Moody's expects 4-fold decrease in Azerbaijan's external vulnerability indicator

Including SOFAZ assets, Azerbaijan's elevated external vulnerability indicator (around 80%) would decrease to under 20%, Report informs, citing Moody's Investors rating agency.

"Despite strong trade links to Russia, the Russian invasion of Ukraine has had limited impact on the economy, with non-oil real GDP reaching 11% in May 2022," reads the agency's report.

Moody's expects Azerbaijan's real GDP growth to reach 4% this year. "After having demonstrated resilience throughout the coronavirus pandemic – resulting in a smaller recession than peers and maintaining a stable currency –, Azerbaijan entered the Russia/Ukraine crisis with a strong economic recovery bolstered by high hydrocarbon prices," the agency says.

The agency expects large current account surpluses over the next few years (15-20% of GDP) due to high hydrocarbon prices, higher oil production quotas, and increased gas exports.

Moody's also expects recent improvements in institutional capacity to mitigate pressure from soaring inflation, which surpassed 14% this year, including almost 20% for food.

In response, the Central Bank of the Republic of Azerbaijan (CBAR) has increased policy rates by 150 basis points to 7.75% since September 2021 and raised reserve requirements. Following enhanced macroeconomic policy and exchange rate management that have underpinned macro and external stability in recent years, Moody's expects the CBAR to maintain the de facto peg to the US dollar for the foreseeable future.

The government has also implemented anti-inflation measures, such as tax and tariffs cuts or subsidies for food products and food export bans, as well as a stockpile policy. Moody's believes that the government has additional fiscal buffers to provide targeted cash transfers to low-income households if required.

In times of high oil prices, Moody's expects the government will maintain fiscal prudence by limiting its reliance on State-Oil Fund of Azerbaijan (SOFAZ) transfers – as illustrated by the revised 2022 budget.

"The fiscal rules suspended during the pandemic are being revised to allow for increased flexibility in spending non-oil revenues, aimed at boosting economic activity in years where non-oil revenues are higher than expected. For example, non-oil revenues overperformed last year and are expected to do so this year, enabling a reallocation of spending towards reconstruction for Nagorno-Karabakh and anti-inflation measures. Meanwhile, the new fiscal rules reaffirmed the authorities' commitment to reduce the non-oil deficit as a percent of non-oil GDP and implement a ceiling on the debt burden," Moody's analysts say.

Moody's also expects governance reforms to reduce contingent liability risks over time: "Through the holding company Azerbaijan Investment Holding (AIH), the authorities have increased their supervision over state-owned entity (SOE) debt. Other reforms such as ameliorating corporate governance, introducing financial disclosure and audit rules are ongoing."

Moody's does not expect Aqrarkredit, where toxic assets from the International Bank of Azerbaijan (IBA) were transferred in 2017, to need large capital injections by the government.

Assets held by SOFAZ, which are foreign currency denominated and invested in liquid markets, continued growing in 2021 despite the pandemic. In the time of high oil prices, the accumulation of hydrocarbon revenues at SOFAZ – rather than their use for budgetary purposes as per increasingly prudent fiscal management highlighted above – enables the sovereign to replenish its significant fiscal buffers, which Moody's expects to exceed 500% of general government debt this year. Based on Moody's oil price assumptions of $50-70 per barrel over the medium term, the size of SOFAZ assets is likely to keep growing over the next few years.

Large SOFAZ assets underpin Azerbaijan's large net creditor position and contain external vulnerability risks, and can be used to absorb external shocks, including through lower oil prices.

"Since the 2015-16 oil price shock, Azerbaijan has enhanced its fiscal management, leading to a stronger balance sheet and a return of the debt burden to less than 20% of GDP (including direct debt and that of Azerbaijan Railways). The government contained fiscal deterioration, despite lower economic growth and a decline in hydrocarbon prices during the pandemic. While activating the escape clause of its fiscal rules, Azerbaijan effectively used its sizeable fiscal buffers during the pandemic to provide counter-cyclical spending, limiting deterioration in the government's debt metrics, while enhancing fiscal flexibility," says the agency.

The debt burden has since consolidated and remains on track to decline further, according to Moody's estimates.