In Moody's view, the downgrade to Ba1 from Baa3 at the time of the initiation of the rating review on 5 February 2016 captures appropriately the significant deterioration of Azerbaijan's credit profile in recent months. The steep decline in the oil price delivered a significant shock to the oil-reliant Azeri economy, resulting in a severe economic, currency and banking sector crisis and causing Azerbaijan's fiscal position and government debt metrics to deteriorate markedly over the past year. Set against that, the country's large stock of foreign currency assets held in the State Oil Fund of the Republic of Azerbaijan (SOFAZ), the country's sovereign wealth fund, helps cushion the economy and government balance sheet and gives Azerbaijan time to adjust to lower oil prices.
The decision to assign a negative outlook essentially reflects the ongoing threat to Azerbaijan's credit profile from weakening economic strength amid a deepening recession. This is driven by falling economic activity in non-oil GDP sectors, heightened stress in the banking system, and the potential for economic dislocation from further depreciation in the exchange rate. Geopolitical event risks have also risen with the recent re-escalation of the Nagorno-Karabakh conflict.
Azerbaijan's long-term and short-term foreign-currency bond and deposit ceilings remain unchanged at Ba1/NP and Ba2/NP, respectively. At the same time, the long-term local-currency bond and deposit country ceilings remain unchanged at Ba1.
RATINGS RATIONALE
RATIONALE FOR CONFIRMING THE Ba1 RATING
In Moody's view the downgrade undertaken in February adequately captures the severely negative impact of the oil price shock on Azerbaijan's economic and fiscal strength, set against the country's still substantial fiscal buffers and compared with regional and other oil-exporting peers.
The sharp decline in oil prices has delivered a significant shock to Azerbaijan's credit profile, causing economic fundamentals to materially worsen. As oil and gas account for over 90% of the country's goods exports, Azerbaijan's real GDP growth rate decelerated materially to just 1.1% in 2015 (from 2.8% in 2014) and has since entered what looks likely to be a deep recession. Overall real GDP declined by around 3.5% Y-o-Y in March 2016, with economic activity in non-oil GDP sectors -- the backbone of Azerbaijan's strong growth performance in recent years -- contracting by around 5.7% Y-o-Y (compared to growth of 1.1% Y-o-Y in December and 9.2% Y-o-Y in June 2015). Per capita income has declined by roughly one third to around USD5,400 in 2015 (from USD8,000 in 2014) and is expected to decrease further this year.
At the same time, the combination of a worsening fiscal position, declining nominal GDP and the fall in the local currency's value caused the government's debt burden to increase significantly in 2015 (given that its debt is largely denominated in foreign currency). The government's debt-to-GDP ratio rose to above 28% of GDP by the end of 2015 from a low 11% in 2014. Moody's projects that the ratio will level off at around 30% of GDP in 2016, assuming that a significant portion of the consolidated budget deficit of around 13% of GDP in 2016 will be covered by non-debt creating funding source, including the use of government cash reserves as well as SOFAZ's assets. However, Azerbaijan's gross debt burden could rise further should the government decide to partially fund the deficit through additional debt issues.
Set against that, the government retains sizeable fiscal buffers that could help it absorb shocks, specifically SOFAZ's significant foreign currency assets. These fiscal buffers could help Azerbaijan cope with the challenges from the ongoing economic, currency and banking sector crises and allow it time to adjust to lower oil prices. As a result, the government has room to let fiscal deficits widen during periods of lower oil prices, economic recession and reduced fiscal revenues. SOFAZ's assets are predominantly invested in high-grade, liquid instruments.
SOFAZ's foreign currency assets remain very large, despite declining by 9.5% to USD33.6 billion in 2015 (from USD37.1 billion in 2014). Levels are high not only relative to Azerbaijan's GDP and general government debt, but also compared to other oil exporting countries' sovereign wealth funds. SOFAZ's foreign assets account for roughly 100% of Azerbaijan's GDP forecast for 2016, underlining the government's very high shock absorption capacity. Consequently, Azerbaijan's sizeable sovereign wealth fund assets support its credit standing, largely offsetting the country's underlying fiscal vulnerabilities stemming from the government's heavy reliance on oil and gas revenues as well as a large share of foreign-currency government debt.
RATIONALE FOR ASSIGNING A NEGATIVE OUTLOOK
Moody's decision to assign a negative outlook on Azerbaijan's Ba1 government bond rating reflects the view that the economic situation, heightened stress in the banking system and geopolitical risks could continue to weigh on its credit profile.
Azerbaijan's economic growth outlook remains weak. Moody's recently revised its 2016 growth forecast for Azerbaijan, expecting real GDP to shrink by 3.3%, compared to a previous forecast contraction of 0.7%, reflecting its expectation of a contraction in both the oil/gas and non-oil/gas GDP sectors. It projects real economic activity to stay flat in 2017, rising only slowly thereafter. Moreover, risks to economic growth are tilted to the downside, given (a) the deteriorating position of Azerbaijan's banking sector which dampens the outlook for private investment, and (b) the adverse effects from devaluation and inflation on households' purchasing power and consumption.
The combination of the economic contraction and currency devaluation (around 50% against the US dollar since mid-February 2015) are increasingly undermining the health of the domestic banking system. The Manat devaluation triggered a flight out of local currency deposits, led to a rise in banks' problem loans, and eroded capital buffers. Problem loans (overdue more than 90 days plus restructured loans) currently account for around 20% of system-wide gross loans, according to Moody's estimates.
Even though the relatively small size of the Azeri banking sector limit the negative credit implications for the sovereign, the banks' weak credit standing add to the headwinds facing the economy and poses an additional threat to the government's balance sheet, as the banking system may require additional financial support. The largest bank in the country, state-owned International Bank of Azerbaijan (IBA; deposit ratings Ba3 stable, BCA b3), benefits from financial support from the state. Specifically, IBA's credit standing was supported in 2015 by the transfer of problematic assets totaling Manat 3.0 billion (around 5.5% of GDP in 2015) to the state non-credit organization Aqrakredit, which issued bonds in the same amount guaranteed by the state and purchased by the central bank. The bank anticipates additional bad assets transfer and capital injection of Manat 500 million from the state in 2016, which will further improve its capitalization.
Finally, recent military clashes along the contact line of the disputed territory of Nagorno-Karabakh underlines elevated geopolitical event risks that -- if intensifying -- could lead to an additional weakening of economic and fiscal fundamentals via negative confidence effects on private consumption, foreign direct investment and hence economic growth and the government's budgetary position.
WHAT COULD MOVE THE RATING UP/DOWN
Although unlikely in the foreseeable future, upward pressure on Azerbaijan's government bond ratings could follow significant improvements in the country's institutional strength, evidence of sustained economic diversification and/or a decrease in geopolitical risks. A more rapid-than-expected increase in the oil price is unlikely to bring about a reversal in the rating trajectory unless accompanied by the rebuilding of fiscal buffers and a higher level of economic diversification, given the uncertainty surrounding whether any such rise in oil prices could be sustained.
Evidence of credit-supportive institutional strength, most likely through the emergence of a clear, credible fiscal and economy policy response which offers the prospect of containing the deterioration of the fiscal balance and fiscal buffers, while returning the economy quickly to growth, could sustain the rating at its current level.
Conversely, a further sustained fall in the price of oil, continued capital outflows and/or pressure on the exchange rate and/or foreign currency assets, a further marked worsening in the fiscal balance for which there was no clear reversal, and/or further stress in/support for the banking system would exert downward pressure on the rating. Deterioration in the domestic or regional political environment resulting in disruptions to oil production and/or foreign investments in the economy would also be highly credit negative.
Prompted by the factors described above, the publication of this credit rating action occurs on a date that deviates from the previously scheduled release date in the sovereign release calendar, published on ww.moodys.com.
GDP per capita (PPP basis, US$): 17,762 (2014 Actual) (also known as Per Capita Income)
Real GDP growth (% change): 1.1% (2015 Actual) (also known as GDP Growth)
Inflation Rate (CPI, % change Dec/Dec): 7.8% (2015 Actual)
Gen. Gov. Financial Balance/GDP: -4.8% (2015 Actual) (also known as Fiscal Balance)
Current Account Balance/GDP: 13.6% (2014 Actual) (also known as External Balance)
External debt/GDP: 15.5 (2014 Actual, according to World Bank data)
Level of economic development: Low level of economic resilience
Default history: No default events (on bonds or loans) have been recorded since 1983.
On 26 April 2016, 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 decreased. The issuer's institutional strength/ framework, have not materially changed. The issuer's governance and/or management, have not materially changed. The issuer's fiscal or financial strength, including its debt profile, has materially decreased. The issuer has become increasingly susceptible to event risks.
The principal methodology used in these ratings was Sovereign Bond Ratings published in December 2015. Please see the Ratings 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.
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