Weekly Hurriyet Column: The Rating Wars: Episode II

Below is  my Hurriyet Daily News & Economic Review column for this week, which you can also read at the Daily News website. As for the title, after a one-week hiatus, it is the return of the cheesy movie-reference title:)

Coming to more serious matters, I again could not say all I wanted to say due to the strict 3700-character limit. Besides, I would like to respond to a certain Suluman who wrote an opinionated column (maybe, that's what op-ed stands for after all) about Ozan's piece. In addition, I had another very interesting chat with my usual gang, at the end of which I was confuzzled by all the trader details. But I would like to incorporate those comments as well, but after I understand what "repo technicality" is. So as soon as I find some time to call up the trader buddy in the gang and jot down all this, you will see a very detailed addendum to the column (probably tomorrow, as it is already 19.30, my stomach is ringing bells (Turkish idiom), and I have to pick up my brother and his wife later on).

Enough chit-chat already; on to the column:

As the venerable Yoda would say, begun again the rating wars have.

Recent research by Ozan Acar, prepared during his stint as a guest researcher at the Brookings Institution, discusses why Turkey is still rated below investment grade by the credit rating agencies, or CRAs, and whether an upgrade is on the cards.

The standard argument is that markets, as gauged by Turkey’s credit default swap, or CDS, spreads, have already been priced in an upgrade and that the CRAs, whose ineptitude was proven during the European sovereign-debt crises, are simply trailing behind.

Irrespective of problems with the CDS’ which I outlined during the first rating wars, a simple graph of CDS spreads against ratings shows the fragility of this argument: while there is a negative relationship between the two, there are many countries bundled at the 100-150 basis-points range, with some sitting below and others sitting above investment grade.

But those in favor of Turkey receiving an upgrade argue that the country’s fiscal position is sound. After all, its primary balance and debt as shares of gross domestic product, or GDP, look quite strong. However, Ozan shows there is no relationship – after controlling GDP per capita – between these factors and sovereign ratings.

When you think about it, this conclusion actually makes sense. A country’s GDP is different from a company’s revenues or an individual’s income, in the sense that the government has no mandate over all of the country’s GDP to honor its financial obligations.

On the other hand, countries with a lower ratio of interest expenditures to tax revenues enjoy better ratings. Such countries have more resources not only for their financial obligations but also for public services such as education and health, boosting their potential growth.

Unfortunately, despite significant improvement during the last decade, Turkey’s interest payments are still relatively high. Informality and tax evasion ensure that not only the tax base is low, but also that tax revenues are extremely procyclical. Add in a fiscal rule suspiciously swept under the carpet less than a year before the elections and suddenly Turkey’s fiscal position does not look so strong.

Moreover, notwithstanding progress made after the 2001 crisis, one quarter of public debt is still external or linked to foreign currency, making it vulnerable to sharp currency moves. Ozan also finds a negative relationship between real exchange-rate volatility and ratings before concluding that he is not very optimistic about a ratings upgrade.

In other recent research, Citi economists used a statistical model to determine Turkey’s chance of an upgrade. Their framework, which uses the current account deficit, inflation, GDP per capita, public debt to GDP and political stability as determinants of ratings, sees the probability of Turkey becoming investment grade at around 50 percent now and as high as 66 percent in the next two years.

Both papers concentrate on just a few of the many factors taken into consideration by the CRAs. Standard & Poor’s, or S&P, divides its ratings framework into nine categories, each with several different sections, so a definitive empirical study is no easy task.

Although I believe there is a good chance Turkey will become investment grade sometime this year on, if nothing else, the perception of its relatively successful economic performance, monetary policy – one of S&P’s main categories – might be the deal-breaker. If the Central Bank’s unconventional policy mix, which has left many confuzzled, actually works, then Turkey may see investment grade even before summer.

If not, investment grade – which we are sure to get before Fenerbahçe wins the F.A. Cup – will be the least of our worries…

Emre Deliveli is a freelance consultant and columnist for the Hürriyet Daily News & Economic Review and Forbes, as well as a contributor to Roubini Global Economics. Read his economics blog at http://emredeliveli.blogspot.com.