Azerbaijan’s Rating was Downgraded to Negative from Stable

Azerbaijan’s Rating was Downgraded to Negative from Stable

Standard & Poor’s Ratings Services has revised its outlook on Azerbaijan to negative from stable on January 31, 2015. At the same time it affirmed the ’BBB-/A-3’ long- and short-term sovereign credit ratings on Azerbaijan.

S&P reports that the outlook revision reflects its view that Azerbaijan’s government might draw down its currently substantial fiscal buffers or accumulate general government debt more rapidly than what S&P had previously expected in order to compensate for significantly lower oil prices.

“We affirmed the ratings because Azerbaijan’s strong external and government balance sheets continue to support the ratings,” the Agency said in a statement.

The ratings are constrained by Azerbaijan’s modest economic wealth levels, generally weak institutional and governance effectiveness, and limited monetary flexibility.

Azerbaijan’s economy and general government revenues depend on the hydrocarbons sector, which the Agency estimates contributed about 44% of GDP and 95% of merchandise exports in 2013-2014. Since S&P last review, the Agency has significantly lowered S&P expectations on oil prices for 2015-2018.

The Agency now forecasts that the oil price will decrease to $55/barrel in 2015 and will modestly recover to an average $75/barrel in 2016-2018. Deteriorating terms of trade will depress Azerbaijan’s economic growth and hurt its external and fiscal balances.

Azerbaijan’s wealth levels are in the midrange for rated sovereigns, in S&P view, with estimated GDP per capita of about US$7,800 in 2014. In 2014, Azerbaijan’s real GDP growth slowed to 2.8%, from 5.8% in 2013. This was due to decreasing oil production, which was affected by maintenance works at the key Azeri-Chirag-Guneshli oil field, and because of decelerating growth in the non-oil sector. In 2015, the Agency anticipates that the economy will grow by only 1.9%, because oil production and exports will continue to shrink, and the non-oil sector, especially construction, will be affected by lower public-sector capital investment. S&P expects nominal GDP, on the other hand, to contract by over 10% this year due to the sharply lower oil prices.

Over the long term, economic growth will be supported by gas production at new gas fields, which should compensate for stagnating oil production. In 2018, the major Shah Deniz II field, which will bring gas from Azerbaijan to Europe, is expected to come on stream. Gas will be transported via the Trans-Anatolian (TANAP) and Trans-Adriatic (TAP) pipelines. A consortium of the State Oil Company of Azerbaijan Republic (SOCAR), international oil and gas corporations, and the newly created Southern Gas Corridor CJSC are planning to construct the pipelines over the coming years. In late 2013, the final route of both pipelines was determined, and construction is set to begin in 2015.

In S&P view, the risks stemming from high economic concentration are mitigated by the government’s large liquid fiscal assets. The Agency estimates that, in 2015, Azerbaijan will be in a net asset position equivalent to about 51% of GDP.

However, beyond 2015, this ratio might decline, following a deterioration in the country’s government finances.

The government’s liquid assets are mainly accumulated in the State Oil Fund of the Republic of Azerbaijan (SOFAZ), a fiscal reserve fund which is invested externally. The Agency estimates that in 2014, SOFAZ’s assets reached about 50% of GDP.

However, in 2015-2017, SOFAZ’s liquid financial assets will likely gradually decline both in nominal terms and as a proportion of GDP. The fund will no longer accumulate surplus oil-related revenues, and will spend a portion of funds to finance the general government deficit. It will also likely continue to invest in the construction of gas pipelines.

Although Azerbaijan’s fiscal profile remains strong compared with those of peer countries, S&P thinks it is set to weaken in the next two to three years.

The Agency anticipates that, in 2015-2018, the general government fiscal balance will turn negative after a long period of surpluses, primarily because about 70% of general government revenues come from the oil and gas sector. When calculating the general government balance, the Agency consolidated the state budget revenues and expenditures with those of the social protection fund and SOFAZ. SOFAZ provides an annual transfer to the state budget, which comprises about 40% of the consolidated government revenues. Based on S&P current oil price assumptions of $55/barrel in 2015, consolidated revenues might drop by up to 20% compared with 2014. This could translate into a general government deficit of about 6% of GDP in 2015 and 2.5% on average in 2016-2018, compared with a largely balanced budget in 2014 and surpluses of more than 5% of GDP in the previous five years.

S&P expects the government will partly counterbalance weaker revenues with fiscal consolidation measures, primarily by cutting capital expenditures. The Agency’s believes that Azerbaijan currently benefits from large fiscal flexibility, given that capital investments comprised about 40% of total expenditures in 2014 and were budgeted at almost 45% of expenditures for 2015. That said, the Agency does not expect the government to scale back its investment in infrastructure related to its hosting of the First European Games in Baku this year, which will require capital investment equal to about 6% of total expenditures and which is a political priority. However, the Agency sees other capital projects possibly being downsized or postponed.

In line with Azerbaijan’s policy of maintaining low debt levels, S&P assumes the country might cover about one-half of the general government deficit by drawing down on SOFAZ’s funds. Therefore the Agency expects the general government debt will increase by about 2% of GDP annually on average, and will remain below 15% of GDP until the end of 2018.

Despite the sharp drop in oil prices, S&P believes Azerbaijan will maintain its strong external position over the next three years. The current account balance, which hinges on hydrocarbon exports, will likely decline, but the Agency still expects it to remain positive. S&P estimates the current account surplus in 2015 will fall to only 1% of GDP, from an estimated 12% in 2014 and more than 20% on average in the previous five years. However, imports of capital goods will also likely be scaled back, and, from 2016, the balance should improve on the back of recovering oil prices. Over the long term, it will also be underpinned by increasing gas output from new gas fields. Over the next three to four years, the Agency estimates gross external financing needs will stay at about 80% of current account receipts (CARs) plus usable reserves, and the country’s narrow net external asset position (liquid external assets held by the public and banking sector minus external debt) will remain at approximately 120% of CARs. At the same time, Agency’s assessment of Azerbaijan’s external sector takes into account the negative impact of inconsistencies and gaps in reported data, which remain material in Agency’s view.

Azerbaijan’s underdeveloped monetary and banking systems, with weak governance and underwriting standards, are a rating constraint, in S&P opinion. The Central Bank of the Republic of Azerbaijan lacks institutional independence and efficient instruments to implement monetary policy effectively. The Agency believes that, in 2015-2016, Azerbaijan’s monetary flexibility might become constrained by the pressure on the Azerbaijan manat coming from adverse terms of trade. In late 2014 the central bank had already used about 7% of its foreign currency reserves to support the manat, which was hit by the volatility in the Russia ruble and the Kazakhstani tenge, and S&P expects intermittent interventions in the foreign exchange market will continue.

In 2014, the inflation rate slowed, despite two separate decreases in the refinancing rate. Domestic credit growth, especially unsecured retail lending, which had been expanding rapidly in the previous couple of years, also slowed after a number of regulatory measures were introduced. In S&P opinion, system wide average lending growth for 2015 will be within 10%-13%. The Agency also expects the share of nonperforming loans to increase, based on the high correlation with oil prices that the Agency had observed in previous years.

The local capital market is shallow and underdeveloped, in S&P opinion, with most banks directly or informally controlled by the government and the ruling elite. These factors contribute to Agency’s assessment that the monetary transmission mechanism is weak. The Agency anticipates that the largest bank, International Bank of Azerbaijan, which accounts for about 35% of total banking assets, will continue to receive capital injections from the state in the next three years.

The Agency continues to view domestic political and geopolitical risk as rating constraints. In Agency’s view, decision-making is heavily centralized and insufficiently transparent, which can lead to less predictability in policymaking. Accountability, transparency, and development of independent institutions are still nascent in an international comparison. The outbreaks of violence with neighboring Armenia (not rated) over the Nagorno Karabakh territory became more frequent in 2014, but S&P doesn’t expect it to escalate into open armed confrontation over the medium term.

The negative outlook reflects S&P view of a potential weakening of Azerbaijan’s fiscal or external profile (and with it the resiliency of the economy to confront shocks) over the next two years, resulting from the recent substantial oil price decline. The negative outlook also reflects the possibility that future pressure on the exchange rate might constrain monetary flexibility more than the Agency currently expects.

The Agency could lower the ratings if it observed a more rapid deterioration in Azerbaijan’s general government fiscal balance and depletion of its fiscal buffers compared with Agency’s current expectations. This could stem from the government’s inability or unwillingness to implement sufficient budget austerity measures, or from more considerable disbursement of SOFAZ’s reserves.

S&P could revise the outlook to stable if the fiscal pressure is counter balanced by a timely and sufficient response from the government, and Azerbaijan’s external position and the fiscal profile remain strong in line with Agency’s base-case assumptions.

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