OREANDA-NEWS. Fitch Ratings has affirmed Turkey's Long-term foreign and local currency Issuer Default Ratings (IDR) at 'BBB-' and 'BBB', respectively. The Outlooks are Stable. The issue ratings on Turkey's senior unsecured foreign and local currency bonds have also been affirmed at 'BBB-' and 'BBB', respectively. The Country Ceiling has been affirmed at 'BBB' and the Short-term foreign currency IDR at 'F3'.

The rating on Turkey's Hazine Mustesarligi Varlik Kiralama Anonim Sirketi's (Hazine) USD1.5bn of global certificates (Sukuk), due March 2018, has also been affirmed at 'BBB-'

KEY RATING DRIVERS
Falling oil prices have contributed to lower inflation and a faster contraction of the current account deficit (CAD), notwithstanding sharp falls in exports to Russia, Ukraine and the Middle East. Public finances remain robust with no sign of fiscal slippage ahead of the general election in June, while the banking system remains in good shape for the most part, unaffected by developments at Bank Asya. However, tensions over economic policy have spilled over into the public domain, unnerving investors and putting downward pressure on the exchange rate.

Turkey's economy continues to show signs of rebalancing. The CAD fell to 5.6% of GDP in 2014 of GDP from 7.9% in 2013, while annual credit growth to the non-financial sector has eased to 16-17% in recent months from 25% in 2013. However, with growth lagging at an estimated 2.8% in 2014, underlying tensions over the future direction of economic policy have escalated, overshadowing post-presidential election assurances on policy stability and personnel ahead of parliamentary elections in June.

Fitch considers policy coherence and credibility to be weaker in Turkey than its rating peers. Political pressure on the Central Bank (CBRT) to accelerate cuts in interest rates has masked the beneficial impact of lower oil prices and a narrower CAD and the lira has fallen more than 10% against the US dollar since the beginning of 2015. The CBRT has trimmed interest rates, but it remains cautious in the face of still high inflation of 7.5% y-o-y in February versus its medium-term target of 5% and left interest rates unchanged at its most recent rate-setting meeting.

Turkey's fiscal metrics are superior to or equate with 'BBB' medians in most instances. The general government deficit is estimated to have come in under budget at 1.4% of GDP in 2014, while gross general government debt/GDP remains on a declining trend, falling to a projected 32% in 2016 from 36% in 2013. Non-residents hold about one-fifth of lira-denominated debt, while the Treasury issued USD7.2bn of external bond debt in 2014, including USD1.5bn of pre-financing for 2015. Government-guaranteed debt and loans subject to debt assumption agreements amount to barely 2% of GDP.

Similarly, Turkey's banking system, rated investment grade ('bbb') on Fitch's Banking System Indicator, is not viewed as a constraint on the sovereign rating, while the macro-prudential score, a measure of potential financial sector stress, has eased to 'moderate' from 'high'. The system is well-capitalised, profitable and has only modest non-performing loans of less than 3%. On the other hand, rapid credit growth over a sustained period implies that loan books are highly unseasoned, while banks' net external debt has more than doubled to an estimated 17% of GDP in 2014 from 7% in 2010 and is predominantly short term. Corporate clients have large net open FX positions, which rose to USD183bn in 2014 from USD176bn in 2013.

Turkey should continue to reap the benefits of lower oil prices in 2015, coupled with a stronger recovery in the eurozone, its main trading partner. The trade deficit in January was running at USD2.6bn, half that of the same period in 2014, reflecting a 14% drop in imports. Fitch forecasts a further narrowing of the CAD to 5.1% this year and lower end-year inflation of 6% compared to 9.3% in 2014. Even so, growth may not exceed 3.2% in 2015, falling well short of the aspirations of the Medium-Term Programme (5% in 2015-16).

Net exports were the driving force behind economic growth in 2014. However, Fitch notes that net exports have rarely been an enduring part of Turkish growth, while the recent retrenchment in domestic demand owes almost as much to a decline in investment (with adverse implications for growth) as it does to consumption. The government retains a strong preference for faster growth, but a deteriorating trade-off between growth and the CAD suggests that structural constraints have become more binding over time, highlighting the post-electoral importance of faster progress on the government's structural reform agenda.

Turkey's CAD and associated gross external financing needs (USD220bn including short term debt, 31% of GDP) will remain credit weaknesses. Although the CAD has shrunk to around 5% of GDP, it remains among the highest in EMEA. Reliance on short-term borrowing diminished significantly in 2014, but non-debt creating flows (chiefly FDI) continued to play a minor role (Turkey's buffers against potential volatility in global investor risk appetite remain relatively thin as events in 2013-14 showed, when the CBRT had to raise interest rates sharply to assuage market pressures and restore external financial stability. Risks of a renewed sell-off of Turkish financial assets in the face of a tightening of US monetary policy will remain high, particularly if concerns over CBRT credibility persist. Policy coherence and credibility could come under growing strain after the election, if the CBRT is subjected to greater pressure to adopt a more expansionary monetary policy stance.

Rising geopolitical risks pose additional challenges for Turkish economic rebalancing. Iraq and Russia are Turkey's second and fourth largest trading partners, respectively. Exports to Iraq have plummeted, while trade with Russia has been volatile. Turkish exporters have traditionally displayed great resourcefulness in switching between markets in Europe and the Middle East and North Africa, but their room for manoeuvre could become more limited, slowing further improvements in the trade balance.

RATING SENSITIVITIES
The Outlook is Stable. Consequently, Fitch's sensitivity analysis does not currently anticipate developments with a material likelihood, individually or collectively, of leading to a downgrade. However, the following risk factors individually, or collectively, could trigger negative rating action:
- Further erosion of policy credibility and coherence that weakened Turkey's buffers against volatility in global investor risk appetite.
- Sustained reversal of the recent consolidation in the current account deficit, leading to a rising external funding needs and an even steeper rise in net external indebtedness over time.
- Deterioration in the quality of core public institutions that led to more erratic policy-making, decreased government effectiveness and/or a weaker business climate.

Conversely, the following factors, individually or collectively, could result in positive rating action:
- A more coherent and predictable monetary policy framework that delivers lower and more stable inflation.
- Increased confidence in the sustainability of Turkey's external finances, potentially including a material and lasting reduction in the current account deficit (without bringing growth to a halt), and/or a rebalancing of net capital inflows towards longer-term instruments.
- Structural reforms that translate into higher gross domestic savings, a more flexible labour market and greater foreign direct investment.

KEY ASSUMPTIONS
Turkey's ratings are based on a number of key assumptions:

- Continued commitment to fiscal sustainability.
- No sharp escalation in geopolitical risk to a level that would be disruptive for Turkey's economy.
- The global economy evolves broadly along the lines expected in Fitch's March 2015 Global Economic Outlook.