Fitch Ratings, the international rating agency, warns in a Special Report published today of Turkey's vulnerability to ongoing changes in global interest rates and signs of a rise in risk aversion.
In the report, entitled 'Turkey - Financing in a Harsher Environment', Fitch notes that the short-term and market-sensitive nature of much of Turkey's current account deficit financing exposes it to potentially damaging market risks. The country's exposure to these risks is arguably lower than two or three years ago, but they remain significant. Consequently, the margin for error and/or complacency over government policy implementation is likely to narrow in the weeks and months ahead.
Global financial markets are gradually becoming less accommodative towards emerging markets in general, and Turkey looks vulnerable in view of its recent policy delays, sizeable current account deficit and large external financing needs. Fitch is forecasting a current account deficit of 5.1% of GDP in 2005, largely unchanged on the outcome for 2004. Although economic growth is slowing, and exports continue to hold up well, high global oil prices are expected to swell the import bill this year, thus working against a narrowing of the current account shortfall.
Adding the current account deficit to medium and long-term external debt amortisation scheduled for 2005 means that Turkey is facing an external financing need equivalent to around 12.5% of GDP. If the rollover of the large short-term external debt stock is added to this, the financing needs rise to over 25% of GDP. The quality of external financing will improve marginally in 2005 as foreign direct investment (FDI) increases relative to 2004 levels, but Turkey will remain dependent on short-term market-sensitive capital inflows. Non-resident purchases of local government debt have been large, as has short-term borrowing by the banking system. So-called reverse currency substitution and reverse capital flight are also important external financing items.
Several factors suggest that Turkey is better insulated from shocks than at any time in recent years. The floating exchange rate acts as an important shock absorber, while Turkey's EU accession status should provide some support. Public finances have also strengthened since the last financial crisis, while the banking system has no open foreign currency exposure. However, external shocks remain potentially damaging for Turkey, especially in a changing external financial environment. The Turkish authorities have yet to secure the new IMF programme, although a new letter of intent has been signed. Meanwhile, there are a number of political challenges on the horizon such as an extension of the customs union to include Cyprus that might prove tricky. A referendum in France on 29 May over the EU constitution might also prove damaging for Turkey if, as opinion polls are currently indicating, the French population vote against adopting the new constitution. There will be a further referendum in Holland on 1 June.
Fitch has stress-tested public financing needs and public debt dynamics for adverse exchange and interest rate developments. All things equal, a 10% real deprecation of the Lira (YTL) and a moderate hike in local interest rates would add over 3% of GDP to already high public financing needs this year. A sizeable currency correction would also, of course, pressurise public debt dynamics, and could see general government debt rise once again as a share of GDP. But the changes in the composition of government debt over the past couple of years mean that public debt dynamics are much less 'explosive' than was the case in 2001 and 2002.
One outcome of a foreign market sell-off of Turkish debt would be a slower-than-expected increase in the maturity of local government debt. Non-residents have dominated the local market in recent months, and a cooling of the 'carry trade' could complicate efforts to extend the maturity of new issuance. This suggests that it will be some time before the government is able materially to reduce its liquidity and rollover risk. Public financing needs in Turkey are equivalent to some 40% of GDP, well above rating peers', and second only to Lebanon of the key emerging markets rated by Fitch.