Fitch Ratings has downgraded Turkey’s Long-Term Foreign Currency Issuer Default Rating (IDR) to ‘B+’ from ‘BB-‘. The Outlook is Negative.
KEY RATING DRIVERS
The downgrade of Turkey’s IDRs and the Negative Outlook reflects the following key rating drivers and their relative weights:
High
Policy-driven financial stress episodes of higher frequency and intensity have increased Turkey’s vulnerabilities in terms of high inflation, low external liquidity and weak policy credibility. Fitch does not expect the authorities’ policy response to reduce inflation, including FX-protected deposits, targeted credit and capital flow measures, will sustainably ease macroeconomic and financial stability risks.
Moreover, Turkey’s expansionary policy mix (including deeply negative real rates) could entrench inflation at high levels, increase the exposure of public finances to exchange rate depreciation and inflation, and eventually weigh on domestic confidence and reignite pressures on international reserves. The risk of additional destabilising monetary policy easing or stimulus policies ahead of the 2023 general elections is high, and there is an elevated degree of uncertainty about the authorities’ policy reaction function in the event of another episode of financial stress, as political considerations limit the central bank’s ability to raise its policy rate.
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Authorities expect that the introduction of FX-protected deposits combined with a broader strategy to encourage ‘liraisation’ of the financial system will support exchange rate stability and in turn facilitate a reduction in inflationary pressures. The new mechanism, expanded from retail depositors to corporates, non-residents and Turkish citizens abroad, will compensate term deposit holders if the lira depreciation is greater than the nominal interest rate. As of 9 February, FX-protected deposits were TRY313 billion (5.8% of total deposits), and corporates are expected to increase participation due to tax benefits.
In Fitch’s view, the new instrument’s capacity to sustainably improve confidence is limited in an environment of high and rising inflation, as well as unanchored expectations. Moreover, if the instrument fails to reduce domestic demand for FX, preserving a stable exchange rate without the use of interest rates would require renewed FX intervention or additional capital flow measures similar to those recently introduced requiring the sale of 25% of exporters’ revenues, as well as tighter controls to monitor that credit allocations do not add to FX demand. This policy response could in turn have a negative effect on domestic confidence.
Inflation rose to 48% in January and price pressures remain high, with PPI close to 94% (partly reflecting international commodity prices and supply chain disruptions), continued exchange rate pass-through, rising inflation expectations and utility price and wage hikes. We forecast inflation to reach 38% by the end of the year and average 41% in 2022 and 28% in 2023, the second highest among all Fitch-rated sovereigns. Backward indexation, failure of the authorities to rein in expectations and additional exchange rate volatility represent upside risks to our inflation forecasts.
Medium
Turkish FX liquidity buffers are low relative to peers and risks derived from high financial dollarisation, the vulnerable structure of international reserves and significant exposure to changing investor sentiment. After coming under pressures in November-December, recent figures show an increase in gross (USD114.7 billion) and net (USD16.3 billion) reserves but the net foreign asset position of the central bank (excluding FX swaps) remains negative.
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We expect gross reserves to increase to USD118 billion in 2022 (4.2 months of current external payments), as export rediscount credits, FX conversion of deposits, a new FX swap with the UAE (equivalent to USD5 billion) and EUR1 billion deposit from Azerbaijan’s Sofaz at the Central Bank will more than offset continued current account deficits and domestic FX demand, and limited portfolio inflows.
Although we expect the current account deficit to narrow further to 1.7% of GDP in 2022 from an estimated 2.2% in 2021 and 4.9% in 2020, external financing needs will remain high. External debt maturing over the next 12 months (end-November) amounts to USD167 billion. Access to external financing for the sovereign and private sector has been resilient to previous episodes of stress, but is vulnerable to changes in investor sentiment.
Reduced FX volatility in recent weeks and the introduction of the FX-protected deposits have allowed lira deposits to partially recover and driven some reversal in dollarisation. The scheme could mitigate near-term risks to the stability of bank funding, improve sentiment in the near term and alleviate pressure on capital ratios. Nevertheless, the combination of deeply negative real policy rates and rising inflation creates risks for financial stability, for example if depositor confidence is shaken, and could potentially jeopardise the until now resilient access of banks and corporates to external financing.
In this negative scenario, official international reserves would come under pressure, as a significant portion of banks foreign currency assets is held in the central bank including FX swaps and reserve requirements.
Turkish banks are vulnerable to FX volatility due to high external debt payments, the impact on asset quality (41% of loans denominated in foreign currency) and high deposit dollarisation (61.5%). In addition, Fitch estimates that 10% depreciation erodes the sector common equity Tier 1 ratio by about 50bp, although the regulator has extended regulatory forbearance to cushion the impact of depreciation on capital ratios.
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