Under the Radar: Failure of largest lender only beginning of Azerbaijan�s worries

The failure of IBA highlights Azerbaijan"s exposure to interconnected risk in the financial and energy sectors.

This week"s announcement that the International Bank of Azerbaijan (IBA) has suspended payments on some liabilities marks a serious stumbling block for one of Azerbaijan"s largest financial institutions. IBA has entered Chapter 15 in the United States and is asking foreign investors and institutions for support as it works to manage its unwieldy bad loans, allegedly 80% of its portfolio. Seeking to restructure its commitments, IBA"s latest move only further weakens confidence in the bank and in the overall stability of the Azeri economy, especially given IBA"s ties to the government and state energy giant State Oil Company of Azerbaijan Republic (SOCAR).

Azerbaijan"s financial sector dragging down entire government

IBA"s payment suspension marks the latest indicator of Azerbaijan"s slumping fortunes, as the decrease in oil prices has brought the country to a shuddering halt over the past several years. With control of one third of Azerbaijan"s assets, IBA has become too big to fail, a fact demonstrated by its takeover by the government in 2015, following a drop in oil prices and a steep depreciation of the national currency, the manat. Since the government controls 80% of IBA (up from 51% in 2015), a default by the bank would also seriously impact the credibility of Azerbaijan"s government.

With outstanding debt of $908 million, consisting of two loans and the remainder in Eurobonds, IBA has already missed payment on a $100 million loan to Dublin based Rubrika Finance. Finance minister Samir Sharifov is scheduled to meet international investors in London on May 23rd. If this meeting proves unfruitful, IBA has a scant couple weeks until its next major payment is due, a coupon repayment on a $500 million Eurobond set to mature in 2019. In addition, an additional $185 million loan becomes due on October 26th 2017.

IBA"s dire straits become all the more confusing as the company reported a 24% year-on-year increase in operating revenue to $128 million for Q1 2017. This improved balance, the result of restructuring and cutbacks initially seemed encouraging, yet coupled with recent developments only further muddles investor confidence. IBA"s payment suspension also comes after November announcements claiming that the government was planning on privatizing the bank as early as 2017; a significant increase from the previously stated five year timeline. Add Azerbaijan"s surprise decision to appreciate the manat by 10% over ten days in February, only a month after the central bank declared it would freely float the currency, and market confidence is at an all time low.

2016 saw 10 of Azerbaijan"s 42 lenders lose their licenses, further sowing instability. This loss of market diversity only further highlights the risks from lender ownership consolidation. IBA, Kapital and Pasha comprise more than half of Azerbaijan"s assets, and all three are run by a politically connected trust. Moreover, Dmitri Vasiliev, director of financial institutions at Fitch, explains that "[Fitch] views IBA as a failed institution right now." IBA"s rating was dropped to F after it emerged that the government had transferred $5.8 billion to the institution in the first half of 2016 alone, three times more than originally planned. Indeed, Azerbaijan"s government deficit, set to hit 8.4% of GDP in 2017 is largely due to transfers to the banking sector.

Trying to beat the clock with new energy developments

Since the collapse of the USSR, Azerbaijan"s GDP has increased twenty-fold, driven by oil, notably from the giant Azeri-Chirag-Guneshli field. Despite Azerbaijan"s energy bounty, maturing developed assets has seen oil production decline (and SOCAR"s woes increase) from 1.1 million barrels per day in 2010 to 841,000 in 2017. As of 2016 Azerbaijan has even had to import energy, with 10% of its LNG consumption coming from overseas. Decreasing yields and depleting reserves have pushed the government to explore new production sites. The country"s economy as well as the power of the ruling Aliyev dynasty is firmly based on energy rents.

Azerbaijan is pinning its hopes on recent substantial natural gas finds, with an ultimate goal of supplying Europe via the Trans Anatolian (TANAP) and Trans Adriatic (TAP) pipelines. Together these pipelines form the $45 billion Southern Gas Corridor, with Azerbaijan aiming to supply 10% of European energy needs. Hoping to export as much as 40 billion cubic metres per year by 2025, Azerbaijan has sunk billions into infrastructure projects, yet the government"s financial straits have seen it borrow around $5 billion to realize these ambitions. Alongside these debts, the country"s deteriorating fiscal situation puts ever increasing pressure on the government and its credit rating.

While IBA"s woes are concern enough for Azerbaijan, its connections to state-owned energy giant SOCAR mean that weaknesses in both the financial sector and energy production - by far the largest economic driver - are cascading off each other, with potentially devastating consequences. In the same year that the government increased its control of IBA, the bank provided SOCAR with a $2 billion loan - a 10 year preferential allocation. IBA"s problems become SOCAR"s and vice versa as the energy producer was given a BB with negative outlook ranking by S&P Global Ratings in December 2016. S&P cited SOCAR"s weakening finances and the "very high likelihood of government support," as key factors for the company"s poor showing.

Specifically, SOCAR"s adjusted rate of debt to EBITDA is four fold, with funds from operations to debt between 17-20% for 2016-2018. As the one of the largest taxpayers and employers in Azerbaijan, SOCAR, like IBA is too big to fail, putting the government on the hook at both ends, as organizer of IBA"s loans and chief beneficiary of SOCAR"s revenue. This creates a circular pattern in which weakening SOCAR revenue necessitates more assistance from IBA, which itself is in dire straits, with the government losing money on SOCAR and IBA at the same time.

While the government has traditionally provided loans and equity funding from state-owned banks, most of SOCAR"s debt does not have any state guarantees. Moreover, while 80% of SOCAR"s debt is in foreign currencies, a significant portion of company revenues are earned in manat, which alongside depreciation, exposes SOCAR to weaknesses in the Azeri banking sector. Consequently, "the negative outlook of SOCAR mirrors the negative outlook of Azerbaijan." With negative 3.8% and negative 1.3% year-on-year GDP growth in 2016 and 2017 respectively, Azerbaijan"s economy has been hamstrung by weakness in the financial and energy sectors. The government has even raided Sofaz, the country"s sovereign wealth fund in order to shore up IBA: Sofaz"s holdings have dropped to a mere $64 million, down from $523 million in 2014.

SOCAR"s scandal threatens Azerbaijan"s Southern Gas Corridor plans

Unfortunately for SOCAR, the company has also become embroiled in an ongoing corruption scandal in Malta, long a favourite money laundering destination for Azeri oligarchs and officials according to the Carnegie Endowment for International Peace. The scandal highlights the connections between SOCAR, the Aliyev family and the threat this relationship poses to Azerbaijan"s grand ambitions. With Azeri TANAP and TAP energy deliveries expected to start in 2018, the Malta scandal further tarnishes Azerbaijan"s checkered reputation. Interestingly, the same day as IBA"s payment suspension announcement, the Washington Times featured a glowing endorsement of Azerbaijan and the Aliyev regime"s refusal to play energy politics by S. Rob Sobhani, CEO of Caspian Group Holdings.

In short, Leyla Aliyeva, daughter of President Ilham Aliyev transferred over $1 million to top ranking Maltese officials, including the wife of Prime Minister Joseph Muscat. These payments tie into a 2013 deal for an 18 year contract to supply Malta with natural gas via a SOCAR led consortium. Said consortium would also build a power station and gasification plant in Malta. In 2015, Malta"s auditor general questioned the $15.2 million lost on fuel hedging contracts entered into by state-owned EneMalta with SOCAR at the "ministerial discretion" of energy minister Karl Mizzi.

Investigators have also found a series of undeclared visits by top Azeri officials and SOCAR personnel to Malta over the course of several years; a revelation that coloured the April 17th visit by finance minister Elmar Mammadyarov and SOCAR vice-president Elshad Nasirov. While Malta represents a minuscule portion of total European energy needs, the fallout from this scandal has far wider ramifications, as it undermines Azerbaijan"s efforts to present itself as a reliable, transparent partner.

The Southern Gas Corridor is designed to lessen European reliance on Russian gas imports, imports which carry significant geopolitical baggage. The motivations for energy diversification in Europe go beyond economic considerations, as the region seeks to minimize its exposure to the kinds of energy politics and corruption associated with doing business with Russia. This scandal merely paints Azerbaijan with the same brush. Azerbaijan is already in a precarious position, and at this rate more problems are definitely in the pipeline.

Under the Radar uncovers political risk events around the world overlooked by mainstream media. By detecting hidden risks, we keep you ahead of the pack and ready for new opportunities.

Under the Radar is written by Senior Analyst Jeremy Luedi.