Turkey's investment grade cheers turn to tears

By Carolyn Cohn LONDON, June 11 (Reuters) - The transformation of Turkey in less than a month from newly-minted investment grade darling to market struggler has again put the role of ratings agencies under scrutiny. Turkey won a coveted second investment grade rating from Moody's in mid-May, a decision which swept Turkish bond yields to record lows and stock markets to all-time peaks. Now move on through an apparent change of policy by the U.S. Federal Reserve and a spate of headline-grabbing anti-government protests eliciting a harsh police response. Turkish stocks have fallen some 20 percent in three weeks - twice that of the main emerging market stock index it remains a part of - and there has been a punitive 200 basis point increase in Turkish borrowing costs. Money has flown from the country, helped on its way by Prime Minister Tayyip Erdogan's vehement attacks on speculation in the stock market - something Standard Bank's Timothy Ash said set a collision course with foreign investors. So was Moody's wrong to elevate Turkey to investment status from junk? The answer lies to a large degree in what it is that a rating is intended to show. Debt ratings are designed to tell investors how likely it is that borrowers will repay their debt. A lot of the criteria are therefore focused on economic and budgetary factors. Other issues such as political risk do, however, play a part. "Some parts of Turkey look great, for instance inflation is coming down, then on the other side of equation they have lots of short-term funding and political instability," said Steve O'Hanlon, head of fixed income at ACPI Investment Managers. "How do you capture all those things into the rating?" Moody's upgrade was based on Turkey's low debt to GDP ratio, robust growth and strengthening institutions. Ankara underlined this on Tuesday by reporting that gross domestic product grew 3 percent year on year in the first quarter, exceeding expectations. But there was little mention of political risk in the Moody's announcement. In the face of the market turn around - which is also being driven along with other markets by fears the Fed will pull the plug on its dollar printing - the agency has defended itself. It says the "current level of political and balance of payment risks" were reflected in its Ba3 rating and stable outlook. Another agency, Fitch, which upgraded Turkey to investment grade in November 2012, said that the anti-government protests were not a threat so far to the country's rating. "Political instability and lack of voice accountability is ranked as a weakness in our sovereign rating of Turkey," said Paul Rawkins, director in Fitch's sovereign ratings group. Others note that even though Turkey was lifted to investment grade it is on the lowest rung of that category. And other countries have similar or higher ratings and domestic troubles with opposition groups, including Russia and Bahrain. Add to that the fact that few people could have predicted the timing or vehemence of the anti-government protests or that they would come just as the Fed is hinting it will wind down its dollar-printing programme that has pumped up global assets. TIMING IS EVERYTHING But the timing of Moody's decision - variously seen by analysts as either too early or too late - nonetheless adds to a long line of decisions by credit agencies that have sometimes in retrospect seemed strange to governments and investors through the recent credit and euro crisis. "That's very typical of rating agencies," said Stephen Jen, managing partner of hedge fund SLJ Macro Partners, of the Turkish upgrade. "They can upgrade a country based on macro variables and fundamentals but they are not as sensitive to people. If people are angry, you can see a situation degenerate very quickly." Ratings agencies were sharply criticised during the 2008/09 financial crisis for awarding top-notch grades to complex sub-prime loan packages that became worthless when the crisis broke. They have since been lambasted for giving triple-A ratings to countries such as Ireland, which ended up needing a bailout from the European Union and International Monetary Fund. Agencies also failed to flag the 1997 and 1998 Asian crisis and when they slashed Indonesia, Korea and Thailand to junk status once the problems were already full blown, they drew criticism from policymakers for exacerbating the turmoil. Regulators have tried to loosen the control which the ratings agencies have on markets - new EU rules should make it easier to sue the agencies if they are judged to have made errors, such as in ranking the creditworthiness of debt. But many other ambitious planned changes were ditched, and the idea remains entrenched that a bond needs to have investment grade ratings from two of the three major ratings agencies - Moody's, Standard & Poor's and Fitch - for more cautious investors to buy it. Turkish markets, indeed, saw huge inflows this year on the mere expectation of a second investment grade rating by Moody's following Fitch. Credit default swap and bond markets were ranking Turkey higher than other investment grade countries including peripheral euro zone countries Italy and Spain. The stock market rose around 20 percent in the four-month run up to the decision. This race by investors to get a foothold in the country's markets left it vulnerable to a quick withdrawal of funds if anything unexpected popped up. Cue the Fed and the demonstrators in Taksim square.