Moody on the Turkish economy

My latest column, in which I argued that the Turkish Lira would continue to slide until the Central Bank intervened with a significant interest rate hike, may have seemed pessimistic. But compared to a report and article that I read over the weekend, it is actually optimistic.

In his latest report on the Turkish economy, Mert Yıldız from Roubini Global Economics argues that credit rating agency Moody’s may cut Turkey’s sovereign credit rating from investment grade to junk. According to him, “Moody’s would likely highlight spillovers to the economy from political uncertainty, high and rising external vulnerabilities and low growth potential.”

The decision would have a huge market impact. Yıldız notes that “unlike with other countries at risk of losing investment grade status, a Moody’s downgrade of Turkey does not seem to have been fully priced in to the markets.” He expects the lira to depreciate further to 3.10 or 3.20 to the dollar as a result.

The downgrade would also mean that funds that can only invest in countries rated investment grade or above by at least two major rating agencies would have to exit Turkey. This would result in a bond sell-off, which could raise rates by 1-2 percentage points, according to Yıldız. The rising cost of borrowing would also “adversely affect Turkish banks, probably resulting in an equity sell-off.”

Moody’s has underlined before Turkey’s strong fiscal balance and public debt as a justification of the current investment grade status. However, Yıldız argues that the country’s balance sheet is more vulnerable than it looks - and gives several reasons why it may weaken in the coming months.

For one thing, Treasury-backed debt, which has risen significantly recently, as well as the liabilities of the state-run Housing Development Administration (TOKİ), are not on the books. Besides, while pork barrel spending before the elections and rising borrowing costs are likely to raise expenditures, tax revenues, which are dependent on growth, are likely to fall as the economy slows down. Without structural reforms, it would be unrealistic to expect privatization revenues either.

As for the timing, Yıldız notes that rating agencies are usually behind the curve, and that Turkey should have been downgraded some time ago. He believes that Moody’s will wait for the elections, which are likely to be held on Nov. 1. Unfortunately, the rating agency’s next scheduled review is on Dec. 4.

If you think Yıldız is pessimistic, you should have a look at strategist Russell Napier’s short interview at well-known financial blog Zero Hedge. Napier expects a credit crunch in emerging markets, which could be triggered by Turkey introducing capital controls. “Such controls will mean that Turkey will not pay back principals amounting to $400 billion and the interest on it.”

While I agree with Yıldız’s assessment that a downgrade may be on the cards, Napier’s scenario seems a bit far-fetched even for me. But that’s beside the point. Even if both Yıldız and Napier are wrong, they show that the mood on the Turkish economy has turned sour. If enough people feel this way, we could end up with a self-fulfilling crisis.

Such crises are not caused by an unhealthy economy or bad policies, but because of investors’ pessimism. Their fear of a crisis makes the crisis inevitable, which justifies their expectations. Unfortunately, economic fundamentals and policies are out of whack in Turkey as well.