“Rapidly growing GDP and low debt levels in the public finance sector suggest that the Turkish economy is doing well. Meanwhile, Moody’s has just cut the country's rating, and the lira has reached a historical low in relation to the euro. Why?” asks Marcin Lipka, Conotoxia Senior Analyst.
Economic growth within 7% and a GDP debt of 27.5%. This is the estimation of the basic macroeconomic indicators presented by S&P Global Ratings in Turkey’s February rating review. This was not enough to even slightly improve Turkey's rating. The agency maintained the country's credibility at a waste (BB) level with a negative outlook.
Moody's cut Turkey's credit rating from Ba1 to Ba2 on Wednesday. It is currently at the same level as in the case of S&P, which is two levels below the investment limit. On Thursday, the lira (TRY) reached historical records of weakness to the euro. Five years ago, 2.30 TRY had to be paid for the European currency. Now, it is more than twice as much, approximately 4.70. What are the reasons behind such rigorous ratings by leading rating agencies and the dramatic Turkish currency sell-off?
The first offender - inflation
It can be seen relatively quickly that the Turkish economy lacks balance. According to the Central Bank's quarterly inflation report, prices in 2017 increased by almost 12%. Food costs have risen by less than 14% and the price of cars by 27%. Also, core inflation (excluding fuels and food) is very high - 12% y/y in February.
It is also worrying that the previous central bank inflation forecasts have been significantly exceeded. This may suggest that the monetary policy of the monetary authorities is too mild and instead of limiting price increases and encouraging a return of inflation to the target, it is overstimulating the economy.
This is confirmed, for example, by the data on the growth of granted loans - by about 20% annually. It is likely that this strongly helps consumption and investments, but also causes very high inflation. The economy is in danger of overheating and witnessing a significant decline in activity in subsequent years.
External imbalance
In addition to excessive monetary or fiscal stimulus, there is also a considerable external imbalance in Turkey. The current account deficit (mainly caused by imports higher than exports) exceeded 47 billion USD last year, which is approximately 5% GDP. In comparison to 2016, the deficit increased by 14 billion USD despite the better condition of the services sector (higher tourism revenues).
Deficit financing may take place either through direct investment (a better solution) or through portfolio capital. As pointed out by S&P, financing was primarily based on the first method until 2015. Now, however, the trend has changed and the deficit is financed more by volatile portfolio investments, which are sensitive to global sentiment. If it worsens, the costs of servicing this external imbalance (e.g. through the debt market) may increase significantly. This is a serious risk both for the currency and the stability of the economy.
Institutional problems
In addition to strong economic stimulus and severe external imbalances, Turkey is facing another problem. These are institutional issues, partly related to the situation from mid-2016, and the geopolitical situation.
According to Moody's, events that followed the “failed coup d'état of July 2016 negatively affect the investment climate and relations between Turkey and the United States as well as with the European Union."
S&P also extensively describes the institutional issues. The credit rating agency believes that "the United States may consider fines or other penalties for one or more Turkish financial institutions, including public entities and potentially, companies from other sectors, allegedly allowing Iran to avoid US sanctions. The escalation of tensions with the United States can have serious financial and economic consequences for Turkey, given that Turkish banks are using external financing."
The currency market is telling the truth
This example from Turkey accurately shows that a low debt to GDP ratio and high economic growth may send deceptive signals about a country’s very good economic condition. In this case, the multiplicity and complexity of risks is probably relatively well valued by the currency market, which this week brought the lira to a historical minimum.
