Moody’s downgrade of Turkey is indictment of Erdoğan

Moody’s downgrade of Turkish debt further into junk status on Wednesday reflects the harsh reality that Turkey is being run under one-man rule with policies not conducive to an aspirational emerging market.

The decision by the ratings agency to reduce Turkey’s sovereign bonds one notch to Ba2 contained several references to the erosion of checks and balances under President Recep Tayyip Erdoğan, which, it said, leaves Turkey more vulnerable to external economic shocks.

The frank and open statement by Moody’s came just hours after Turkey’s central bank kept interest rates on hold. Governor Murat Çetinkaya and his Monetary Policy Committee took the decision even as they admitted Turkey’s double-digit inflation rate posed significant risks to pricing behaviour.

Erdoğan’s pressuring of the central bank to comply with his request to keep interest rates artificially suppressed is reflective of his leadership style, which has included a severe crackdown on dissent, and is unnerving investors who are concerned that the deteriorating global backdrop for emerging markets leaves Turkey exposed to a sudden switch in sentiment.  

Moody’s underlined its concerns about the erosion of Turkey’s executive institutions, making particular reference to the ongoing state of emergency in the country, in place since a failed coup attempt in July 2016, and the undermining of the authority of the judiciary. Analyst Kristin Lindow also mentioned a judicial battle in February in which the Constitutional Court, the nation’s highest legal body, made a decision to release political prisoners from jail pending trial, only for the ruling to be discarded by lower courts and the government.

Furthermore, Erdoğan’s plans to eradicate Turkey’s parliamentary system of government at elections next year, following a deeply divisive public referendum in 2017, “are likely to undermine the predictability and therefore the effectiveness of policymaking,” Lindow said.

Few people would disagree that institutional strength is deteriorating in Turkey, according to Tim Ash, a senior emerging markets strategist at BlueBay Asset Management in London. "And I guess we have to assume that both S&P and Fitch likely will follow Moody's lower now," he said.

Moody’s statement also came the same day as Cemil Ertem, Erdoğan’s senior economic adviser, said in an editorial for a local English language daily that monetary policy in emerging market economies should be regulated by the government. Turkey's central bank was rendered independent under International Monetary Fund-backed laws more than a decade ago.

Turkish central bank governor Murat Çetinkaya
Turkish central bank governor Murat Çetinkaya

Such statements from persons close to Erdoğan are concerning investors in Turkey’s stocks and bonds, especially given that Erdoğan, who has solidified his power over the economy, politics and the media in the style of Russian President Vladimir Putin, asserts that high interest rates cause inflation in an economy, straying from conventional economic theory that maintains the opposite. The IMF and Western economic system has also come in for severe criticism from his advisers of late.

Turkey’s inflation is at 10.3 percent, a rate that compares very unfavourably with an emerging-market average of 3.5 percent. The central bank also sets interest rates with a somewhat bewildering set of tools ranging from a borrowing rate of 7.25 percent to a “late liquidity window lending rate” of 12.75 percent.

As a result of the central bank’s failure to hike borrowing costs, inflation is unlikely to return to single digits on a sustainable basis until 2020 at the earliest, Lindow said in the statement.

The central bank in Ankara maintained its late liquidity rate at 12.75 percent on Wednesday, its sole lending instrument of choice at present, and kept the benchmark one-week repo rate at 8 percent.

Erdoğan is also calling on the nation’s banks to reduce interest rates on loans, which currently average an annual 17-20 percent, to help stimulate economic growth, accusing them of profiteering at the expense of the country. State-owned banks are expected to follow his lead in the coming weeks, threatening to distort the lending market and pressure balance sheets.

Economists are concurring with Moody’s opinion that Turkey’s monetary policy is compromised, saying that by keeping rates unchanged the central bank might be leaving the economy exposed.

“The risks are skewed towards higher rates because of overheating pressures and the susceptibility of the lira to both global and Turkey-specific shocks,” Inan Demir, an economist at Nomura in London, said in emailed comments on Wednesday. “However, we do not expect the bank to act unless the currency comes under severe pressure."

Turkey’s lira slumped to a record low of 3.97 to the dollar in November as political tensions with the United States added to concern about accelerating inflation and the global backdrop for the country. It traded around 3.8 per dollar this week.

“Clearly the central bank doesn’t want to rock the boat,” Ash said. "As long as the lira is reasonably stable, they will not do very much."

Intensifying the problems for the Turkish economy is the widest current account deficit in emerging markets.

In the absence of sufficient foreign direct investment, Turkey is financing the shortfall through short-term portfolio inflows in the form of foreign purchases of stocks and bonds, which could exit the country swiftly, and the central bank’s declining foreign currency reserves,

The trade deficit, the biggest contributor to the current account deficit, had more than doubled to $9 billion in January, as imports surged 38 percent and exports rose 11 percent.

Concern about the outlook for the lira has prompted Turks to sell the currency and increase their deposits of dollars, euros and gold.

Political tensions with the United States over Turkey’s military incursion into Syria, territorial disputes with Greece and deteriorating relations with the European Union, prompted by the crackdown on political dissent, are adding to risk perceptions both within Turkey and in global financial capitals.

With his control over Turkish society, including the media and big business, almost complete, Erdoğan is now lashing out at elements out of his control. Those include Turkey's traditional Western allies, who are critical of his increasing authoritarianism, and foreign investors, who see his off-the-wall approach to managing the economy and foreign policy as an increasing risk to their capital.

Earlier this week, Erdoğan maintained that Western powers wanted him toppled in the coup attempt of July 2016, tried to prevent Turkey's Jan. 20 incursion into Syria and were now seeking to undermine the country internationally because they were afraid of its rising power. 

The military foray into Syria is adding to geopolitical risks for the country, which will become more marked and deeper the longer the conflict continues, Moody’s said on Wednesday.

“This overall picture suggests that the possibility of a sudden, disruptive reversal in foreign capital inflows, a more rapid fall in already inadequate foreign exchange reserves and, in a worst-case scenario, a balance of payments crisis, while still quite low, has increased beyond Moody's expectations a year ago,” Lindow said.