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IHS has cut Azerbaijan's short term sovereign bond rating and switched to a Negative outlook due to the elevated risk of worsening external creditor and political relations following what appears to be an Azeri military offensive against the mainly ethnic-Armenian self-declared Nagorno-Karabakh Republic.
Increased risk of fiscal slippage and subsequent potential worsening of relations with international creditors, has prompted IHS to downgrade Azerbaijan's government bond rating by one notch to 20 from 15/100 on our numerical scale.
During 2-5 April Azerbaijan launched a costly military campaign against Nagorno-Karabakh that may derail the earlier drive of fiscal consolidation.
The switch to a Negative outlook reflects an elevated risk to the sovereign's creditworthiness from a potential resumption of hostilities in the near term, or increased defence and social spending.
IHS' short-term risk rating is not comparable to the medium-term ratings of the big three credit rating agencies – Fitch, S&P, and Moody's.
Costly military campaign
A surprise large-scale escalation of violence along the Line of Contact with Nagorno-Karabakh, a mainly ethnic Armenian self-declared entity, prompted IHS to introduce a one-notch downgrade to Azerbaijan's credit rating to reflect the negative impact on the sovereign's overall creditworthiness in the next 12 months. The rating now stands at 20, from 15/100 on IHS numerical scale, or at A from A+ on the generic scale.
IHS also switched the short-term outlook from Stable to Negative, reflecting elevated risks to credit quality from a potential resumption of hostilities in the near term, domestic political instability and associated potential increase in defence and social spending.
In terms of the qualitative changes, the Azeri government bond rating still falls under the Good Quality definition. Furthermore, IHS maintains its medium-term rating and outlook, which are now on a par with the three major ratings agencies' assessments. It places the Azeri government bond rating into Speculative grade of 45/100 on the IHS numerical scale, or BB+ on the generic scale, with a Stable outlook. Fitch is the only credit rating agency to assign a Negative outlook to Azeri government bonds. The primary drivers behind the latest rate cuts remain the negative impact of low crude oil prices, decline in economic activity, weakening of the manat and its negative fallout on the already troubled banking sector. Medium-term economic growth is projected to be affected by the continued weak world crude oil prices. Fiscal discipline is critical if the Azeri economy is to weather the challenging environment, as it is heavily dependent on the energy sector.
A key driver behind IHS' latest rate cut is the five-point risk added to a test for external creditors and political relations. This test was non-scoring previously, but we now believe that the military campaign of 2-5 April is likely to entail a significant increase in defence spending in the near term. Further spending will be channelled to replace the military hardware lost in the recent assault, and also to sustain the current level of mobilisation in the armed forces.
In addition, we expect the Azerbaijani government to boost its fiscal spending, contrary to its earlier decision to commit to a more austere fiscal plan for 2016. The Azeri media, which is almost exclusively controlled by the state, has presented the recent campaign as a resounding victory by Azerbaijan, despite the lack of supporting evidence. The president's credentials as the defender of national interests have been markedly boosted. However this might be short-lived, if the current level of confrontation deflates, and the public's attention reverts to mounting social issues, especially in the light of fresh allegations of offshore business interests made in the "Panama papers" against Azeri president Ilham Aliyev and his close family members. Public discontent was already on the rise before the military campaign, fuelled by double-digit inflation that has set in since early 2016, due to the manat's devaluation. A further rise in social tensions is likely to prompt the authorities to increase their fiscal outlays.
Under its revised 2016 budget, based on a price of USD25 per barrel of Brent dated crude oil, the Azerbaijani authorities have trimmed spending for the year in response to shrinking government revenues. Still, the downward revision is only 2% in annual comparison. This is partially driven by the weakening of the manat – the rate of AZN1.55/USD1.00 was used in the revised budget plan, against the rate of AZN1.05/USD1.00 that the first iteration of the 2016 budget was based on. Considering that around 75% of the government revenues are in hard currency, being generated by energy exports, the weakening of the manat has helped the government to increase its manat revenues. However, double-digit inflation, forecast by the Azeri authorities to stand at around 10–12% in 2016, will erode the government's purchasing power.
The oil price collapse undermined the Azeri manat hard, the banking sector and the overall economy, prompting the Azerbaijani authorities to invite the International Monetary Fund (IMF) and the World Bank to discuss prospects of potential assistance. The IMF decided that currently Azerbaijan can continue without the Fund's credit line, since the sovereign has nearly USD33 billion of hard currency reserves held by the State Oil Fund of Azerbaijan, the country's sovereign wealth fund, as of January 2016. However, the IMF has started a technical assistance programme with Azerbaijan, a phase preceding the potential extension of a credit line. The Fund had welcomed the austere 2016 budget, and advised the country to strictly adhere to fiscal discipline, considering that the unlikely recovery of oil prices in the next five years to the levels seen prior to 2014 price collapse.
Outlook and implications
Any significant expansion in fiscal outlays is likely to raise concerns by the IMF, although it remains unclear how receptive the Azerbaijani authorities have been to the IMF expert advice under the current technical assistance programme.
The Azeri authorities have already stated in local media of their plans to increase defence spending. Under the 2016 fiscal plan the defence spending was already ring-fenced, projected to rise 3.3% annually, standing at USD1.8 billion. Meanwhile the growth generating sectors of the government's activity, such as capital investment and construction sectors will be halved, down by 48.7% y/y and 48.5% y/y respectively. The trimming in government spending, combined by anticipated significant decline in private consumption due to double digit inflation, will most likely undermine Azerbaijan's real GDP growth. We project that the real GDP to contract by 2.4% in 2016, which in turn will affect the government receipts.
As a result of the outbreak of conflict, additional pressures on foreign currency reserves have risen from the sharpest weakening of the manat's exchange rate against the US dollar, down by 3.7% since the 30% devaluation of the Azeri currency in December 2015. The US dollar strengthened to AZN1.52 at the time of writing this article. The decline in manat's external value prompted the Azerbaijani authorities once again make currency market interventions to defend the manat. The news of the dangerous escalation in the conflict zone thus undermined the stabilisation and noticeable rise in manat's external value against the US dollar prior to the most recent episode of violence.
Whatever the political calculus was behind the current confrontation, it will have an exclusively negative economic impact for Azerbaijan, hence compelling us to assign a Negative outlook to the sovereign. It could damage the investor sentiment towards Azerbaijan and thereby undermine the Azeri government's efforts to attract foreign investment to its non-oil sector to finally jump-start that much-needed economic diversification process. For a long time, a return to full-scale war has been the worst case but less likely scenario considered by many investors when venturing into Azerbaijan. But the latest heavy fighting could increase the likelihood of this scenario playing out in the near term, having a dampening effect on the investor sentiment.
The dangerous standoff continues, and there is significant risk of full-scale war, and the associated danger to Azerbaijan's critical energy infrastructure. Right now, the risks to the energy pipelines that lie only around 30 km away from the zone of conflict are low. However, the Armenian side have indicated in the past that in case of the full-scale war they have the capabilities to damage these high-value targets. Considering that oil and gas exports generate around 90% of Azerbaijan's total export and 75% government revenues, an attack on critical infrastructure will be devastating for the Azeri economy.