SOVEREIGN AND SUPRANATIONAL

ISSUER IN-DEPTH
21 September 2020
Government of Turkey
FAQ on credit risks amid sustained lira pressure
Sustained lira depreciation, steady capital outflows and a significant drop in the central
bank's foreign-currency reserve position have again shifted the focus to Turkey's (B2
negative) balance-of-payments position. In this report, we answer a number of frequently
asked questions from investors on the related credit risks.

CLIENT SERVICES » Why is Turkey’s external position now such a risk? The government has almost
Americas 1-212-553-1653 depleted the buffers that would allow it stave off a potential balance-of-payments crisis.
Asia Pacific 852-3551-3077 Foreign-currency (FX) reserves are now at a 20-year low and the central bank's FX swap
Japan 81-3-5408-4100
position has nearly doubled since the beginning of the year. Despite this intervention,
the lira has depreciated by around 25% relative to the US dollar since the beginning
EMEA 44-20-7772-5454
of the year. As a result, the risk of a balance-of-payments crisis that triggers an abrupt
economic adjustment and a deterioration in the government's balance sheet has
increased substantially.

» Has this limited the range of policy options available to the government? Although
this is not the first time that Turkey has seen a significant weakening in the lira, limited
foreign-currency buffers and a stressed economy mean currency pressures are unlikely to
ease without more aggressive policy action. However, the country’s institutions appear
to be unwilling or unable to deal with these challenges. The government continues to
prioritize credit growth, and political pressures on central bank independence mean real
interest rates remain negative despite above-target inflation. The scale of intervention in
the FX market this year makes it difficult to see the lira as a floating currency regime. As
a result, there is a significant probability of a disorderly exchange rate adjustment that
triggers significant economic and fiscal disruption.

» Does a healthy fiscal position not offset these credit risks? In the past, the
government's balance sheet mitigated the credit pressures arising from Turkey's structural
external vulnerabilities. However, we expect primary deficits and lira depreciation will lead
to a rise in the government's debt burden to almost 42% of GDP next year. Moreover,
high levels of foreign-currency and floating-rate debt increase the sovereign's vulnerability
to shifts in investor sentiment. A high risk that contingent liabilities could crystalize on
the government's balance sheet further weakens Turkey's credit profile.
 MOODY'S INVESTORS SERVICE SOVEREIGN AND SUPRANATIONAL

Why is Turkey’s external position now such a risk?

Although Turkey has faced bouts of currency pressure before, in net terms the government has almost depleted the external buffers
that would allow it starve off a potential balance of payments crisis. As of 4 September, Turkey's gross foreign-exchange (FX) reserves
(which exclude gold reserves, in line with our methodology) had fallen to $44.9 billion, which is its lowest level since November 2005
and a more than 40% decline since the beginning of the year. In fact, if we net out banks’ required reserves for lira and FX liabilities, net
foreign-exchange reserves are now close to zero (see Exhibit 1).

At the same time, the central bank's short FX swap position has also grown significantly to $53 billion from $30 billion in March (see
Exhibit 2). If these swaps were not rolled over, all the commercial banks’ reserves at the central bank would be insufficient to cover this
short position. Concurrently, state-owned banks have more than doubled their short FX position $4.8 billion from $2 billion in January.

Concurrently, a collapse in goods exports and an exceptionally weak tourism season due to Covid has driven the current account back
into deficit after a short-lived surplus in 2019 (see Exhibit 3). Net portfolio account outflows have increased six times in the first half
of 2020 and net FDI was half the level of a year ago (see Exhibit 4). This will make the current account difficult to finance, hence the
downward pressure on the lira. The hit to tourism from coronavirus will also worsen this situation because the sector generates a great
deal of foreign currency.

Immediate government liquidity risks are limited because buffers comfortably cover the government's refinancing needs. Turkey also
holds sizeable gold reserves that are now almost equal FX reserves ($43.6 billion in July). In part, this is because commercial banks are
allowed to hold up to 10% of their reserve requirements at the central bank in gold but also likely reflects an increase in tensions with
the United States and Europe.

Exhibit 1 Exhibit 2
Central bank reserves have been depleted in an unsuccessful The central bank's short FX swap position has grown significantly
attempt to support the currency US$ billion
Gross and net FX reserves (excl. gold), US$ billion
Gross reserves Gold Net reserves (rhs) Up to 1 month 1-3 months 3-12 months
140 40 0
35
120
30 -10
100 25
20 -20
80
15
60 10 -30

40 5
0 -40
20
-5
0 -10 -50

-60

Sources: Central Bank of the Republic of Turkey (CBRT), Moody's Investors Service (MIS) Sources: CBRT, MIS

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on
www.moodys.com for the most updated credit rating action information and rating history.

2 21 September 2020 Government of Turkey : FAQ on credit risks amid sustained lira pressure
 MOODY'S INVESTORS SERVICE SOVEREIGN AND SUPRANATIONAL

Exhibit 3 Exhibit 4
The current account balance has returned to negative territory … while its financing has shifted toward portfolio and debt
after a recession led to a short-lived surplus in 2019... financing after the global financial crisis
12-month moving sum (US$ billion) 12-month moving sum (US$ billion)
Goods Services Primary income Net Errors and Ommissions Other investment
Secondary income Current Account Portfolio investment Direct investment
60 Financial account excl reserve assets
40 110
20
0
60
-20
-40
-60
10
-80
-100
-120 -40

May/2012

May/2013

Jan/2014
May/2014

May/2015

Jan/2016
May/2016

May/2017

Jan/2018
May/2018

May/2019

May/2020
Jan/2012

Jan/2013

Jan/2015

Jan/2017

Jan/2019

Jan/2020
Sep/2012

Sep/2013

Sep/2014

Sep/2015

Sep/2016

Sep/2017

Sep/2018

Sep/2019
Jun/2012
Oct/2012

Jun/2013
Oct/2013

Jun/2014
Oct/2014

Jun/2015
Oct/2015

Jun/2016
Oct/2016

Jun/2017
Oct/2017

Jun/2018
Oct/2018

Jun/2019
Oct/2019

Jun/2020
Feb/2012

Feb/2013

Feb/2014

Feb/2015

Feb/2016

Feb/2017

Feb/2018

Feb/2019

Sources: CBRT, MIS Feb/2020 Sources: CBRT, MIS

However, Turkey's structural reliance on foreign currency to finance economic growth because of its low savings rate increases the
economic risks of a balance of payments crisis. We forecast that external debt will be 67.5% of GDP in 2020, about two-thirds of which
is owed by the private sector. Some of this is owed by companies with foreign-currency denominated cash flows that they can use
for debt service, but much of it is owed by SMEs who are having to convert lira to FX in order to service their loans. A lack of foreign
financing and a rise in the size of foreign-currency liabilities would likely lead to a sharp correction in private consumption, investment,
and government consumption.
Exhibit 5 Exhibit 6
The stock of outstanding short-term debt has remained high since The private sector has large rollover needs
2017 Maturity profile of external private sector loans (US$ billion)
Short-term external debt outstanding (US$ billion)
Long-term debt Short-term debt
Central Bank General Government Banks Trade credit Other corporate credit
7
160 6.1
6 5.7
140
4.8
120 5
4.3
100 3.8
4
3.0 3.2
80 2.9 2.9
3
60 2.2
2 1.6 1.7
40

20 1

0 0
Jan-2010
May-2010

May-2011

May-2012

May-2013

May-2014

May-2015

May-2016

May-2017

May-2018

May-2019

May-2020
Jan-2011

Jan-2012

Jan-2013

Jan-2014

Jan-2015

Jan-2016

Jan-2017

Jan-2018

Jan-2019

Jan-2020
Sep-2018
Sep-2010

Sep-2011

Sep-2012

Sep-2013

Sep-2014

Sep-2015

Sep-2016

Sep-2017

Sep-2019

Sources: CBRT, MIS Sources: CBRT, MIS

Turkey is also heavily dependent on imported energy, which is priced in dollars. Imports would likely become more expensive and
lead to a spike in inflation, while the high import content of exports would limit any competitiveness gains from a weak lira. In theory,
recent gas finds in the Black Sea could reduce this dependency, but they are years away from being exploited.

Dollarization intensifies these risks. Turkey has the second-highest dollarization vulnerability indicator in the single B-rated universe.
Growing confidence in the domestic economy had supported de-dollarization before the currency crisis in 2018, but the share of
deposits denominated in hard currencies such as US dollars or euros have accounted for over 50% of the total deposits in the banking
system since 2018.

3 21 September 2020 Government of Turkey : FAQ on credit risks amid sustained lira pressure
 MOODY'S INVESTORS SERVICE SOVEREIGN AND SUPRANATIONAL

A balance-of-payments crisis would also weaken the government's balance sheet. We already estimate lira depreciation has increased
the government's debt burden this year. An increased reliance on domestic borrowing will also increase its interest payments (see Q3).

A number of state-owned banks would likely post losses on the short FX positions they have accumulated trying to defend the lira in
recent months. In late January, data from the banking regulator indicates that these short positions stood at $2 billion, but they now
stand at $4.8 billion (Exhibit 6). Moreover, if the state-owned banks were to see sudden and significant withdrawals of FX deposits,
these short positions could suddenly be uncovered.

Has this limited the range of policy options available to the government?
Although this is not the first time that Turkey has seen a significant weakening in the exchange rate,1 limited foreign-currency buffers
and a coronavirus-hit economy mean currency pressures are unlikely to ease this time round without more aggressive policy action
than in 2018 (Exhibit 7). However, the country’s institutions appear to be unwilling or unable to deal with the challenges it faces.

In particular, political pressure means that, in real terms, the policy rate is now negative despite inflation being well above target and
a rise in inflation expectations. There is also little evident willingness or ability to introduce measures that could address the structural
underpinnings of Turkey’s macroeconomic problems – the economy's chronic shortfall in domestic savings relative to the economy's
investment needs, labour-market rigidities that inhibit job creation and weak productivity. The scale and number of interventions and
regulatory actions in the FX market this year also make it difficult to see the lira as a floating currency regime.

Instead, the government has focused on supporting the economy via credit growth (see Exhibit 8). State-owned banks have been
encouraged to expand credit creation to counter the economic downturn and to offer programmes that assume and restructure credit
card and other consumer debt at extended maturities and below market rates. Although some of the measures taken by the banking
regulator to support domestic demand during the pandemic are now being withdrawn, credit growth is still likely to exceed 30% at the
end of the year.
Exhibit 7 Exhibit 8
Turkey's central bank kept the policy rate unchanged at its August Credit growth is bouncing back after a trough in 2019
meeting % change
%
Policy rate Inflation rate Credit to private sector (%, y-o-y) Inflation (%, y-o-y)
CBRT target Upper/lower limit 40
25 35
30
20 25
20
15 15
10
10 5
0
5 -5
-10
May/2016

May/2017

May/2018

May/2019

May/2020
Jan/2016

Jan/2018

Jan/2019

Jan/2020
Jul/2016
Sep/2016
Nov/2016
Jan/2017

Jul/2017

Nov/2017

Jul/2018
Sep/2018
Nov/2018

Jul/2019
Sep/2019

Jul/2020
Nov/2019
Sep/2017
Mar/2016

Mar/2017

Mar/2018

Mar/2020
Mar/2019

Sources: Turkstat, CBRT, MIS Sources: CBRT, MIS

The government could seek outside assistance that could help it muddle through. Turkey already successfully tripled its swap line with
Qatar in late May. However, its unorthodox monetary policy stance makes similar support from other central banks, such as the Fed,
unlikely. The government could go to the IMF for assistance, which would be credit positive because it would likely be supportive of
measures that would help Turkey durably resolve some of these challenges but this is unlikely because of the president's long-standing
resistance to seeking IMF assistance.

Beyond swap lines, Turkey's size and its clear structural economic imbalances limit the meaningful support other types of bilateral
assistance could provide to ease the currency crisis. Turkey's borrowing from the European Investment Bank (Aaa stable), which is the

4 21 September 2020 Government of Turkey : FAQ on credit risks amid sustained lira pressure
 MOODY'S INVESTORS SERVICE SOVEREIGN AND SUPRANATIONAL

country's single-largest lender, was also frozen through at least the end of 2019 and remains heavily restricted. Sanctions on Turkey
from either the United States (US, Aaa stable) or European Union (EU, Aaa stable) are possible this autumn, and military tensions in
the eastern Mediterranean remain high; any of these factors could prove an accelerant that could pose material threats to the country's
credit profile.

As the government's options narrow, there is a risk the government could introduce a moratorium on foreign-currency payments
across some or all asset classes to preserve foreign currency or impose capital controls. Either outcomes would be highly damaging for
domestic businesses and would likely constitute an event of default by the sovereign because they can impair sovereign debt service.
Moreover, they would not solve the fundamental structural challenges the Turkish economy faces.

Does a healthy fiscal position not offset these credit risks?

Turkey's historically strong deficits and debt metrics compared to similarly rated peers have been a key source of support to its credit
profile. However, fiscal deficits have widened markedly since 2018. In 2019 for example, the central budget deficit increased 70% year-
on-year. The deterioration reflects a number of factors like unconventional policy measures to support the lira, an expensive stimulus
program in 2019 to fight the aftermath of the 2018 lira crisis and steadily rising interest payments (see Exhibit 9). In 2019, the central
government's interest payments rose 35% in nominal terms, compared to average inflation of 16%.

The government announced a series of tax hikes for 2020 (including an increase in income tax rates on top-bracket earners and
introduction of a capital gains tax), but the weak economy, the current direction of fiscal policy to deal with the coronavirus crisis, and
persistent issues like tax evasion are likely to limit their impact on Turkey's growing fiscal deficit (Exhibit 10). Unconventional fiscal
policy decisions have also undermined policy credibility and highlight the extent of the government's concerns over the public finances.

We expect the weak economy and fiscal measures to manage the economic effects of coronavirus will lead to a rise in the deficit
to 7.5% of GDP (using the IMF definition, which excludes one-off revenue sources). Together with lira depreciation and a rise in the
government's interest costs, we expect this will increase Turkey's debt-to-GDP ratio to 42.9% in 2020 from 32.5% in 2019. Moreover,
a recovery in the economy after the coronavirus shock is unlikely to offset primary deficits of more than 2% and an ever-increasing
interest burden. As a result, we expect Turkey’s debt burden to increase to above 45% of GDP by 2023.
Exhibit 9 Exhibit 10
Interest payments have risen sharply… … contributing to a worsening fiscal performance
Interest payments (TRY billion) Cash deficit (TRY billion)
2015 2016 2017 2018 2019 2020 2015 2016 2017 2018 2019 2020
120 40

20
100
0

-20
80
-40

60 -60

-80
40
-100

-120
20
-140

0 -160
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Sources: Ministry of Treasury and Finance, Moody's Investors Service Sources: Ministry of Treasury and Finance, MIS

Risks to our baseline forecasts are elevated. This situation could be exacerbated if, for example, the government's desire to revive
growth were to lead to larger than expected budget deficits or if it needed to cover additional losses from public-private partnerships
(PPPs), the Credit Guarantee Fund or the Turkish Wealth Fund. The disclosed amounts of guarantees appear significant but
manageable; the treasury-guaranteed external debt stock totaled $14 billion (1.8% of 2019 GDP) at the end of Q1 2020, and there are
a further $17 billion (2.2% of 2019 GDP) of loans subject to debt-assumption agreements.

5 21 September 2020 Government of Turkey : FAQ on credit risks amid sustained lira pressure
 MOODY'S INVESTORS SERVICE SOVEREIGN AND SUPRANATIONAL

Moody’s related publications

» Credit Opinion: Government of Turkey – B2 negative: Update following downgrade to B2, negative outlook maintained, 11
September 2020

» Rating Action: Moody's downgrades Turkey's ratings to B2 and maintains negative outlook, 11 September 2020

» Sector In-Depth: Sovereigns – Global: Global risk appetite recovery supports emerging market funding; liquidity strains to persist
for lowest-rated sovereigns, 14 September 2020

» Issuer Comment: Government of Turkey: Erosion of reserves heightens risks to the economy and public finances, 10 August 2020

» Issuer In-Depth: Government of Turkey – B1 negative: Annual credit analysis, 11 July 2020

» Issuer In-Depth: Government of Turkey: FAQ on external vulnerabilities amid coronavirus pandemic, 5 May 2020

» Methodology: Sovereign Ratings Methodology, November 2019

Endnotes
1 In the summer of 2018, the lira depreciated even more dramatically. At the time, it took a combination of very significant interest rate hikes (which have
since been unwound) and announced a package of structural reform measures (that were generally not followed up with concrete action) to restore some
elements of stability.

6 21 September 2020 Government of Turkey : FAQ on credit risks amid sustained lira pressure
 MOODY'S INVESTORS SERVICE SOVEREIGN AND SUPRANATIONAL

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7 21 September 2020 Government of Turkey : FAQ on credit risks amid sustained lira pressure
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8 21 September 2020 Government of Turkey : FAQ on credit risks amid sustained lira pressure