Fitch Ratings has downgraded Azerbaijan’s Long-term foreign and local currency Issuer Default Ratings to ’BB+’ from ’BBB-’.

The Agency informs that the outlooks are negative. The issue rating on Azerbaijan’s senior unsecured foreign currency bond has also been downgraded to ’BB+’ from ’BBB-’. The Country Ceiling has been revised to ’BB+’ from ’BBB-’ and the Short-term foreign-currency IDR has been downgraded to ’B’ from ’F3’.

Fitch motivates its actions with the fact that low oil prices have caused a significant deterioration in the fiscal position.

The consolidated general government budget deficit was 5.3% of GDP in 2015 and Fitch expects deficits of 12.5% of GDP in 2016 and 7.5% of GDP in 2017. Receipts from oil and gas, which averaged more than 50% of consolidated budget revenues over the past five years, fell by an estimated 40% in 2015 and Fitch expects them to drop by a further 30% in 2016. At an oil price of USD 25/b, the revised draft 2016 budget projects a consolidated deficit of 15% of GDP.

The Agency points out that even two devaluations of 2015 failed to reduce dependence and compensate the reduction of earnings because of oil price fall.

Devaluation has also created urgent social pressures, and the government intends to spend an additional 2% of expected 2016 GDP to compensate the parts of society whose purchasing power has been most hurt by the devaluation. Fitch expects current expenditure in the 2016 state budget to rise 40% to around AZN8.6bn, while capital spending will be slashed by 40% to around AZN5.3bn.

Fitch says that assets of the State Oil Fund of Azerbaijan (SOFAZ) were USD34.7bn (68% of GDP) at end-3Q2015, from USD37.1bn (50% of GDP) at end-2014 and Fitch expects them to fall further to around USD31bn by 2017. However, the ratio of SOFAZ assets to GDP has increased and will rise further because lower oil prices have depressed the nominal value of GDP.

Currency devaluation reduces the draw on SOFAZ assets, since its transfer to the government is denominated in manat, but the government will be under pressure to increase transfers from the fund. General government debt, which includes explicit contingent liabilities, jumped to 28.3% of GDP in 2015 from 11.2% of GDP at end-2014. The increase is driven by a guarantee on the bonds of state-owned bank Aqrarkredit, which will buy up the troubled assets of the International Bank of Azerbaijan. Fitch expects the debt ratio to stay at this level in 2016-17.

“The Central Bank’s unsuccessful policy of defending the manat contributed to a fall in its official foreign exchange reserves to USD6.1bn or 3.4 months of import cover at end-2015 from USD15.8bn at end-2014. This compared unfavourably with a ’BBB’ category median of 5.6 months of import cover,” the Agency emphasized.

According to Fitch’s estimate, the reserves fell a further USD1.2bn in January due to capital flight after a 50% devaluation in late December. In response, the Central Bank ordered the closure of currency exchange shops and parliament passed a law imposing a 20% tax on foreign currency transfers abroad. The law was later rejected by the President on grounds of protecting investor interests.

Fitch expects real GDP to contract by 3.3% in 2016, even as the median ’BBB’ country will grow by 2.6%. Oil output will fall slightly as the long-term trend of declining production in Azerbaijan’s oil fields is exacerbated by a fire on a key platform on SOCAR’s Guneshli field. Fitch expects non-oil activity to contract by 4%, as the government cuts back on spending, bank lending comes to a stop and consumer confidence and purchasing power fall. However, much of the fall in spending should be absorbed through a reduction in imports.

Consumer prices jumped 4.3% month on month in December and a further 5.8% in January. Fitch expects annual average consumer price inflation to reach 14% year on year in 2016, after a 4% year on year increase in 2015. “There are reports of prices of some products quickly adjusting by 50%, indicating that the consumer price index may understate actual inflation. Price increases and generally deteriorating economic conditions triggered isolated protests across the country,” the Agency said.

The weakness of the banking sector, which Fitch’s Banking System Indicator rates at ’b’, will be exacerbated by the devaluation and shrinking economy. With deposit dollarisation climbing to 85% in December, there is also an underlying shortage of local currency liquidity and the monetary transmission mechanism is impaired.

To encourage deposit growth and confidence in the financial system, the authorities lifted taxes on deposit interest and provided a full guarantee to all bank deposits. The guarantee creates a contingent liability to the sovereign, as the deposit compensation fund could borrow from the Central Bank under a state guarantee. However, the banking sector is small enough for the authorities to easily provide support if needed, with assets of 50% of GDP.

The country is a net external creditor, and Fitch expects that import compression will help it maintain current account surpluses of around 5% of GDP in 2016-2017, after an estimated 1% of GDP in 2015. Fitch expects official foreign exchange reserves to rise to 4.9 months of import cover from 3.4 months in 2015.

Fitch expects growth to pick up in 2017 and particularly in 2018, when the Shah Deniz Stage Two gas development is expected to begin to come on-stream. Key energy and transport infrastructure projects are being prioritised and maintained. Restoration of price competitiveness following the devaluation should aid non-oil growth, particularly in tourism and agriculture.

The main factors that, individually or collectively, could trigger negative rating action are:

- A failure to adjust expenditure or revenue to the lower oil price environment, resulting in a more rapid draw-down of external assets.

- A further fall in hydrocarbon prices, or a prolongation of the current price weakness.

The main factors that, individually or collectively, could trigger positive rating action are:

- An improvement in the budgetary position, beyond the measures currently envisaged, sufficient to increase Fitch’s confidence in the longer-term sustainability of Azerbaijan’s sovereign balance sheet strengths.

- A sustained rise in hydrocarbon prices that restores fiscal and external buffers.

- Improvements in governance and the business environment, and progress towards diversifying the economy away from hydrocarbons.

Fitch assumes that Brent crude will average USD 35/b in 2016 and USD 45/b in 2017 and rise to long-term average of USD 65/b. --0--