Is Standard & Poor's so wrong?

For readers unfamiliar with the ratings practices of financial services companies, I can simplify the meaning of the revision by saying that Turkey's rating will not be changed by S&P within the next 12 months. As an upgrade in Turkey's rating was expected, this decision provoked the fury of Prime Minister Recep Tayyip Erdoğan, who accused S&P of behaving on ideological grounds and alluded to a conspiracy against Turkey. A passionate debate followed in the media, as you can imagine.

For impatient readers, let me start with the answer to the headline's question: I do not think that S&P is so wrong. The critical point lies in the “so.” I believe, like Timothy Ash, chief emerging markets economist at the Royal Bank of Scotland (RBS), that Turkey merits a better rating given some of the macroeconomic fundamentals: A low budget deficit (under 3 percent), low and decreasing public debt (under 40 percent) and decreasing but still sizable economic growth (expected to be 3-4 percent in 2012) . You would agree with me when I say these are very scarce virtues nowadays. Having said that, let me point out that the Turkish economy also has weaknesses, such as a high current account deficit (CAD) and high inflation. S&P's decision, whatever the current rating (BB), is about its changing expectations, particularly regarding the CAD. And on this point it could be right.

I would like to quote S&P's basic argument on this issue: “Less-buoyant external demand and worsening terms of trade have, in our view, made economic rebalancing more difficult, and have increased the risks to Turkey's creditworthiness given its high external debt and the sate budget's reliance on indirect tax revenues.” Faithful readers of this column may remember that my first article in Today's Zaman -- published last February -- headlined with “Exports will be the key for a soft landing.” Indeed, to achieve a successful soft landing or “economic rebalancing,” the positive contribution of net exports to growth must continue, as has been the case since the third quarter of 2011. This means exports have to grow more rapidly than imports in order to have a more balanced and relatively high growth, as well as a shrinking CAD.

If this does not happen, what should we expect? As is rightly asserted in S&P's report, the risk of an exchange rate shock would be very likely, given the high and increasing private external debt and the financing of the larger part of the CAD by inherently unstable “hot money.” The consequences of an exchange rate shock are quite straightforward in the Turkish economy: an increase in inflation, which is already unacceptably high, and an increase in interest rates, which would increase the budget deficit and decrease economic growth. In this scenario, Turkey's creditworthiness would be adversely affected, for sure.

So, the critical question is: How likely is it that the positive contribution of net exports to growth will become negative? In other words, could the increase in imports be higher than the increase in exports? The last news on this front is not that good. Last Monday, the Turkish Statistics Institute (TurkStat) revealed its foreign trade statistics for March: Seasonally adjusted exports stagnated from February to March, while imports increased by 4.3 percent. Two days later the Turkish Exporters Assembly (TİM) reported a decline in exports in April. And as I had written in my Radikal column -- that the fate of a soft landing will depend on the state of European economies on the same day as the S&P report was published -- indeed, the poor export performance of the last two months has originated solely from shrinking exports in the European market, which still accounts for 42 percent of Turkish exports. The ongoing “mild recession” in Europe started to reveal its adverse effects on Turkish exports, and buoying exports on other markets will not be enough to compensate for the losses in Europe. Unfortunately, there is a serious risk that the European recession will become worse.

Having said this, the government still has an important trump card up its sleeve. I am talking about structural reforms: New investment incentives have been announced, as well as a willingness to implement severance pay reform and fiscal devaluation in order to lower labor costs and push exports. A new law facilitating the purchase of property by foreigners has recently been accepted by Parliament and foreign direct investment (FDI) is on the increase. The new Trade Law, anticipated for the last two years, will finally be enforced in July. I believe Turkey has a serious opportunity to avoid an exchange rate shock if the government continues to go further on economic reforms. And last but not least, if this is the case, S&P is promising to consider an upgrade!