Fitch Ratings Feb. 11, 2022 Fitch Ratings - London - 11 Feb 2022: Fitch Ratings has downgraded Turkey's Long-Term Foreign Currency Issuer Default Rating (IDR) to 'B+' from 'BB-'. The Outlook is Negative. The downgrade of Turkey's IDRs and the Negative Outlook reflects the following key rating drivers and their relative weights: High Policy-driven financial stress episodes of higher frequency and intensity have increased Turkey's vulnerabilities in terms of high inflation, low external liquidity and weak policy credibility. Fitch does not expect the authorities' policy response to reduce inflation, including FX-protected deposits, targeted credit and capital flow measures, will sustainably ease macroeconomic and financial stability risks. Moreover, Turkey's expansionary policy mix (including deeply negative real rates) could entrench inflation at high levels, increase the exposure of public finances to exchange rate depreciation and inflation, and eventually weigh on domestic confidence and reignite pressures on international reserves. The risk of additional destabilising monetary policy easing or stimulus policies ahead of the 2023 general elections is high, and there is an elevated degree of uncertainty about the authorities' policy reaction function in the event of another episode of financial stress, as political considerations limit the central bank's ability to raise its policy rate. Authorities expect that the introduction of FX-protected deposits combined with a broader strategy to encourage 'liraisation' of the financial system will support exchange rate stability and in turn facilitate a reduction in inflationary pressures. The new mechanism, expanded from retail depositors to corporates, non-residents and Turkish citizens abroad, will compensate term deposit holders if the lira depreciation is greater than the nominal interest rate. As of 9 February, FX-protected deposits were TRY313 billion (5.8% of total deposits), and corporates are expected to increase participation due to tax benefits. In Fitch's view, the new instrument's capacity to sustainably improve confidence is limited in an environment of high and rising inflation, as well as unanchored expectations. Moreover, if the instrument fails to reduce domestic demand for FX, preserving a stable exchange rate without the use of interest rates would require renewed FX intervention or additional capital flow measures similar to those recently introduced requiring the sale of 25% of exporters' revenues, as well as tighter controls to monitor that credit allocations do not add to FX demand. This policy response could in turn have a negative effect on domestic confidence. Inflation rose to 48% in January and price pressures remain high, with PPI close to 94% (partly reflecting international commodity prices and supply chain disruptions), continued exchange rate pass-through, rising inflation expectations and utility price and wage hikes. We forecast inflation to reach 38% by the end of the year and average 41% in 2022 and 28% in 2023, the second highest among all Fitch-rated sovereigns. Backward indexation, failure of the authorities to rein in expectations and additional exchange rate volatility represent upside risks to our inflation forecasts. Medium Turkish FX liquidity buffers are low relative to peers and risks derived from high financial dollarisation, the vulnerable structure of international reserves and significant exposure to changing investor sentiment. After coming under pressures in November-December, recent figures show an increase in gross (USD114.7 billion) and net (USD16.3 billion) reserves but the net foreign asset position of the central bank (excluding FX swaps) remains negative. We expect gross reserves to increase to USD118 billion in 2022 (4.2 months of current external payments), as export rediscount credits, FX conversion of deposits, a new FX swap with the UAE (equivalent to USD5 billion) and EUR1 billion deposit from Azerbaijan's Sofaz at the Central Bank will more than offset continued current account deficits and domestic FX demand, and limited portfolio inflows. Although we expect the current account deficit to narrow further to 1.7% of GDP in 2022 from an estimated 2.2% in 2021 and 4.9% in 2020, external financing needs will remain high. External debt maturing over the next 12 months (end-November) amounts to USD167 billion. Access to external financing for the sovereign and private sector has been resilient to previous episodes of stress, but is vulnerable to changes in investor sentiment. Reduced FX volatility in recent weeks and the introduction of the FX-protected deposits have allowed lira deposits to partially recover and driven some reversal in dollarisation. The scheme could mitigate near-term risks to the stability of bank funding, improve sentiment in the near term and alleviate pressure on capital ratios. Nevertheless, the combination of deeply negative real policy rates and rising inflation creates risks for financial stability, for example if depositor confidence is shaken, and could potentially jeopardise the until now resilient access of banks and corporates to external financing. In this negative scenario, official international reserves would come under pressure, as a significant portion of banks foreign currency assets is held in the central bank including FX swaps and reserve requirements. Turkish banks are vulnerable to FX volatility due to high external debt payments, the impact on asset quality (41% of loans denominated in foreign currency) and high deposit dollarisation (61.5%). In addition, Fitch estimates that 10% depreciation erodes the sector common equity Tier 1 ratio by about 50bp, although the regulator has extended regulatory forbearance to cushion the impact of depreciation on capital ratios. Turkey's 'B+' IDRs also reflect the following key rating drivers: Turkey's ratings reflect weak policy credibility and predictability, high inflation, low external liquidity relative to high external financing requirements and dollarisation, and geopolitical risks. These credit weaknesses are set against low government debt and deficits, manageable sovereign financing needs, high growth and structural indicators, such as GDP per capita and Human Development, relative to rating peers. Public finances are a strength relative to peers. Fitch estimates that general government debt increased to 42% of GDP at end-2021, below the 'B' median of 68%, as the depreciation of the lira was balanced by lower financing needs and net repayments of domestic foreign currency debt. Debt dynamics will remain vulnerable to increased currency risks, as 66% of central government debt was foreign currency-linked or denominated at end-2021, up from 39% in 2017. Fitch estimates that Turkey's fiscal deficit declined to 3% of GDP at the general government level and 2.9% at the central government level in 2021, the latter below the revised 3.5% fiscal target. We forecast that the general government deficit will widen to 4.2% in 2022 and 4.5% in 2023. Fiscal risks stem from potential payments related to the FX protected deposit scheme, fiscal measures to cushion the impact of inflation on the economy, rising interest payments and expenditure linked to inflation such as wages and pension transfers. Government debt amortisations are manageable, averaging 3.5% of GDP in 2022-2023 and our baseline assumption is that the sovereign will maintain access to external markets based on the record of regular external bond issuance, despite repeated periods of stress in recent years. We expect the Turkish economy to slow to 3.2% in 2022 from 11% in 2021, balancing still favourable external demand dynamics, recovery in the tourism sector and an accommodative policy stance against tighter financing conditions, deterioration in consumer sentiment, and the negative impact of a weaker exchange rate and high inflation. Despite growth resilience, GDP per capita in US dollar terms has deteriorated since 2013, falling by almost USD4,000 to an estimated USD8,633 in 2021, due to the multi-year weakening of the currency. On the domestic front, the support for the government continues to be under pressure as a result of rising inflation and the sharp depreciation of the lira in 2021. We expect the proximity of general elections, due by June 2023, to heavily influence policy in the direction of supporting growth. Geopolitical tensions have eased over the past year and Turkey has sought to rebuild relations with countries in the region. Nevertheless, key foreign policy issues remain unresolved such as Turkey's 2019 purchase of the S-400 Russian missile system, US cooperation with the Kurdish People's Protection Units (YPG) in Syria or the maritime disputes in the Eastern Mediterranean. The evolution of relations with Russia is uncertain due to Turkey's support and arms sales to Ukraine. ESG - Governance: Turkey has an ESG Relevance Score (RS) of '5' for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Turkey has a medium WBGI ranking at 37 reflecting a recent track record of peaceful political transitions, a moderate level of rights for participation in the political process, moderate but deteriorating institutional capacity due to increased centralisation of power in the office of the president and weakened checks and balances, uneven application of the rule of law and a moderate level of corruption. RATING SENSITIVITIES Factors that could, individually or collectively, lead to negative rating action/downgrade: -Macro: Policy initiatives that exacerbate macroeconomic and financial stability risks, for example an inflation-exchange rate depreciation spiral or weaker depositor confidence. -External Finances: Signs of reduced access to external financing for the sovereign or the private sector, for example due to further deterioration of investor confidence, that would lead to balance of payments pressures including sustained reduction in international reserves. -Structural features: A serious deterioration in the domestic political or security situation or international relations that severely affects the economy and external finances. Factors that could, individually or collectively, lead to positive rating action/upgrade: - Macro: A credible and consistent policy mix that stabilises confidence and reduces macroeconomic and financial stability risks, for example by reigning in inflationary pressures. -External Finances: A reduction in external vulnerabilities, for example due to a sustained improvement in terms of the level and composition of international reserves, reduced dollarisation and sustained improvement in the current account balance. Sovereign Rating Model (SRM) and Qualitative Overlay (QO) Fitch's proprietary SRM assigns Turkey a score equivalent to a rating of 'BB+' on the Long-Term Foreign-Currency (LT FC) IDR scale. Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to SRM data and output, as follows: - Structural: -1 notch, to reflect vulnerabilities in the banking sector due to the significant reliance on foreign financing and high financial dollarization, and the risk that developments in geopolitics and foreign relations, including sanctions, could impact economic stability. - Macro: -1 notch, to reflect that risks to macroeconomic and financial stability are not fully captured by the SRM, as the current policy mix and potential reaction to shocks could further weaken domestic confidence, reduce reserves and lead to external financing and domestic liquidity pressures. Policy uncertainty also remains elevated due to the risk of additional monetary policy easing and other stimulus measures due the proximity of general elections due by June 2023. - External Finances: -1 notch, to reflect a very high gross external financing requirement, low international liquidity ratio, a weak central bank net foreign asset position, and risks of renewed balance of payments pressure in the event of changes in investor sentiment. Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM. Best/Worst Case Rating Scenario International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://urldefense.com/v3/__https://www.fitchratings.com/site/re/10111579__;!!LIr3w8kk_Xxm!4eiIFZT-VzLgUEsuT3MjAxEYeR_OeY7wSFaNwFCkpWQtzwKPs7HR-row9omF4A$ . REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING The principal sources of information used in the analysis are described in the Applicable Criteria. ESG Considerations Turkey has an ESG Relevance Score of '5' for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch's SRM and are therefore highly relevant to the rating and a key rating driver with a high weight. As Turkey has a percentile rank below 50 for the respective Governance Indicator, this has a negative impact on the credit profile. Turkey has an ESG Relevance Score of '5' for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in Fitch's SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight. As Turkey has a percentile rank below 50 for the respective Governance Indicators, this has a negative impact on the credit profile. Turkey has an ESG Relevance Score of '4' for Human Rights and Political Freedoms as the Voice and Accountability pillar of the World Bank Governance Indicators is relevant to the rating and a rating driver. As Turkey has a percentile rank below 50 for the respective Governance Indicator, this has a negative impact on the credit profile. Turkey has an ESG Relevance Score of '4[+]' for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver for Turkey, as for all sovereigns. As Turkey has track record of 20+ years without a restructuring of public debt and captured in our SRM variable, this has a positive impact on the credit profile. Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or to the way in which they are being managed by the entity.