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Turkey highly relies on volatile capital flows to finance its large gross financing requirements. Hence, foreign investor confidence is of key importance for the country. The sharp depreciation of the Turkish lira in August 2018 highlights how vulnerable the economy can be in case of drastic change in risk aversion. Partly driven by the sharp lira depreciation, the inflation rate surged to 25.2% in October but has since eased somewhat to 21.6% in November. The Central Bank increased its one week repo rate from 17.75% to 24% in mid-September. Consumer and investor confidence fell dramatically and real GDP contracted in Q3 2018. If the contraction continues, the Turkish economy – which was overheating – may be in recession at the end of the year. This contrasts with the spectacular real GDP growth achieved over the past 5 years (above 6 % on average in the 2013-2017 period). In this context, the main question is what will be the main drivers of Turkey’s short-term country risk in 2019? 

Liquidity position remains weak

In order to answer this question, let us start with the short-term political risk, which represents the liquidity of a country. Despite a slight monthly increase of 1%, the foreign exchange reserves (excluding gold) dropped sharply by almost 20% year-to-date and by nearly 30% year-on-year based on the figures of end of October 2018. They are sufficient to cover an estimated 3 months of import (down from almost 4 months in 2017) and only nearly 60% of the external short-term debt (down from 70% in 2017). Worryingly, they are not sufficient either to cover the external debt service. This means that Turkey’s economy remains highly dependent on capital flows to finance its large gross financing requirements and thus remains vulnerable to change in investor risk perceptions. That said, the gross financing requirements (which consist of short-term external debt, MLT amortisation and current account deficit) are likely to decrease in 2019.

Indeed, the lira depreciation and the drop in consumer confidence let to a sharp improvement of the current account balance that turned into a surplus in Q3 2018, the first quarterly surplus since Q3 2003. This significant rebalancing is largely explained by a sharp drop in imports of goods and services. However, given that since August the lira has recovered somewhat, it remains to be seen whether the ongoing rebalancing will continue. On the one side, domestic demand is expected to remain depressed, which should continue to weigh on imports (and thus play for a continuation of the rebalancing). On the other side, with the recovery of the lira (cf. Graph 2, the prices of imports in local currency are also decreasing and the competitiveness of exports (including services exports as tourism) is deteriorating. Beside domestic demand and exchange rate fluctuation, other drivers of the current account balance are also at play such as oil prices (Turkey being a net fuel importer), external demand (the EU being Turkey’s largest trade partner) and gold imports (used as protection against high inflation and exchange rate depreciation).

Credendo currently classifies the short-term political risk of Turkey in category 4/7. However, should the foreign exchange reserves be further under pressure, or the current account balance plunge again into a large deficit, or the access to the financial market to refinance the short-term external debt be disrupted, may the short-term political risk be downgraded to category 5.

High commercial risk

Turkey’s commercial risk – which represents the macroeconomic factors and business environment that affect the payment capacity of all obligors in a country – is currently classified in category C (the highest risk on a scale from A to C). The ongoing real GDP contraction, which is likely to continue, is one driver of commercial risk – given the obvious link between growth performances and obligors creditworthiness – but it is not the only one. Monetary uncertainty arising from high inflation (likely to be close to 20% at the end of the year) and doubts about the independence of the central bank constitute an additional risk as does the risk related to the predictability of macroeconomic policies. Following the June 2018 parliamentary and presidential elections, the institutional framework changed from a parliamentary system – where the presidency was a representative function – to an executive presidency with a light check on the head of state. Under the new constitution, the president is able among others to appoint judges and senior bureaucrats, issue decrees with the force of law, declare the state of emergency and dissolve the parliament. Looking ahead, this means that the president has a vast power that can be used for the better (e.g. maintain sound general government finances) or the worse (e.g. try to boost economic growth by creating additional domestic and external imbalances).

The sharp depreciation of the lira, of almost 30% year-to-date, represents also a key risk for corporates. Indeed, the corporate debt (of more than 70% of GDP in June 2018) has increased rapidly over the last years (cf. Graph 4) and is mainly denominated in foreign currency. Hence, the lira depreciation results in a more expensive debt in local currency terms, which is likely to affect the capacity of corporates with large currency mismatch to pay it back. In addition, the lending rate has increased sharply and banks are likely to be less willing to lend. In the past, the sharp increase in the corporate debt was mainly financed by the banking sector. The latter is heavily dependent on external funding as net foreign liabilities represented around 17% of GDP in 2017. After the August confidence crisis, banks were still able to access to the financial markets to rollover their debt albeit at a higher cost. Hence, looking ahead, it will be key to monitor the evolution of the banking sector on liabilities’ side (among others their capacity to rollover their short-term debt and have access to capital market at a decent price) and on the assets side as a deterioration of their quality is likely in a context of lower economic growth and large corporate indebtedness.

Analyst: Pascaline della Faille - P.dellaFaille@credendo.com