Pimco Sees Risk of Turkey Outflows on Possible Downgrade

Pacific Investment Management Co., the world’s biggest bond manager, said Turkey faces an investor exodus should credit rating companies downgrade the nation’s debt amid warnings on political risks.

Turkey, which moved from junk for the first time in two decades last year, risks losing its Baa3 debt rating with Moody’s Investors Service after the ratings company said it has a negative outlook on the country. Two-year note yields have surged by 96 basis points to 9.21 percent over the past month, the second-biggest leap after Ukraine in Europe, Middle East and Africa, according to data compiled by Bloomberg.

“Turkey is particularly exposed to global turbulence as it has a substantial current account deficit, and continues to run unorthodox monetary policy,” Michael Gomez, head of emerging markets portfolio management at Newport Beach, California-based Pimco, said in an e-mail. “Following the upgrades to investment grade, substantial funds flowed into Turkey, and there is a risk that these could revert if they are downgraded to sub-investment grade.”

Moody’s last week said risks to the Turkish economy remain “skewed to the downside” after Prime Minister Recep Tayyip Erdogan’s victory in presidential elections, which has deepened divisions within his government over economic policy. Morgan Stanley has listed Turkey among the “Fragile Five” economies most vulnerable to a withdrawal of the foreign investment needed to finance their deficits.

Losing Status

Potential action by ratings firms in the coming months is “non-negligible,” Barclays Plc strategists Durukal Gun and Andreas Kolbe said in an e-mail. Losing investment-grade status would imply exclusion from investment-grade bond indexes and could lead to outflows of as much as $2 billion from local bonds and $5 billion from eurobonds, according to Barclays.

“We recommend a defensive strategy for Turkish sovereign and local markets,” Barclays said, recommending investors switch from Turkey’s 30-year bonds to those of Morocco.

Economy Minister Nihat Zeybekci said over the weekend that Turkey “doesn’t take any notice” of Moody’s warnings, and that the risks it cites are irrelevant to the economy. He released a statement yesterday calling Moody’s “prejudiced.”

The uncertainty over Turkey’s economic direction will last at least until parliamentary elections scheduled by next June, according to Moody’s analyst Alpona Banerji. She cited the “weakening independence” of the central bank and other key institutions as another risk to Turkey’s economic stability.

Government Pressure

Zeybekci is among ministers close to Prime Minister Erdogan who have put pressure on central bank governor Erdem Basci to lower rates, saying cuts are necessary to invigorate growth. Zeybekci this month blamed rate levels for inflation running more than 4 percentage points above the central bank’s target.

Fitch Ratings said on Aug. 11, the day after Erdogan won the presidential election, that government pressure to reduce rates could undermine the central bank’s “tenuous credibility.” In response, Zeybekci labeled Fitch “ill-intentioned.”

Turkey’s current account deficit was $4.09 billion in June, overshooting the average expectation of 13 economists in a Bloomberg survey. Foreigners have sold a net $1.52 billion of Turkish bonds and invested a net $1.86 billion in stocks since the start of the year, according to central bank data.

Slower Economy?

Moody’s joins economists at UBS AG and Deutsche Bank AG in predicting that growth in the Turkish economy will slow to 3 percent in 2014, from 4 percent last year. Zeybekci said Moody’s had got it wrong, and that the economy will grow “way above” 3 percent, barring extraordinary developments. Moody’s didn’t return requests for comment.

The effect of a cut in credit ratings by Moody’s “would be manageable,” Dorothea Froehlich, an asset manager at MainFirst Schweiz AG in Zurich, said in an e-mail. “Current valuations, especially of bank debt, reflect the downgrade risk and imply a premium to investment grade paper in other emerging markets.”

Russia and Poland’s two-year notes trade at 8.88 percent and 2.23 percent respectively, according to data compiled by Bloomberg.

It is concerning that the majority within the government “who recently commented on economic policy seem to have views on these issues contrary to those the rating agencies would likely like to hear,” Barclays’s Gun and Kolbe said. “The question of who runs the country’s economic policy management has become crucial, in our view.”

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