On November 5, 2012, Turkey’s financial industry finally received the news that it had been waiting for all year. Fitch, the international ratings agency, had upgraded Turkey’s sovereign credit rating to BBB-, the lowest level within the coveted category known as investment grade.

The upgrade had been widely anticipated, but even so it proved to be a powerful trigger. Turkish Eurobonds rallied hard for the rest of November and into December, pushing yields on benchmark 10-year lira bonds, which had been above 8% in October 2012, down to historic lows below 6.5%. Yields on 10-year sovereign dollar bonds, the benchmark for foreign borrowings by Turkey’s private sector, declined in tandem to under 3.5%.

Coming at a time when loose monetary policies in developed markets were already driving capital to emerging markets globally, the upgrade spurred a record boom in financial flows to Turkey. Portfolio inflows topped $30bn in the second half of 2012, more than the $22bn of portfolio inflows during the whole of 2011, according to central bank data.

For an economy as dependent as Turkey’s is on foreign capital inflows, the drop in interest rates is expected to result in a direct boost to the nation’s growth and profits. But increased inflows of foreign capital also pose risks and challenges, from the short-term risks of inflation and competitiveness to the longer-term challenge of ensuring that capital is directed towards sustainable growth.

Politics & Ratings

For the government and many working in its financial sector, the upgrade to investment grade was long overdue. Turkey’s dollar sovereign bonds had long been trading at spreads over US treasuries similar to or better than those of several countries rated at the lowest rung of investment grade, such as Croatia and Romania.

By May 2012, a public controversy erupted when ratings agency Standard & Poor’s (S&P) cut its outlook for its rating of Turkey from positive to stable, indicating that an upgrade had become less likely. S&P at the time had the lowest rating of Turkey of any major agency, at two notches below investment grade. S&P announced that the change was prompted by a worsening trade climate, however, Turkey’s prime minister, Recep Tayyip Erdoğan, publicly denounced the move, referring to it as “ideological”.

Upgrade Rationale

By the time Fitch upgraded Turkey in November 2012, the global climate was improving, while a slowdown in growth driven by the European crisis had cut import demand, reducing Turkey’s dependence on foreign financing.

As Fitch explained in the news release announcing its decision, “The upgrade to investment grade reflects a combination of an easing in near-term macro-financial risks as the economy heads for a soft landing and underlying credit strengths including a moderate and declining government debt burden, a sound banking system, favourable medium-term growth prospects, and a relatively wealthy and diverse economy.” While the ratings agency expected the current account deficit to widen again as economic growth accelerated, it believed Turkey’s fiscal policies and controls on credit expansion made it more resilient. Fitch said it “expects the economy to remain more volatile than investment grade peers, but… the country’s strong sovereign, bank and household balance sheets, and economic and exchange rate flexibility provide important buffers against shocks spreading into a wider financial crisis.”


Of the $30.4bn of portfolio inflows in the second half of 2012, nearly half, $14.2bn, went into government debt securities, according to the central bank. That was up from $7.5bn in the first half of the year. The effect of foreign buying on interest rates was obvious: yields on sovereign 10-year lira bonds dropped by 224 basis points during the period, according to Borsa Istanbul data.

Meanwhile, foreign flows into equities also accelerated, reaching as high as $5bn during the second half of 2012. This spike was up from the roughly $1.2bn seen during the first half of the year.

These effects were as the central bank had anticipated in a study published in September 2012, weeks ahead of the move by Fitch. The central bank examined how investment-grade upgrades had affected 20 other emerging markets between 1990 and 2011. It found, unsurprisingly, that foreign capital flows increased and interest rates fell.

However, Turkey’s experience also differed in many ways from the established pattern, partly because of the central bank’s active management, and partly because the upgrade, unusually, came at a time when economic growth was slowing.

For example, the Turkish central bank study found a clear pattern for private sector foreign borrowing and domestic credit expansion to accelerate around the time of investment-grade upgrades. That did not happen in Turkey. Instead, the upgrade appeared to help drive a change in the composition of banks’ foreign fundraising towards longer-term bonds. Foreign flows into Turkish banks’ debt securities increased to $7.2bn in the second half of 2012 from $1.7bn in the first half, while foreign flows into bank loans and deposits decreased, to $3.5bn in the second half of 2012 from $11.2bn in the first half.

Effect on the Lira

The efforts of the government had other effects. A Turkish central bank study found that currencies appreciated and current accounts deteriorated in the vast majority of countries upgraded to investment grade. In Turkey, the lira’s exchange rate was relatively stable in late 2012, while inflation slowed and the current account improved. Although much of that owed to slowing growth, active central bank policy also played a role. The central bank purchased $14.5bn of FX assets in the second half of 2012, up from $6.3bn in the first half of 2012. The central bank also lowered interest rates while hiking required reserves to discourage hot money inflows and sop up excess lira liquidity.

Other Potential Impacts

Perhaps unexpectedly, the study found no evidence that foreign direct investment increased after upgrades. That has also been Turkey’s experience. Moreover, the study found ambiguous evidence about the impact of upgrades on growth. Although countries grew faster after investment-grade upgrades, so did neighbours that were not upgraded. According to Zeki Önder, the executive vice-president of Şekerbank, “The Fitch upgrade was a symbolic victory for Turkey.” Yet he also echoed a critique heard from many in the banking sector. “Credit ratings are limited measures when it comes to assessing the overall performance of any given economy,” he told OBG. Özgür Güneri, the CEO of Finansinvest, told OBG that the upgrade’s effects would be felt over the longer term, by increasing access to financing for a broader range of Turkish companies. “This is an opportunity that companies across the economy must seize by improving their auditing standards and transparency,” he said.

However, Güneri also cautioned: “As more liquidity enters the economy due to the ratings upgrade and the new pensions law, we have to be careful to ensure that this capital is channelled in the right direction. We don’t need a flood of cash into real estate, for example. Rather, this money should be used to support infrastructure projects, emerging firms and productive sectors of the economy.”

Second Upgrade

After the Fitch upgrade, market speculation moved on to when Turkey would receive a second upgrade to investment-grade status from one of the other major agencies. Attention fell mainly on Moody’s, which rated Turkey one notch below investment grade. However it was S&P that acted earlier, in March 2013, lifting its rating from two notches to one notch below investment grade.

S&P cited some of the same reasons as Fitch, while noting also improved export performance and the government’s progress in peace talks with Kurdish rebels. “We expect this to be more lasting than previous efforts: if so, security-related costs would decline and the regional economy, as well as cross-border trade flows, would be boosted,” S&P said in a release. Moody’s released a statement in April calling progress in peace talks “credit positive”, increasing anticipation that the firm could soon give Turkey its second investment-grade rating.

Opinions differ on the importance of a second upgrade. Some executives and analysts told OBG a second upgrade would be as important as the first, as many funds aren’t allowed to invest in a country until at least two major agencies rate it investment grade. Others said most funds interested in investing in Turkey required only one investment grade rating. Erkin Şahinöz, managing director and CIO of Rhea Portföy Yönetimi, told OBG, “Capital inflows will continue until the second upgrade, and then equity markets will be poised for a correction. Over the longer run, what has happened in other countries is that capital inflows become more sustained.”