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Rating Action:

Moody's affirms Azerbaijan's Ba2 rating; maintains stable outlook

12 Apr 2019

Singapore, April 12, 2019 -- Moody's Investors Service ("Moody's") has today affirmed the Government of Azerbaijan's long-term issuer and senior unsecured debt ratings at Ba2 and maintained the stable outlook.

The key drivers of the rating affirmation are:

1. A growing net creditor position of the government, bolstered by ongoing fiscal reforms;

2. Banking sector risks that are gradually receding, although the financial system remains fragile; and

3. Limited prospects for economic diversification, and institutional constraints that limit the shock absorption capacity of the economy

The decision to maintain the stable outlook reflects balanced risks. On the upside, ongoing fiscal and financial sector reforms may shore up the resilience of the sovereign credit profile to shocks including lower oil prices, and contribute to improving policy credibility and effectiveness to a greater extent than Moody's currently expects. At the same time, on the downside, credit resilience and the commitment to and effectiveness of reforms are still relatively recent and have not been significantly tested in a less favourable environment, in particular for oil prices.

Concurrently, Moody's has affirmed the backed senior unsecured bond rating of Southern Gas Corridor CJSC (SGC), that benefits from an explicit guarantee from the government, at Ba2 and maintained the stable outlook.

Azerbaijan's long-term local currency bond and deposit ceilings remain unchanged at Ba2. The Ba2 long-term foreign currency bond ceiling and Ba3 long-term foreign currency deposit ceiling are also unchanged. The short-term foreign currency bond and deposit ceilings remain unchanged at Not Prime. These ceilings act as a cap on the ratings that can be assigned to the obligations of other entities domiciled in the country.

RATINGS RATIONALE

RATIONALE FOR THE RATING AFFIRMATION

A GROWING NET CREDITOR POSITION, BOLSTERED BY ONGOING FISCAL REFORMS

Azerbaijan's rating continues to be supported by the government's significant net asset position. Sovereign wealth assets at the State Oil Fund of the Republic of Azerbaijan (SOFAZ) were 1.7 times the sum of the government's direct debt and its explicit guarantees as of the end of 2018, which underpins the government's fiscal strength, lowers government liquidity risk, and reduces external vulnerability. Moody's expects the ongoing fiscal reforms, including the implementation of a new fiscal rule and the government's debt strategy, to bolster the net creditor position further.

A key aspect of the fiscal reforms is the introduction of a new fiscal rule, which has been adopted for the government's 2019 budget. By imposing strict limits to the growth of consolidated government expenditure, Moody's expects the fiscal rule to primarily instil fiscal prudence and limit procyclical spending when oil prices are high, which would support ongoing saving of hydrocarbon revenue at current oil prices.

The fiscal rule also aims to reduce the reliance of the government on hydrocarbon revenue by targeting annual declines in the non-oil deficit, and allowing countercyclical spending through its escape clause, which will likely be triggered when oil prices fall sharply or when economic growth slows significantly. If effectively implemented, these provisions will contribute to greater economic stability. This would be aided by the greater predictability and lower procyclicality of SOFAZ transfers to the state budget that will provide stability to the manat through regular auctions of US dollars by the Central Bank of Azerbaijan (CBAR). However, Moody's believes the economic benefits of the fiscal rule will depend on its consistent implementation over time, given the discretionary nature of some elements, including activation of the escape clause.

Further supporting the government's fiscal strength, its long-term debt strategy for 2018-25 targets a reduction in the direct government debt burden and places restrictions on the incurrence of new direct debt and the provision of new guarantees. If adhered to, the debt strategy and fiscal rule will allow Azerbaijan to gradually restore some of the lost fiscal space over 2015-17, although the debt burden will remain higher relative to levels prior to 2015.

Moody's expects the government's debt burden to decline to 29% of GDP by 2020, from around 33% as of the end of 2018 and a peak of slightly more than 37% as of the end of 2017. The debt burden will nevertheless remain higher than the average debt to GDP ratio of around 12% between 2009 and 2014. Moody's assumptions for the government's debt burden includes all of its direct debt and some explicit guarantees, which largely consists of guarantees that were issued to Aqrarkredit, the state-owned enterprise that acquired bad assets from the International Bank of Azerbaijan (IBA) during IBA's restructuring.

BANKING SECTOR RISKS ARE GRADUALLY RECEDING, BUT THE FINANCIAL SYSTEM REMAINS FRAGILE

Azerbaijan's banking sector weighs on the sovereign's credit profile, reflecting contingent liabilities that remain from the restructuring of IBA and bad asset acquisition of Aqrarkredit, and impaired credit intermediation, following a sharp credit contraction over 2016-18. While Moody's expects ongoing financial sector reforms and initiatives to gradually lower contingent liability risks from banks and support the nascent credit recovery, confidence in the financial system remains fragile and high levels of dollarisation will continue to pose risks to the banking sector.

Moody's expects the ongoing financial sector reforms to increase the quality of prudential policymaking, bank supervision, and information sharing, which will allow banks to better assess and manage credit risks. Key reforms include the establishment of the Financial Market Supervisory Authority (FIMSA) as a standalone prudential regulator and supervisor, a new credit bureau, and a collateral registry for moveable assets. In particular, FIMSA is implementing new banking regulations and its powers will be formalised under a new FIMSA Act, which Moody's expects will be approved by parliament and the president by 2020.

Stricter regulatory requirements for capital adequacy and on foreign exchange exposure will enforce higher levels of bank capitalisation and limit foreign exchange risks relative to 2014-17. In particular, Moody's estimates that tangible common equity as a percent of risk-weighted assets across Moody's rated banks, which account for around two thirds of the banking sector, has risen to an average of 20% as of the end of 2018 from 12% as of the end of 2016. The increase has been one of the largest across banking systems in the region over this period. The higher capital levels have in part allowed credit growth to the real economy to resume in the fourth quarter of 2018. This growth has mainly been driven by loans in local currency, which will be less vulnerable to sharp depreciations of the manat.

While nonperforming loan (NPL) levels remain high at around 12% of total loans as of the end of 2018, Moody's also expects asset quality to improve, driven by the ongoing economic recovery and aided by the recently announced measures aimed at reducing the debt burden of small, retail borrowers. The measures would reimburse small borrowers for the large foreign exchange depreciation in 2015 and encourage banks to restructure long-overdue loans, costing less than 2% of GDP but contributing to lower NPLs in the banking system.

However, the sector remains fragile as confidence in the financial system remains weak and dollarisation levels remain high. The government extended its unlimited deposit guarantee on qualifying deposits for another year through March 2020, which in Moody's view demonstrates a deficit in confidence in banks. Dollarisation levels are also among the highest in the region, with foreign currency deposits accounting for 65% of total deposits as of the end of February 2019, compared to foreign currency loans that account for 37% of total loans. This implies ongoing vulnerability of bank balance sheets to local currency depreciation.

LIMITED PROSPECTS FOR ECONOMIC DIVERSIFICATION, INSTITUTIONAL CONSTRAINTS LIMIT THE SHOCK ABSORPTION CAPACITY OF THE ECONOMY

Notwithstanding the growing net creditor position of the government and the gradual reduction in banking sector risks, Azerbaijan's economy and sovereign credit profile will remain highly exposed to developments in the hydrocarbon sector. Limited prospects for economic diversification and institutional challenges ranging from relatively weak policy credibility and effectiveness to uncertainties over the rule of law will continue to constrain the shock absorption capacity of the economy.

Moody's does not expect a significant reversal in Azerbaijan's reliance on its hydrocarbon sector over the medium term. The hydrocarbon sector contributed more than 90% to total exports and 75% to industrial production in 2018, while hydrocarbon revenue accounted for around 60% of consolidated government revenue in the same year. The exposure to the hydrocarbon sector is among the highest across hydrocarbon producers that Moody's rates. Lower income levels and a smaller economy relative to other highly concentrated hydrocarbon producers further limit Azerbaijan's economic resilience.

The government has set its sights on economic diversification through the 11 strategic roadmaps covering sectors such as agriculture, financial services, heavy industry and manufacturing, tourism, and transport and logistics. However, structural and institutional challenges will, in part, hamper the government's efforts, with diversification outcomes likely to vary across sectors. These challenges include skills shortage, rule of law uncertainty, the dominance of large holding companies, and lack of access to the World Trade Organisation, which impedes the development of goods trade beyond hydrocarbons. Moody's assesses tourism and transport and logistics as having relatively greater diversification potential, with benefits materialising only over a long time.

Furthermore, policy credibility and effectiveness remain relatively low compared to similarly rated peers and other major hydrocarbon producers. Although the ongoing implementation of fiscal and financial sector reforms, as well as more proactive central bank communication through a monetary policy calendar, point to a modest increase in institutional capacity, significant uncertainty remains over the exchange rate regime and stability in the value of the manat. Azerbaijan's exchange rate regime has been officially floating since December 2015, but the value of the manat has been very stable against the US dollar since early 2017. In Moody's view, the lack of volatility in the manat raises questions over the commitment of the central bank to a floating rate regime, while the stability of the exchange rate may also result in complacency among businesses and consumers and run counter to longer-term efforts to allow the exchange rate to be a shock absorber for the economy.

RATIONALE FOR THE STABLE OUTLOOK

The stable outlook reflects balanced risks to the ratings.

On the upside, ongoing fiscal and financial sector reforms may shore up the resilience of the sovereign credit profile to shocks, including lower oil prices, by lowering the government debt burden and banking system risk beyond Moody's expectations, and contribute to increasing policy credibility and effectiveness to a greater extent than Moody's currently expects. Further increases to the credibility and effectiveness of macroeconomic policies, including exchange rate flexibility and the transition towards inflation targeting, would also raise institutional strength.

On the downside, credit resilience and the commitment to and effectiveness of reforms are still relatively recent and have not been significantly tested in a less favourable environment, in particular for oil prices. A sharp depreciation of the manat, while not in Moody's baseline scenario, would also raise economic and banking sector risks.

WHAT COULD CHANGE THE RATING UP

The rating would likely be upgraded if ongoing and further reforms, including in macroeconomic and financial policies, looked likely to raise policy credibility and effectiveness significantly and provide more powerful buffers against shocks. This would likely be reflected in part through prospects of a more rapid decline in the government's debt burden and contingent liabilities than Moody's currently expects. Over time, it would also probably involve marked progress in economic diversification that would reduce the economy's high dependence on hydrocarbons.

WHAT COULD CHANGE THE RATING DOWN

The rating would likely be downgraded if it became increasingly likely that the fiscal reforms that support macroeconomic stability and a sustained reduction in the debt burden lose momentum or potentially reverse. Banking sector weaknesses resurfacing and significantly raising contingent liability risks would also put downward pressure on the rating. A sharp escalation of the conflict in Nagorno-Karabakh that would weigh on economic activity and government finances would also likely lead to a downgrade.

GDP per capita (PPP basis, US$): 17,529 (2017 Actual) (also known as Per Capita Income)

Real GDP growth (% change): 0.1% (2017 Actual) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): 7.9% (2017 Actual)

Gen. Gov. Financial Balance/GDP: -1.6% (2017 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: 4.1% (2017 Actual) (also known as External Balance)

External debt/GDP: 37.3% (2017 Actual)

Level of economic development: Low level of economic resilience

Default history: No default events (on bonds or loans) have been recorded since 1983.

On 09 April 2019, a rating committee was called to discuss the rating of the Azerbaijan, Government of. The main points raised during the discussion were: The issuer's economic fundamentals, including its economic strength, have not materially changed. The issuer's institutional strength/ framework, have not materially changed. The issuer's fiscal or financial strength, including its debt profile, has not materially changed. The issuer's susceptibility to event risks has not materially changed.

The principal methodology used in these ratings was Sovereign Bond Ratings published in November 2018. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

The weighting of all rating factors is described in the methodology used in this credit rating action, if applicable.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating.

Christian Fang
Asst Vice President - Analyst
Sovereign Risk Group
Moody's Investors Service Singapore Pte. Ltd.
50 Raffles Place #23-06
Singapore Land Tower
Singapore 48623
Singapore
JOURNALISTS: 852 3758 1350
Client Service: 852 3551 3077

Marie Diron
MD - Sovereign Risk
Sovereign Risk Group
JOURNALISTS: 852 3758 1350
Client Service: 852 3551 3077

Releasing Office:
Moody's Investors Service Singapore Pte. Ltd.
50 Raffles Place #23-06
Singapore Land Tower
Singapore 48623
Singapore
JOURNALISTS: 852 3758 1350
Client Service: 852 3551 3077

No Related Data.
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