Fitch Ratings Predicts Significant Reduction in Foreign Exchange Reserves of Azerbaijan

The international rating agency Fitch has affirmed Azerbaijan's long-term foreign currency issuer default rating (IDR) at 'BB +' with a negative outlook, with the greatest concern being the expectations of a decrease in the country's foreign exchange reserves allocated to help the state budget, as well as the situation in the banking sector.

Fitch notes that the rate of sales of currency by the State Oil Fund (SOFAZ) at the CBA's currency auctions "ceased to be compatible with its annual conversion in 2020 of the amount of $ 6.7 billion in the framework of transfer transfers to the state budget."

“SOFAZ has already sold currencies for $ 4.1 billion, of which $ 2.5 billion in March-April and the pace is high. Amendments to the budget law would require allowing further sales of foreign currency beyond the annual package (the approved transfer amount),” the rating agency notes.

It should be emphasized that the government avoids commenting on the official increase in the volume of transfers from SOFAZ to the state budget (ASTNA addressed this issue to the Minister of Finance and Assistant to the President of Azerbaijan for Economic Affairs). The need to amend the law on the budget for 2020 was previously indicated by Standard & Poor’s.

This week, Minister of Finance Samir Sharifov, when discussing the results of the half-year, said the government will forecast the state budget 2020, but did not specify the details.

According to ASTNA, the Ministry of Finance will introduce these changes in August. It is noteworthy that usually in August, the Ministry of Finance has already prepared forecasts for the next year, but the COVID-19 pandemic and the strongest fluctuations in oil prices in the spring "knocked out" government experts.

The April OPEC + deal, in which Azerbaijan is participating, was able to calm oil prices by mid-summer. The reference grade Brent, to which the cost of Azerbaijani oil is tied, is traded above $ 40 per barrel against $ 20-26 in April-May.

Participants in the OPEC + deal recognize the market as more predictable and from August they will increase oil production, including Azerbaijan.

This situation will help the government to predict the economic development of Azerbaijan at the end of the year, but, according to Fitch, it will still be worth the loss of the country's oil revenues accumulated earlier.

Fitch predicts Brent will average $ 35 / barrel in 2020, $ 45 / barrel in 2021 and $ 53 / barrel in 2022.

“Our negative outlook for Azerbaijan reflects the impact of the combined shock from lower oil prices and the COVID-19 pandemic on Azerbaijan’s external reserves and the risk of a significant macroeconomic adjustment ... Azerbaijan's very strong external balance sheet (sovereign net foreign assets were 84% of GDP at end-2019) is absorbing most of the impact from lower oil prices. External assets totalled USD49.5 billion at end-2019 (27 months of current external payments) and we forecast them to fall to USD38.3 billion (23 months of CXP) in 2020. External assets comprise mainly SOFAZ assets (USD 41.3 billion at end-1Q20), with the Central Bank of Azerbaijan's FX reserves increasing slightly to USD6.4 billion at end-May 2020.... Lack of predictability and transparency in the process of developing  policy aggravates the risk of errors in it (Azerbaijan's experience from the oil shock in 2014-2015)," the Fitch analysis says.

According to the Azerbaijani government, in July the country reached the level of 2019 in terms of foreign exchange reserves (more than $ 43 billion - SOFAZ assets and about $ 6 billion - Central Bank reserves), but Fitch advises "not to relax."

The agency recalls that Azerbaijan is highly dependent on hydrocarbons: oil and gas account for about 40% of GDP, 81% of revenues from the export of goods and services, and two-thirds of tax revenues.

Due to lower oil and gas prices, Azerbaijan's current account balance will deteriorate to -4.0% of GDP in 2020 (2019: 9.1%), and may return to surpluses of 4.4% and 6.1% in 2021 and 2022, respectively.

“Azerbaijan's strong external balance (sovereign net foreign assets accounted for 84% of GDP at the end of 2019) is absorbing much of the impact of low oil prices,” cautions Fitch.

This situation will lead to the fact that the consolidated budget balance in 2020 will be with a deficit of 6.8% of GDP (with a break-even fiscal policy at $ 50.7 / barrel) compared with a surplus of 9.1% in 2019.

"A sharp drop in oil prices affects revenues to SOFAZ and to the budget against the background of increasing spending on social benefits and benefits, since the unemployment rate in Azerbaijan in 2020 will increase to 8.0% from 5.0% in 2019," notes Fitch.

An increase in government spending due to the pandemic will, according to analysts, lead to the fact that the state debt of Azerbaijan will grow to 23% of GDP at the end of 2020 (against 19% at the end of 2019) and will be able to return to 19% of GDP only by 2022.

SOCAR's gas investment projects affect the growth of the national debt.

 GDP

 Fitch predicts that real GDP growth in Azerbaijan will decline by 4.2% in 2020 (the previous forecast was 4.8%) due to quarantine measures and low energy prices.

“We predict that real GDP growth will recover to 2.5% in 2021 and 2.8% in 2022 as oil prices recover and aggregate demand, but is constrained by the availability of oil and gas investments,” Fitch reports.

The Agency, relying on World Bank analyzes, indicates that weak accountability, uneven application of laws, a rather high level of corruption, obstacles to healthy competition, and the inability to attract direct investment in the non-oil sector impede the development of the Azerbaijani economy and its diversification.

 Banks

The quality of bank assets in Azerbaijan will be influenced by COVID-19 and a decline in hydrocarbon prices.

“Banks in Azerbaijan are still recovering from legacy asset quality problems following the 2015 devaluation and remain weak, as reflected in its Fitch Banking System Indicator (BSI) 'b'. Aggregate banking sector NPLs are moderate and declined slightly to 7.3% in May 2020 (end-2019: 8.3%) as the CBA revoked licenses from four troubled banks. After debt restructuring in 2017, the country's International Bank returned to profitability and improved asset quality, but it still has an unhedged open foreign exchange position of USD 0.7 billion as of June 2020 (2017: USD 1.9 billion),” the Fitch report said.

Note that the IBA recently announced that its net profit for the first half of 2020 amounted to 146 million 277.47 thousand manat (a decline of 51.3% compared to January-June 2019), and its assets decreased by 8, 1% - up to 8 billion 477.362 million manat.

In January-June 2020, the bank’s loan portfolio grew by 1.8% to 2 billion 418.518 million manat, but the volume of deposits in IBA decreased by 15% to 4 billion 792.183 million manat.

Fitch believes that Azerbaijan's rating could be downgraded in the event of changes in the structure of economic policy that undermine macroeconomic stability, for example, an uncontrolled devaluation of the exchange rate. The rating could also be negatively affected by persistently low oil prices or a longer external shock, which could have a significant negative impact on the economy, banking sector, public finances or external position.

At the same time, higher oil prices, which reduce the likelihood of indiscriminate exchange rate depreciation, confidence in the government's ability to reduce the consolidated budget deficit and preserve financial assets, and a low public debt to GDP ratio could lead to an improvement in the rating.

The agency hopes that the escalation in the conflict with Armenia over Nagorno-Karabakh will not continue to "such an extent that could affect the economic and financial stability of Azerbaijan."

Recall that Azerbaijan has already called on the world community to pay attention to the fact that Armenia shells the Tovuz region of Azerbaijan (away from Nagorno-Karabakh), through which all export oil and gas pipelines of Azerbaijan, the Baku-Tbilisi-Kars railway and the Baku-Tbilisi highway go.