Standard and Poor’s: Azerbaijan ‘BBB-/A-3’ Ratings Affirmed On Strong External Position; Outlook Remains Negative

Standard and Poor’s: Azerbaijan ‘BBB-/A-3’ Ratings Affirmed On Strong External Position; Outlook Remains Negative

S$P’s has published its new assessment for Azerbaijan.

OVERVIEW

• Azerbaijan’s external position remains strong and we forecast continued current account surpluses over 2015-2018, although weaker than in recent years primarily because of the decline in oil prices.

• We are therefore affirming our ‘BBB-/A-3’ long- and short-term ratings on Azerbaijan.

• The outlook remains negative, reflecting the risks of Azerbaijan’s fiscal buffers weakening and thereby reducing the economy’s capacity to counter potential economic shocks.

RATING ACTION

Standard & Poor’s Ratings Services affirmed its ‘BBB-/A-3’ long- and short-term foreign and local currency sovereign credit ratings on the Republic of Azerbaijan. The outlook remains negative.

RATIONALE

Our ratings on Azerbaijan remain supported by the sovereign’s strong external and fiscal positions, primarily reflecting the sizable foreign-invested sovereign oil fund SOFAZ, which has assets in excess of $35 billion (about 60% of estimated 2015 GDP). Nevertheless, we forecast a steady downward trend in the government’s net asset position to below 50% of GDP. In our view this could weaken the economy’s capacity to counter potential economic shocks.

The ratings are constrained by Azerbaijan’s modest income levels, relatively weak institutional effectiveness, and limited monetary flexibility. We believe the latter has reduced further in the aftermath of the February manat devaluation. Rapid dollarization of the economy has occurred over the last several months.

In our view, the economy is currently facing a number of pressures related to the sizable decline in the oil prices over the last year. Azerbaijan remains heavily dependent on the hydrocarbons sector, which amounted to about 40% of GDP and 95% of merchandise exports in 2013-2014.

No devaluation is projected for 2015-2018

After several years of the exchange rate remaining stable, the Central Bank of the Republic of Azerbaijan (CBA) devalued the Azerbaijani manat (AZN) against the U.S. dollar by 33% (manat per dollar rate) in February 2015. The decision followed a sustained decline in CBA’s foreign-exchange reserves in the preceding months to about $15 billion at the start of February 2015 from $17 billion in November 2014. In our view, the stability of the manat since the devaluation suggests that the currency remains largely pegged to the U.S. dollar, even though CBA has announced a move to a regime targeting a euro-dollar currency basket. At present, we do not project a further devaluation during our 2015-2018 forecast horizon.

We expect CBA’s foreign-exchange reserves to remain stable through the rest of the year: they continued to decline during February to April but stabilized in May. We nevertheless believe that the rapid dollarization in the aftermath of the February devaluation will further hamper the already-weak monetary flexibility: as of end-May foreign currency deposits exceeded 70% of total deposits, a significant increase from 50% in January.

8.0 % inflation is projected for 2015

Given the small banking system and shallow domestic capital markets, we believe CBA will continue to find influencing domestic monetary conditions a challenge. In an attempt to stimulate non-oil growth and support SME and mortgage lending, CBA lowered the refinancing rate to 3.0% from 3.5% from July 13. We do not expect this to have a significant effect, however. We forecast credit growth to reduce to 12% this year from 24% in 2014, reflecting banks consolidating balance sheets following the February devaluation. In our view, monetary policy will also face conflicting goals as CBA attempts to ease manat liquidity conditions at a time when inflation will surpass 8% owing to the effects of devaluation.

In our view, the February 2015 devaluation will also have a negative impact on household purchasing power and we forecast that domestic consumption will decline this year for the first time since 1999 (with the exception of 2010).

Oil output will be declined

We also forecast exports to contract in real terms owing to reduced oil production, which primarily reflects the main oilfields aging. We understand that, absent sustained investment, oil production will likely reduce by 1%-2% a year.

At the same time, we also project imports to contract following the devaluation and expect net exports to contribute positively to GDP growth, forecast at 2.2% in 2015, down from 2.8% in 2014. From 2016, a gradual recovery in consumption and stronger investments will support stronger economic performance, which nevertheless will remain much weaker than during the pre-2008 boom years when it consistently exceeded 20% annually.

Over the long term, Azerbaijan should benefit from production at new gas fields, which we expect to partly 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. We
understand that the project remains on track and the construction of TAP and TANAP started as planned earlier this year.

At present, the ratings on Azerbaijan remain supported by the sovereign’s strong fiscal position. The government controls sizable liquid assets currently estimated at about 60% of GDP. These primarily reflect the State Oil Fund of the Republic of Azerbaijan (SOFAZ), a fiscal reserve fund which is invested externally. Given the government’s low debt burden, we estimate its net asset position at about 52% of GDP in 2015.

Following more than a decade of general government budgetary surpluses, we project a sizable deficit of 8.9% of GDP in 2015. When calculating the general government balance, we consolidate the state budget revenues and expenditures with those of the social protection fund and SOFAZ. SOFAZ provides transfers to the state budget, which comprise about 40% of the consolidated government revenues. Based on our current oil price assumptions of $55/barrel in 2015, we
project consolidated revenues to drop by about 20% compared to 2014.

We expect the government will partly counterbalance weaker revenues with fiscal consolidation measures, primarily by cutting capital expenditure. In our view, Azerbaijan currently benefits from a high level of fiscal flexibility, given that capital investments comprised over 30% of total expenditures in 2014 and were budgeted at similar levels for 2015. We expect state expenditures in 2015 to amount to only 90% of the planned spending, broadly in line with the government’s
plans.

Also in line with the government’s policy of maintaining low debt levels, we expect the consolidated deficit to be primarily financed by drawing down on the existing fiscal reserves with only one-third being financed through external borrowing. We expect that one-third of the consolidated deficit will be financed by Treasury deposits at CBA and another third through a net drawdown of the assets of SOFAZ. We anticipate that the general government sector will return to a surplus position from 2016 onward in line with a gradual recovery in oil prices.

SOFAZ assets will be declined

We expect SOFAZ assets to decline to $33 billion in 2015 from $37 billion in 2014. This partly reflects the pronounced depreciation of the euro against the dollar (SOFAZ’s assets are primarily invested in foreign fixed-income securities with about 30% of total denominated in euro) and a roughly $2 billion allocation for the financing of the aforementioned consolidated deficit.

SOFAZ’s assets will gradually return to growth from 2016 onward as oil prices start to recover. However, we expect nominal GDP growth to be stronger and, as a result, the government’s net asset position as a percent of GDP may weaken over the forecast period, absent stronger fiscal consolidation.

We expect Azerbaijan’s current account surpluses to persist over the next four years. That said, the surplus will moderate to 2.2% of GDP in 2015 from over 13% of GDP last year reflecting the oil price decline. At the same time, we expect imports to contract following the manat devaluation.

In the next few years, we expect current account surpluses to grow again but to remain below pre-2015 levels. This is largely explained by our oil price forecasts (which we project to be at 55$/bbl in 2015, 65$/bbl in 2016, and $75/bbl thereafter) and stagnating oil production. The current account should be supported from 2019, when Azerbaijan starts exporting higher volumes of natural gas to Europe from the Shah Deniz II gas field. Overall, we expect Azerbaijan’s net external asset position to remain strong, averaging a sizable 76% of current account receipts over 2015-2018.

Azerbaijan continues to face a number of domestic political and geopolitical risks. In our view, decision-making is highly centralized and lacks transparency, which can reduce policymaking predictability. The outbreaks of violence with neighboring Armenia over the Nagorno-Karabakh territory became more frequent in 2014, but we don’t expect them to escalate into open, armed confrontation over the medium term.

OUTLOOK

The negative outlook reflects risks of Azerbaijan’s fiscal buffers weakening and thereby reducing the economy’s capacity to counter potential economic shocks.

We could lower the ratings over the next year if we were to conclude that the government’s fiscal consolidation efforts are insufficient to arrest the projected material decline in its net asset position. We could also lower the ratings if we believed that the growth outlook had deteriorated compared to our current projections. This could be the case, for instance, if oil production declines faster than we currently anticipate while growth in Azerbaijan’s non-oil sector is not sufficient to
compensate.

We could revise the outlook to stable if pressures on Azerbaijan’s fiscal accounts abate, for instance as a result of a timely and credible response from the government, while Azerbaijan’s external position remains strong.

Standard and Poor’s, 2015

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