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Turkey: Fitch downgrades rating outlook to negative on rate cuts and lira depreciation

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Fitch Ratings downgraded the outlook for Turkey’s credit rating to negative, citing the “early” monetary easing pointing to a deterioration in domestic confidence. While pointing out that the weakening of the currency may create risks for macroeconomic and financial stability, which may exacerbate financing pressures; Recently, aggressive rate cuts, changes in economic management and growth-oriented economy perspective are the factors that generally form the basis of pressure. The recent Central Bank rate cuts, which took place with an unusual approach at a time when inflation was close to 20%, and President Mr. Recep Tayyip Erdoğan’s assessments that interest rates may decrease depending on his economic approach form the basis of our expectation for the continuation of the current policy.

 

“The early monetary policy easing cycle of the central bank and the expectation of further rate cuts or additional economic stimulus ahead of the 2023 presidential election led to deterioration in domestic confidence, reflecting a sharp depreciation in the Turkish lira, including an unprecedented intraday.”

 

In the evaluations in the report; It is pointed out that after the 2018 and 2020 crises, Turkey is entering this new stress period from a fragile position with a high degree of uncertainty regarding the policy response function of economic authorities, high external financing requirements, deteriorating inflation dynamics and weakened external buffers. Despite rising inflation (19.9% ​​year-on-year in October) and the tightening in external financing conditions, the central bank lowered the main policy rate to 15% in November (with a total decrease of 400 basis points since September). As a result; It is stated that real interest rates decreased deeply from 2.75% in March to the negative zone (-4.9%), weakening domestic confidence and increasing foreign exchange demand.

 

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The central bank has repeatedly changed its policy guidance in recent months from a commitment to maintaining positive real rates to focusing on core inflation dynamics and more recently closing the current account deficit. Fitch considers that Central bank intervention in the foreign exchange market, if it continues, will not alone address the main reasons behind depreciation pressures and risks further weakening the composition of already weak Central bank international reserves. The lira, which has lost more than 30% of its value in the last period; Negative real rates, the lack of policy guidance, statements by government officials advocating a weakening of the lira as part of an economic development strategy are expected to remain under pressure amid rising inflation and inflation expectations. There is a high degree of uncertainty regarding the timing and type of policy response to these factors.

 

Fitch; forecasts inflation to reach 25% by the end of 2021 and remain one of the highest among countries rated at an average of 20% in 2022-2023. Weak lira, higher international commodity prices and rising inflation expectations pose upside risks to inflation forecasts. Maintaining a highly negative real policy rate could further undermine domestic confidence and potentially jeopardize the hitherto flexible access of banks and companies to external finance, raising risks to financial stability if, for example, depositor confidence is shaken. Moreover, the government’s focus on supporting faster commercial loan growth, the main reason behind the easing cycle in Fitch’s view, and the prospect of significant real wage increases for 2022 could reverse the improvement in the current account. External debt due in the next 12 months amounted to USD 168 billion (end of September), mostly related to banks and companies. Mitigating factors include continued access to external finance and reduced private sector external leverage during times of stress.

 

If we look at the economic evaluation estimates;

 

·        The general government debt-to-GDP ratio is expected to increase significantly from the forecast of 39% in August to 47% of GDP. The fiscal deficit / GDP is likely to outperform the government’s revised 2021 fiscal target of 3.5%, and Fitch predicts the deficit will remain below peers in 2022-2023. Debt dynamics will be vulnerable to increased currency risks, as 60% of central government debt is denominated or denominated in foreign currency in October 2021, up from 39% in 2017.

·        While GDP growth, estimated at 10.5% in 2021, was strong compared to peers, GDP per capita in US dollars has deteriorated since 2013, decreasing by approximately US$4,000 to a forecast of US$8,500. There is a high level of uncertainty regarding the 3.5% growth forecast for 2022. According to Fitch; The recent monetary policy easing and the stimulus of additional credit support measures announced will be offset by the reduced impact of monetary policy on domestic financing costs and the deterioration in consumer and investor.

·        External financing pressures eased in 2021, driven by a narrowing current account deficit, moderately high international reserves, and uninterrupted access by banks and companies to sufficient external financing to renew their large debt repayments.

·        International reserves recovered thanks to strong export revenues, net foreign borrowing and new currency swap with China and currency swap with South Korea, as well as US$6.4 billion IMF SDR allocation. Fitch estimates reserves will reach $119 billion by the end of 2021, but will decline to $111 billion in 2022-2023 given the ongoing current account deficits and financial dollarization and the limited upward trend in portfolio inflows.

·        Net reserves (excluding foreign currency receivables, mostly from placements by Turkish banks) reached US$25 billion in mid-November (still well below US$41.1 billion at the end of 2019), and net reserves remain negative excluding currency swaps with local banks.

·        Although risks to banks’ Sovereign Credit Profiles continue to be significant, the banking system has been resilient to financial market stress, most recently in March. The relative stickiness of deposits during times of stress in recent years is a factor supporting the rating. In addition, the current foreign currency liquidity of the banking sector is sufficient to meet the short-term foreign currency debt.

·        However, the banking sector remains vulnerable to exchange rate volatility due to the impact on capitalization, asset quality, refinancing risk (given by short-term foreign currency financing) and high deposit dollarization (56% including precious metals).

·        Geopolitical risks will remain high, but current sanctions have had a limited impact on the economy so far.

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