Turkey needs to reinstate credible economic management framework to ensure credit rating, says Scope

The Executive Presidency of Recep Tayyip Erdogan and post-election governance changes have reopened questions around the overall direction of economic policy making. Turkey requires a credible economic programme that prioritises sustainable growth.

President Recep Tayyip Erdogan’s appointment of Berat Albayrak, his son-in-law, to run the economy, alongside planned changes to the governance of the central bank and remarks about the lowering of interest rates have raised renewed concerns surrounding Turkey’s post-election monetary, fiscal and financial stability outlooks.

The Turkish lira traded at 4.8 to the dollar at the time of this writing, down around 22% since the start of 2018. Scope is closely monitoring developments in Turkey (BB+/Stable).

Scope analyst Jakob Suwalski explains what is at stake.

Investors appear nervous about the outlook for Turkey. Are they right to be?

Turkey is vulnerable to external shocks, as shown in the economy’s recent history—especially in an environment of global rate normalisation and current wider emerging market stresses. President Erdogan’s victory in elections last month has given him extremely broad powers. These capacities range from the ability to rule by decree, to the means to stamp out dissent (evidenced in July dismissals of more than 18,000 civil servants), to greater influence over monetary policy. The appointment of his son-in-law and departures of economic-moderates such as Deputy Prime Minister Mehmet Simsek cast a cloud over the quality and direction of policy making over a longer-term window moving ahead, with the President having a mandate until 2023. Further weakening of Turkey’s policy framework could thus have significant credit relevant implications. In the short term, elevated capital outflows would accentuate prevailing external vulnerabilities, in view of a current account deficit of above 6% of GDP and moderate levels of FX reserves of USD 133.5bn as of April.

Why is inflation such a concern for investors?

The central bank’s rate hikes in May and June, taking the policy rate to 17.75%, were steps taken to reconvince investors of the bank’s ability to combat high inflation. However, with the pass-through of currency devaluations, inflation reached 15.4% YoY in June—the highest level since December 2003 and well above a central bank target of 5%. Hence Turkey’s real policy rate is reduced.

In Scope’s view, monetary and fiscal policy ought to be kept tight if not tightened in order to stabilise the lira and lower above-potential economic growth (7.4% YoY in Q1 2018, which Scope expects to slow to 5% for the full year 2018). Instead, changes in economic governance raise questions for policy making independence, and Erdogan’s comments on low interest rates have at the minimum increased uncertainty surrounding future rate decisions and amplified investor concerns. Focusing Turkey’s economic agenda on lower but more sustainable growth is the most direct route to increasing the credibility of Turkey’s policy making institutions and, in turn, lessening inflationary stresses. The treasury and finance minister Albayrak has highlighted that the main economic priority will be on reducing inflation with the help of monetary and fiscal policies. Scope notes that the next central bank Monetary Policy Committee meeting comes on 24 July.

Doesn’t currency weakness and high inflation push up interest rates and external funding risks, making it more expensive for companies to service both local- and foreign-currency loans?

10-year Turkish local bond yields have increased to above 17%, and the weakening lira has undoubtedly made it harder on Turkish borrowers to repay external financing requirements, which total about 25% of GDP this year, roughly in line with the ratio of recent years. External debt maturing within one year as of the end of Q1 2018 amounted to USD 182bn, of which 57% was owed by the banking sector, 40% by the non-financial private sector, with the remainder by the government.

The lira’s decline has driven up costs on foreign-currency loans, causing a balance sheet mismatch between income streams and debt servicing costs. This is important given the Turkish private sector’s significant foreign-currency-denominated liabilities. The central bank’s actions in May to make it easier on exporters to repay foreign-currency debt, while a step in the right direction, do not go far enough. The external debt is, however, structured robustly and banks have sufficient foreign currency liquidity such as to limit the economy’s exposure to sudden capital outflows and short-lived market shutdowns to an extent, increasing the probability of many borrowers being able to bridge a crisis.

The Executive Presidency of Recep Tayyip Erdogan and post-election governance changes have reopened questions around the overall direction of economic policy making. Turkey requires a credible economic programme that prioritises sustainable growth.

President Recep Tayyip Erdogan’s appointment of Berat Albayrak, his son-in-law, to run the economy, alongside planned changes to the governance of the central bank and remarks about the lowering of interest rates have raised renewed concerns surrounding Turkey’s post-election monetary, fiscal and financial stability outlooks.

The Turkish lira traded at 4.8 to the dollar at the time of this writing, down around 22% since the start of 2018. Scope is closely monitoring developments in Turkey (BB+/Stable).

Scope analyst Jakob Suwalski explains what is at stake.

Investors appear nervous about the outlook for Turkey. Are they right to be?

Turkey is vulnerable to external shocks, as shown in the economy’s recent history—especially in an environment of global rate normalisation and current wider emerging market stresses. President Erdogan’s victory in elections last month has given him extremely broad powers. These capacities range from the ability to rule by decree, to the means to stamp out dissent (evidenced in July dismissals of more than 18,000 civil servants), to greater influence over monetary policy. The appointment of his son-in-law and departures of economic-moderates such as Deputy Prime Minister Mehmet Simsek cast a cloud over the quality and direction of policy making over a longer-term window moving ahead, with the President having a mandate until 2023. Further weakening of Turkey’s policy framework could thus have significant credit relevant implications. In the short term, elevated capital outflows would accentuate prevailing external vulnerabilities, in view of a current account deficit of above 6% of GDP and moderate levels of FX reserves of USD 133.5bn as of April.

Why is inflation such a concern for investors?

The central bank’s rate hikes in May and June, taking the policy rate to 17.75%, were steps taken to reconvince investors of the bank’s ability to combat high inflation. However, with the pass-through of currency devaluations, inflation reached 15.4% YoY in June—the highest level since December 2003 and well above a central bank target of 5%. Hence Turkey’s real policy rate is reduced.

In Scope’s view, monetary and fiscal policy ought to be kept tight if not tightened in order to stabilise the lira and lower above-potential economic growth (7.4% YoY in Q1 2018, which Scope expects to slow to 5% for the full year 2018). Instead, changes in economic governance raise questions for policy making independence, and Erdogan’s comments on low interest rates have at the minimum increased uncertainty surrounding future rate decisions and amplified investor concerns. Focusing Turkey’s economic agenda on lower but more sustainable growth is the most direct route to increasing the credibility of Turkey’s policy making institutions and, in turn, lessening inflationary stresses. The treasury and finance minister Albayrak has highlighted that the main economic priority will be on reducing inflation with the help of monetary and fiscal policies. Scope notes that the next central bank Monetary Policy Committee meeting comes on 24 July.

Doesn’t currency weakness and high inflation push up interest rates and external funding risks, making it more expensive for companies to service both local- and foreign-currency loans?

10-year Turkish local bond yields have increased to above 17%, and the weakening lira has undoubtedly made it harder on Turkish borrowers to repay external financing requirements, which total about 25% of GDP this year, roughly in line with the ratio of recent years. External debt maturing within one year as of the end of Q1 2018 amounted to USD 182bn, of which 57% was owed by the banking sector, 40% by the non-financial private sector, with the remainder by the government.

The lira’s decline has driven up costs on foreign-currency loans, causing a balance sheet mismatch between income streams and debt servicing costs. This is important given the Turkish private sector’s significant foreign-currency-denominated liabilities. The central bank’s actions in May to make it easier on exporters to repay foreign-currency debt, while a step in the right direction, do not go far enough. The external debt is, however, structured robustly and banks have sufficient foreign currency liquidity such as to limit the economy’s exposure to sudden capital outflows and short-lived market shutdowns to an extent, increasing the probability of many borrowers being able to bridge a crisis.