Turkey: Deterioration of Credit Profile, Unsustainable Governance Raise Likelihood of Deeper Crisis
The outcome of elections due in 2023 will be decisive for Turkey’s credit outlook.
Scope Ratings expects growth in Turkey of only 2.3% in 2022 before 2.4% in 2023, amid risk of sudden economic reversal, after 11% in 2021. Inflation, meanwhile, has risen to highs of 61.1% in March, and is seen staying elevated.
Structurally loose monetary policy, high inflation, negative net foreign-currency reserves as well as elevated and rising sovereign FX exposure increase the risks facing the long-run capacity of the government to repay debt especially during sudden future depreciations of the lira.
The risk of more severe crisis is high in view of testy market conditions and the economy’s external vulnerabilities
The risk of more severe crisis is high in an emerging-market economy with external vulnerabilities like Turkey’s given the spill-over effects on financial markets from Russia’s war in Ukraine. In addition, normalisation of monetary policy by G4 central banks amplifies capital outflow from developing countries.
Turkey’s capacity to repay sovereign debt is, furthermore, intertwined with the likelihood of domestic instability during a forthcoming phase surrounding presidential and legislative elections scheduled mid-2023.
The deterioration of the country’s credit profile underscored our decision of 11 March to downgrade Turkey’s long-term foreign-currency ratings to B- and maintain a Negative Outlook.
The resilience of the domestic banking system is critical to assessing how deep crisis might run
The resilience of the domestic banking system is critical to assessing how deep the economic crisis might run. The sovereign-banking nexus has tightened – with the government dependent at this stage on domestic banks for funding in domestic and in foreign currency.
The banks have been one of the country’s core credit strengths and so long as the banks stand, the sovereign stands. Nevertheless, economic mismanagement and associated credit risks will likely weaken Turkish bank balance sheets, and thus raise the possibility of greater vulnerabilities over the medium run.
A core vulnerability is the value of lira
A core vulnerability is the value of the lira. Periods of significant depreciation impair bank capital adequacy, forcing the government’s recent recapitalisation of several state-owned banks, not to mention raising inflation and compromising sovereign debt sustainability due to FX denomination of the state debt. The government has sought to stabilise the value of lira with policies that artificially ease sell-off pressure. They include protecting lira deposits against FX loss and requiring exchange of 25% of exporter FX revenue to lira.
Unfortunately, such policies are unlikely over the long run to prove sustainable or prevent another severe currency crisis. Instead, the lira savings scheme sacrifices a crucial credit strength of Turkey, namely, the health of the sovereign balance sheet. After TRY 10bn of payments in one week of maturing accounts – equivalent to 0.1% of GDP – the programme was recently expanded to include foreign companies and individuals, with payments expected to increase with time.
We assume general government deficits will average 5.9% of GDP during 2022-26 – more elevated than before the Covid-19 crisis – with government debt increasing to 65.0% of GDP by 2026 from 27.4% at its 2015 low, driven by currency depreciation of an assumed 24% a year over 2022-26, creating debt-servicing stress for a 67% share of central-government debt in foreign currency.
Central bank reserves adjusted for swaps represents a net liability of USD 58.7bn in February. The economy’s current account weakening this year to a deficit of around 8% of GDP – due to elevated global energy and commodity prices, and reliance on wheat import from Russia and Ukraine – represents a further challenge with respect to reserves.
Scheduled 2023 elections could prove to be a make-or-break moment
The current economic trajectory is unsustainable. Scheduled 2023 elections could prove one make-or-break moment. Should President Recep Tayyip Erdoğan hold to power after 2023, economic mismanagement is likely to endure. Alternatively, were opinion polls to prove right, and Erdoğan be defeated, a resetting of the policy framework of Turkey might ensue – fundamentally altering the country’s credit outlook.
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Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.