Baku. 22 August. REPORT.AZ/ A better-than-expected performance of the state budget in the first half of the year meant that the Government of Azerbaijan (Ba1 negative) drew only AZN 1.8 billion (3.3% of GDP) from the State Oil Fund (SOFAZ, unrated), 51.7% of the amount originally envisaged for the period. Report referring to the Moody's international rating agency, at the same time, SOFAZ far outperformed its own budget and was able to make a sizeable contribution to the consolidated budget surplus. These trends are credit positive for Azerbaijan because it will slow the buildup of debt and maintain the sovereign’s robust reserve buffers. The better performance of the state budget was partly due to spending restraint, with 88.8% of planned expenditures realized during the first six months of the year and a large cut in capital spending. At 25.3% of GDP, expenditure in the January-June period was 20% lower than the 31.7% of GDP average spending ratio for the same period during the last three years (see Exhibit 1). Higher than planned non-SOFAZ revenue also contributed, likely due to the positive impact of inflation on indirect taxes. Although it is difficult to analyze the state budget revenues in the same way (as vast majority of the budget incomes come from adjustable transfer from SOFAZ), the government appears to have generated around 105% of its forecasted non-SOFAZ revenues.
Overall, the consolidated budget (i.e., the combined budgets of the state, SOFAZ, State Social Protection Fund and Nakhichevan autonomous region) generated a surplus of AZN705 million (around 1.3% of GDP) in H1 2016, which compares very favorably to the authorities’ full-year expectation of a AZN9.3 billion (around 17.9% of GDP) deficit. The maintenance of the SOFAZ savings buffer in spite of the steep decline in oil prices in the early months of 2016 represents an important credit strength. While Azerbaijan is one of the most exposed sovereigns in our sovereign rated universe to oil price volatility, with 60%-70% of consolidated general government revenue originating from oil sales, the government still has much more fiscal space that many other Ba-rated peers, even excluding the oil fund (see Exhibit 4). Its debt-to-GDP ratio more than doubled to 28.6% from 11.2% in 2014, but we expect that the further increase this year will not be as large. The reason for this partly relates to our forecast of a much lower consolidated budget deficit than the official forecast, which now appears much more realistic after the first half outcome (we have revised our own forecast down to a 9.4% of GDP deficit). In addition, the government plans to finance the state budget deficit mainly or wholly from SOFAZ transfers, so the principal factor contributing to the rise in Azerbaijan's government debt will be the impact of the devaluation on the foreign currency share of the debt. Another consideration regarding our debt-to-GDP estimate for 2016 is the path of nominal GDP, the denominator of the ratio. The sharp reduction in the government’s capital spending in 2016 has taken its toll on real GDP, which declined by 3.4% in the first half of 2016 compared to a year earlier, following a 6.5% year-over-year contraction in the fourth quarter of 2015. We estimate real GDP will contract by 3.3% for the full year, but that the rise in the GDP deflator associated with higher inflation will partly offset that decline. Consequently, we forecast the debt-to-GDP ratio will rise to 31.6% at the end of 2016.
In spite of the slowing rise in the debt burden, we believe the risks to this and next year’s economic and budget performance remain skewed toward the downside, mainly because of the shock to the banking system from the double devaluation of the manat in late 2015 and early 2016.1 As a result, 10 out of 41 banks in the country have lost their licenses, and the government had to bail out the state-owned International Bank of Azerbaijan (IBA, Ba3, 38% of total banking assets). The cost of the bail out was equivalent to 4.9% of 2015's GDP. The government now plans to privatize the bank. Further to that, we have observed a decline in lending activity since the beginning of 2016 (-13.0% as of end-June). These downside risks to growth and the potential crystallization of additional contingent liabilities from the banking system onto the government's balance sheet constitute important challenges that can complicate the fiscal consolidation and economic recovery over the next few years.