Turkey: Country risk hampered by weak monetary policy credibility and reliance on external funding

• Very strong real GDP growth in 2021.
• Weak liquidity remains an Achilles heel for Turkey despite a sharp increase in nominal gross foreign exchange reserves.
• The Turkish lira has depreciated sharply and pressure on the currency remains significant.
• High corporate indebtedness – often denominated in foreign currency – increases the non-payment risk.
• Credendo country risk classifications have a stable outlook.

Very strong growth in 2021

The IMF (WEO October 2021) expects real GDP growth to reach 9% this year. The high economic growth is even more impressive taking into account that – unlike many economies in the world – the Turkish economy did not contract last year but rather grew by 1.8%. Next year, the growth projection is less impressive but remains solid at 3.3%. The impressive growth in 2021 is explained by various factors stemming from the fact that the economy is well diversified, the vaccination rate is relatively high (almost 60% of the population is fully vaccinated) and domestic and external demands are strong. The high growth is also driven by the willingness of the authorities to support their economy with fiscal and quasi-fiscal measures as well as with a very accommodative monetary policy. That being said, the very loose monetary policy is not without consequence for inflation.

High inflation is a source of concern

Since 2016, average annual inflation has reached double figures, well above the central bank’s 5% target. This high inflation – 19.9% in October 2021, according to official figures – is driven by global factors (high commodity prices, global demand/supply mismatches) as well as domestic factors (exchange rate depreciation and very accommodative monetary policy). Whereas many emerging markets’ central banks are increasing their benchmark interest rate to stem inflation pressure, the central bank of Turkey cut its one-week repo rate to 15% in November 2021 after having only briefly increased it to 19% in March this year. As a result, the real benchmark interest rate is still negative. The recent interest rate cuts and frequent dismissals of central bank governors and members of the monetary policy committee are weakening the credibility of the central bank, which is only independent in name. What is more, policy uncertainty has increased over the past few years. The monetary policy is just one example of this deterioration. When looking at the World Bank governance indicators, a signification deterioration of most indicators can also be observed. Indeed, regulatory quality deteriorated from the rank of 66.3 in 2014 to 51.9 in 2020 whereas rule of law deteriorated from 57.2 to 40.4 and governance effectiveness from 68.3 to 52.4. The low monetary policy credibility and deterioration of governance indicators are weighing on foreign investor confidence and the attractiveness of the country for foreign direct investments. Amid subdued long-term investment, the economy relies on short-term capital flows to finance its structural current account deficit, which is a vulnerability given Turkey’s weak liquidity.

Higher gross foreign exchange reserves

In the past (see graph 1), the gross foreign exchange reserves have been under pressure. The gradual erosion of the gross foreign exchange reserves have led Credendo to downgrade the short-term political risk rating to category 5/7. However, since the low of September 2020, the gross foreign exchange reserves have been on the rise thanks to the IMF SDR allocation in August, higher short-term borrowing by the central bank (e.g. swaps) and higher portfolio inflows. The recent sharp increase in nominal foreign exchange reserves is very positive. Moreover, the current account deficit is expected to narrow from 5.2% of GDP in 2020 to 2.4% this year despite the increase in oil prices and strong domestic demand. Indeed, a strong rebound in current account receipts – driven by strong demand from Europe, a rebound in the tourism sector and improved competitiveness of exporters amid a weak lira – is expected to more than offset the higher imports.

However, for the time being the short-term political risk outlook remains stable as the gross foreign exchange reserves are not sufficient to cover the very high short-term external debt. Moreover, Turkey – given its reliance on short-term capital inflows – remains vulnerable to a change in global financial conditions. Such deterioration could be driven by domestic and global factors (e.g. the decision of the US Fed to tighten its monetary policy sharper than currently expected by the market to stem inflation pressure in the USA). Last but not least, in its latest Article IV consultation, the IMF noted that the quality of the foreign exchange reserves deteriorated in 2020 with an increasing share of reserves consisting of non-SDR basket currencies and/or owed to banks in the form of deposits at the central bank and swaps. When looking at banking sector aggregated data, an increase in claims on the central bank has indeed been observed in 2020 (by more than 60%) and this year to almost 11% of GDP.

Exchange rate pressure to continue

Amid weak liquidity and weak monetary policy credibility, the Turkish lira (TRY) has been under pressure (see graph 2) over the past few years. The sharp depreciation of the Turkish lira is a source of concern. Indeed, a share of the high private corporate debt – estimated at 72% of GDP in Q1 2021 following welcome deleveraging in 2018/19 (see graph 3) – is denominated in foreign currency and is therefore more costly to reimburse in local currency terms when the exchange rate depreciates. On the upside, this debt is largely domestic and financed by the banking sector amid a very accommodative monetary policy. Hence, the gross external debt and as such Turkey’s solvency is still moderate (at about 60% of GDP in 2020 according to World Bank figures).

However, it makes the banking sector vulnerable to currency shocks. The asset quality of the banking sector can deteriorate when the continuous depreciation of the lira makes it difficult for companies to pay back their debt in foreign currency (NPLs stood at 5% in 2020, a manageable level, partly explained by forbearance measures). On the liabilities side, the banking sector relies heavily on external funding and is thus vulnerable to change in risk perceptions. That being said, since 2017 the banking sector’s reliance on external funding relative to GDP has diminished from 16.6% in December 2017 to 10.2% in 2021, a rather reassuring trend.

Solid central government finances

On a positive note, it should be borne in mind that one of the strengths of the Turkish economy remains the sound finances of its central government. This has allowed the Turkish authorities to support their economy with fiscal support measures (at about 2% of GDP) and quasi-fiscal measures (at about 10% of GDP). That being said, public debt has recently increased, to almost 40% of GDP in 2020 – still a favourable level – as has the share denominated in local currencies (to 56% in 2020). This means that the central government is also increasingly exposed to exchange rate risk.

Stable country risk outlook

Credendo country risk classifications have a stable outlook. Indeed, the very strong growth, solid public finances, sharp increase in gross foreign exchange reserves, moderate external debt and debt service ratios support the classifications. On the other hand, the high reliance on external funding, weak monetary policy credibility and continuous pressure on the Turkish lira are weighing on the classifications.

Analyst: Pascaline della Faille – p.dellafaille@credendo.com