Turkish Downgrade Sets the Stage for Deeper Economic Malaise

Erdogan works to cement his political position and crack down on dissent; the economic ramifications could be enormous.

Nearly 2 months after the attempted overthrow of Turkish Prime Minister Recep Tayyip Erdogan, the outlook for the economy continues to crumble, with the latest evidence coming from ratings agency Moody’s.

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Following the lead of S&P from earlier in the summer, Moody’s downgraded the sovereign outlook for Turkey to ‘junk’ status which could pave the way for a massive exodus of investment capital from the struggling economy.  A crackdown on dissent and the Kurds combined with an uptick in violence and terrorism domestically has badly hurt the formerly bustling tourism industry.

Furthermore, a high degree of household leverage coupled with the government’s insistence on meeting exceptionally high growth targets could further balloon the risks for the outlook.  As Erdogan works to cement his political position and crack down on dissent, the economic ramifications could be enormous.

The Latest Downgrade

Although the move was deemed hasty by the Turkish Government, S&P was the first of the three major credit rating agencies to downgrade the sovereign outlook to junk status.  The latest decision by Moody’s to drop the rating from the lowest investment grade rating of Baa3 to a junk investment rate of Ba1 has only accelerated the problems for Turkish policymakers as they work to restore confidence.

The immediate reaction of Turkish officials was outcry, mirroring other previous statements on ratings revisions that seem to link the action with undermining their authority and credibility. Turkish President Binali Yildrim characterized the move as partial and biased, stating “we believe they are attempting to create a certain perception of the Turkish economy”.  Unfortunately for Yildrim and Turkey’s funding needs, political risks are particularly unsettling for foreign investors.

One of the main reasons behind the backlash from officials was the fact that Turkey needs significant foreign investment to help close its current account deficit.  With most of the momentum of the domestic economy hinging on consumption, accounting for nearly two-thirds of GDP expansion, imports vastly exceed exports, contributing to a deficit between inflows and outflows.

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This deficit needs to be financed, often externally, via the bond market. However, with the latest downgrade, many funds that have mandates to only hold investment grade assets will be forced to either cut their holdings of Turkish bonds or be prevented from buying them.  As a result, financing costs will likely rise for the country, the evidence of which is the 10-year yield which briefly rose above 10.00% earlier in the week before retreating to 9.46%.

Risks Rising

turkey-inflation-rate

Besides desperately needing external investors to help close the funding gap between imports and exports, the heavy emphasis on domestic consumption as a driver of growth has its limits as well.  Erdogan has long been keen on dropping the nation’s interest rates, hoping that the move will spur growth and help tackle inflation which has largely outstripped GDP expansion for the last five years.

However, contrary to what Erdogan believes, accommodative monetary policy does not traditionally work as a mechanism to fight inflation. While it might help spur growth, the other outcomes of easing rates may not be desirable for the Turkish economy in its current state.  Besides causing the Lira to fall further versus peers, low rates may also spur higher inflation despite the global deflationary wave.

In keeping with Erdogan’s philosophy of easing credit conditions, the latest cut to the lending rate last week marks the 7th straight month of cuts.  However, while borrowers may view the outcome as positive, it further raises the risks of enduring stagflation, marked by high inflation and high unemployment combined with low growth.

While the government is trying to reduce the proportion of economic growth generated by spending activity, the latest measures show that it is no closer to weaning itself off a consumption driven model.  As consumers continue to lever themselves with more debt, it could conceivably create even greater risks for the economy down the road once they can no longer borrow to finance purchases. Should spending collapse, the strategy of continuing to lower rates will likely backfire on the government and central bank, causing further downgrades and an increased flow of capital out of the country.

Looking Ahead

With two of the three major sovereign ratings agencies downgrading the outlook, the icing on the cake for Turkey will likely be the 2017 review conducted by Fitch.  Between now and then a lot can change, however, the current crackdown against dissent and move to purge suspected Gulenists from their positions within government will only exacerbate investor flight.  One of the main issues cited behind the downgrades was the ongoing political consolidation.

It does not help that tourism, a critical industry, has suffered tremendously thanks to uncertainty that lies ahead.  If there is one thing investors, especially foreign investors, like to avoid, it is uncertainty. Until the government can show that it has stabilized and is working to tackle high unemployment and inflation, investors are unlikely to return in droves to take advantage of Turkey’s high yields.

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