external financing environment, jump in inflation and the impact of the plunge in the exchange rate on the private sector, which has significant foreign currency-denominated debt. In Fitch’s opinion, economic policy credibility has deteriorated in recent months and initial policy actions following elections in June have heightened uncertainty. This environment will make it challenging to engineer a soft landing for the economy.
Fitch expects the CAD to widen to 6.1% of GDP in 2018, driven by higher fuel prices, and in 1H, higher household consumption. The fall in the lira, combined with Fitch’s forecast of lower oil prices and the ongoing tourism recovery, will cause the deficit to narrow to 4.1% in 2019. FDI is forecast to remain around 1% of GDP, meaning that the deficit will be largely debt financed. Fitch forecasts net external debt to rise to 35% of GDP at end-2018, compared with the current ‘BB’ range median of 8%.
Turkey’s large gross external financing requirement leaves it vulnerable to shocks. For 2018, Fitch estimates it at USD229 billion, comprising a CAD of USD54 billion, medium and long-term amortisation of USD57 billion and short-term debt of USD118 billion. Fitch assumes that gross international reserves will decline to USD96 billion by end-2018, reducing Turkey’s liquidity ratio to 70%. Net reserves are less than half of gross reserves.
Headline inflation jumped to a 15-year high of 15.4% (up 2.6% mom) in June, in the aftermath of the sharp depreciation of the lira (by 27% year to date). Although we expect the cumulative 500bp hike in the policy interest rate by the central bank (CBRT) since April to ease inflationary pressure, Fitch forecasts annual average inflation to be more than double the current ‘BB’ range median, at 13% in 2018 and 10.8% in 2019.
Notwithstanding the simplification of interest rate setting around the one week repo rate announced in June, monetary policy credibility has been damaged by comments by President Erdogan suggesting a greater role of the presidency in setting monetary policy after the elections. Subsequent amendments to the central bank’s articles of association appear to strengthen the president’s influence, notably over key appointments. Monetary policy has persistently been unable to bring inflation near its 5% target and inflation expectations have become unanchored.
In Fitch’s view, a sustained reduction of inflation would require an increase in the credibility and independence of monetary policy and tolerance of a period of weaker economic growth. The prospects for this as well as structural economic reform are uncertain. Key figures from the previous administration with reformist credentials were excluded from a new cabinet, appointed on 9 July, while the son-in-law of the president was appointed as Minister of Treasury and Finance.
The significant tightening of financial conditions will cause GDP growth to slow. After a buoyant 2% qoq in 1Q (7.4% yoy) and reasonable April, it is likely that the economy has contracted and Fitch expects it to continue to shrink until 4Q. Fitch’s base case is for GDP growth of 4.5% in 2018 and 3.6% in 2019, supported by healthy external demand, a continued recovery in tourism, infrastructure spending and employment growth. A period of growth below trend (estimated by Fitch at 4.8%) may allow a partial unwinding of imbalances. However, the risk of a hard landing for the economy has increased.
Currency weakness poses a test to the private sector, given its open net FX position of USD221 billion at end-April, while tighter financial conditions test its large external financing requirement. The private sector has regularly demonstrated capacity to cope with adverse financing and exchange rate shocks, but a series of recent corporate debt restructurings point to the crystallisation of risks stemming from high corporate borrowing in recent years.
Tougher financing conditions and a weaker economy will likely hit the performance of the banking sector, heightening pressure on asset quality, capitalisation and liquidity and funding profiles. External debt rollover rates for banks have held up, and banks generally have sufficient foreign currency liquidity to meet foreign currency wholesale liabilities maturing within a year. However, the cost of financing has gone up and market demand for some instruments has tailed off.
Headline NPLs remain stable at around 3%, but the volume of at-risk restructured loans and watch-list loans continues to rise, although the switch to IFRS9 complicates the assessment. Banks may not be able to fully pass on higher CBRT rates, putting pressure on margins, and the high loan-to-deposit ratio (127%; 152% TRY) and weaker demand for foreign currency lending will likely constrain credit growth. Fitch placed 25 banks on Rating Watch Negative on 1 June reflecting heightened risks following increased market volatility.
Turkey’s ‘BB’ IDRs also reflect the following key rating drivers:
Fiscal performance has deteriorated modestly at the central government level over the first five months of the year, but this does not yet capture a pre-election economic support package; the largest item of which was a bonus for pensioners that cost TRY21 billion (0.6% of GDP). Although spending growth is likely to ease after the elections, the slowing economy will hit fiscal revenues. As a result, Fitch forecasts the general government deficit to widen to 2.9% of GDP in 2018 from 2.1% in 2017. A tightening of policy is assumed from 2019 in line with the completion of the electoral cycle.
Moderate general government debt is a rating strength and is forecast to remain so despite the deterioration in headline fiscal performance. At 28.1% of GDP at end-2017, general government debt/GDP is well below the current peer median of 44.5%. Debt/revenue of 83.8% was almost half the current peer median, reflecting the large revenue base. Contingent liabilities, which are rising from a low base (driven primarily by PPPs), are unlikely to have a material impact on public finances over the forecast period, but pose a risk over the medium term. Significant infrastructure projects, likely to be PPP financed, are being discussed ahead of the centenary of the formation of the Turkish Republic in 2023.
President Erdogan secured a new term with 52.6% of the vote in the presidential election on 28 June, which completed the transition to an executive presidency under a new constitution that was approved by a narrow margin in 2017. The ruling AKP won 42.6% of the vote at the concurrent parliamentary election and the dynamics of its coalition with the nationalist MHP are to be tested. Local elections, due in March 2019, will complete the electoral cycle and are expected to be keenly contested.
Political and geopolitical risks weigh on Turkey’s ratings and World Bank governance indicators have fallen below the ‘BB’ median. Tolerance of dissenting political views is reducing in the opinion of independent observers. The state of emergency is expected to be lifted in July, but the President has significant capacity to rule by decrees under the new constitution and a purge of followers of the group that the government considers responsible for the coup attempt in July 2016 continues.
There are a number of active pressure points in relations with the US and EU. The conviction of an employee of a state-owned bank for evading Iranian sanctions in January 2018 brings the risk of fines for the institutions implicated, which could have broader implications for the external financing of the financial sector. Turkey remains involved in active conflict in neighbouring Syria. The composition of the ruling coalition suggests progress toward the resolution of the conflict in the south east is unlikely.
Turkey is a large and diversified economy with a vibrant private sector. Human Development and Doing Business indicators as measured by the World Bank, are in excess of the ‘BB’ median. GDP per capita is double the peer median, although the volatility of economic growth is well in excess of peers reflecting a vulnerability to regular domestic and external shocks.
SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)
Fitch’s proprietary SRM assigns Turkey a score equivalent to a rating of ‘BBB’ on the Long-Term Foreign-Currency (LT FC) IDR scale.
Fitch’s sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:
– Macroeconomic policy and performance: -1 notch, to reflect political pressure on monetary policy and uncertainty over the commitment to macro stability.
– External finances: -1 notch, to reflect a very high gross external financing requirement and low international liquidity ratio.
– Structural features: -1 notch, to reflect an erosion of checks and balances leading to a political environment that may continue to adversely affect economic policymaking and performance, and the risk of serious terrorist attacks.
Fitch’s SRM is the agency’s proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch’s QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
The main factors that, individually, or collectively, could lead to a downgrade are:
– A sudden stop to capital inflows or hard landing of the economy, particularly if it heightens stresses in the corporate or banking sectors.
– Failure to rebalance the economy and implement reforms that provide a path to addressing structural deficiencies and reducing inflation and external vulnerabilities.
– A marked increase in the government debt/GDP ratio to a level closer to the peer median.
– A serious deterioration in the political or security situation.
The main factors that, individually, or collectively, could lead to a stabilisation of the Outlook are:
– A sustainable rebalancing of the economy evident in a reduction in the CAD and inflation that reduces external vulnerabilities.
– A political and security environment that supports a pronounced improvement in key macroeconomic data.
– Fitch forecasts Brent Crude to average USD70/b in 2018, USD65/b in 2019 and USD57.5/b in 2020.
The full list of rating actions is as follows:
Long-Term Foreign-Currency IDR downgraded to ‘BB’ from ‘BB+’; Outlook Negative
Long-Term Local-Currency IDR downgraded to ‘BB+’ from ‘BBB-‘; Outlook Negative
Short-Term Foreign-Currency IDR affirmed at ‘B’
Short-Term Local-Currency IDR downgraded to ‘B’ from ‘F3’
Country Ceiling downgraded to ‘BB+’ from ‘BBB-‘
Issue ratings on long-term senior unsecured foreign-currency bonds downgraded to ‘BB’ from ‘BB+’
Issue ratings on long-term senior unsecured local-currency bonds downgraded to ‘BB+’ from ‘BBB-‘
Issue ratings on short-term senior unsecured local-currency bonds downgraded to ‘B’ from ‘F3’
Issue ratings on Hazine Mustesarligi Varlik Kiralama Anonim Sirketi’s foreign-currency global certificates (sukuk) downgraded to ‘BB’ from ‘BB+’
Issue ratings on Hazine Mustesarligi Varlik Kiralama Anonim Sirketi’s local-currency global certificates downgraded to ‘BB+’ from ‘BBB-‘