Moody’s improves forecasts on ratings of Azerbaijan and Southern Gas Corridor CJSC

30  Moody’s Investors Service (“Moody’s”) has today changed the outlook on Azerbaijan’s rating to positive from stable and affirmed the long-term issuer and senior unsecured debt ratings at Ba2.

The positive outlook reflects Moody’s assessment that governance and in particular policy effectiveness is improving, albeit from a low base, which may raise the resilience of the government’s credit profile. In particular, enhancements to the monetary and macro policy framework may promote stability in the external and banking sectors in the face of shocks, while continued effective use of sizeable fiscal buffers would allow counter cyclical spending and limits the deterioration in the government’s fiscal and debt metrics.

The rating affirmation balances credit strengths from the country’s sizeable net creditor position that underpins fiscal strength and lowers government liquidity and external vulnerability risks, as well as relative domestic political stability that supports the implementation of oil and gas projects, against credit challenges including still limited prospects for economic diversification, longstanding institutional and governance weaknesses, and geopolitical tensions with neighbouring Armenia.

Concurrently, Moody’s has changed the outlook on the backed foreign currency senior unsecured rating of Southern Gas Corridor CJSC (SGC) to positive from stable, and affirmed the Ba2 rating. SGC has received explicitly guarantees on all of its foreign currency debt.

Azerbaijan’s local and foreign currency ceilings remain at Baa3 and Ba2, respectively. The narrower-than-average two-notch gap between the local currency ceiling and the sovereign rating reflects the large footprint of the government on the economy and still weak institutions and governance, notwithstanding ample sovereign wealth assets that support the country’s external and macroeconomic stability. The two-notch gap between the foreign currency ceiling and the local currency ceiling takes into consideration still limited confidence in the local currency and the lack of currency flexibility against the dollar, which raise the risk of transfer and convertibility restrictions. These ceilings typically act as a cap on the ratings that can be assigned to the obligations of other entities domiciled in the country.

Please click on this link for the List of Affected Credit Ratings. This list is an integral part of this Press Release and identifies each affected issuer.

Rationale for the positive outlook 

An improving macroeconomic and fiscal policy framework — albeit from relatively weak levels — points to greater resilience of the government’s credit profile. Policy adjustments since the 2014-17 shock have the potential to shore up stability of Azerbaijan’s macroeconomic environment, banking sector, and fiscal and debt metrics through shocks, as seen during the coronavirus pandemic.

Enhancements to exchange rate management and the communication of monetary policy by the Central Bank of Azerbaijan (CBAR) are likely to foster stability in Azerbaijan’s external and foreign exchange market dynamics. Besides the predictable supply of US dollars through regular auctions of transfers by the State Oil Fund of Azerbaijan (SOFAZ) into the government’s budget, CBAR has the ability to step up the frequency of the auctions to meet temporary increases in the demand for dollars. In monetary policy communication, regular publication of and increased transparency in monetary policy priorities, decisions and meetings also help manage inflation and risk sentiment. In 2020, these combined to keep the manat stable against the dollar, despite the significant shock of the coronavirus pandemic and its impact on oil prices. Foreign exchange reserve levels rose slightly over the course of 2020, signalling limited external pressures, in turn allowing CBAR to cut policy rates by 125 basis points to provide monetary accommodation. Going forward, consistent reliance on predictable and transparent monetary and exchange rate policy would boost macroeconomic stability and the resilience to shocks.

Similarly, continued application of reforms enacted ahead of the coronavirus shock and proactive regulatory forbearance during the pandemic would improve bank regulation and oversight further, supporting stability of the sector and containing any potential second round effects of a shock through impairments to credit supply and contingent liability risks to the sovereign. Already, measures implemented in the wake of the large 2014-17 oil price shock, such as restrictions on foreign currency exposure, the resolution of legacy problem loans, and recapitalisation requirements, have raised the resilience of banks’ balance sheets. Moody’s expects the resumption of banking sector reforms this year, including the rollout of Basel 3 requirements relating to liquidity and risk management to further promote stability in the banking system.

Furthermore, effective use of fiscal buffers within the framework of Azerbaijan’s fiscal rules has the potential to reduce macroeconomic risks while limiting the deterioration in fiscal and debt metrics in comparison with peers. This was also illustrated during the pandemic. By activating the escape clause to its fiscal rule for 2020-21 and increasing the level of SOFAZ transfers slightly compared to 2019 — instead of reducing the transfers with the decline in oil revenue — the government was able to support the economy through cash handouts to low income families, unemployment benefits, the temporary creation of public jobs, wage and tuition subsidies, and discounts on utility bills in 2020, as well as higher infrastructure spending this year. While fiscal buffers have increased at a slower pace, the increase in the government’s debt burden has been relatively modest, reaching 23% of GDP at the end of 2020 from slightly above 20% a year prior. This compares to the median increase of over 10 percentage points of GDP across Ba-rated peers. Moody’s assumptions for Azerbaijan’s government debt include all of its direct debt and the guaranteed debt of Azerbaijan Railways, which is undergoing restructuring and receives ongoing financial support from the government. At the same time, Moody’s no longer includes the guaranteed debt of Aqrarkredit — which amounted to around 13% of GDP at the end of 2020 — in government debt; the rating agency expects Aqrarkredit will continue to service its obligations without government financial support.

Overall, the enhancements to Azerbaijan’s policy framework, if sustained, would lower government liquidity risk, contain external vulnerability, and provide policy flexibility, especially aided by Azerbaijan’s large net creditor status and sizeable sovereign wealth assets.

Rationale for the rating affirmation

The affirmation of Azerbaijan’s Ba2 rating is underpinned by the government’s large net asset position — which in addition to providing fiscal flexibility also contains government liquidity and external vulnerability risk as discussed above — and the relative stability in domestic politics that will continue to facilitate the implementation of oil and gas projects and provide policy continuity. Balanced against these credit strengths are the country’s still significant reliance on oil and gas to drive longer-term economic growth and support government finances, still limited prospects for economic diversification beyond this sector, as well as longstanding institutional and governance challenges and geopolitical tensions with Armenia that weigh on economic competitiveness.

Assets held by SOFAZ, which are foreign currency denominated and invested in liquid markets, continued growing in 2020 despite the pandemic, and are large enough to cover nearly 480% of the government’s direct debt. Based on Moody’s oil price assumptions of $45-65 per barrel over the medium term, the size of SOFAZ assets is likely to keep growing over the next few years, absent a sharp increase in transfers to the government.

Meanwhile, Moody’s expects Azerbaijan’s economy to continue to be driven by developments in its oil and gas sector for the foreseeable future. The oil and gas sector accounts for around 45% of GDP directly, 90% of total goods exports, 70% of industrial production and 60-70% of consolidated government revenue. In 2021, besides base effects stemming from the relaxation of coronavirus-related restrictions on activity and movement, increased oil production under the agreement with the Organization of Petroleum Exporting Countries and higher gas production as exports to Europe ramp up with the completion of the Trans-Adriatic Pipeline at the end of last year underpin Moody’s real GDP growth forecast of around 3.5%. Over the next 2-3 years, Moody’s estimates growth to average around 3%, supported by ongoing reinvestment in the existing oil and gas fields — such as a new platform in the largest Azeri-Chirag-Guneshli field that will help sustain production at current levels for some time — and increased oil and gas production from the completion of ongoing projects at the Karabakh and Absheron fields.

Diversification prospects remain limited. Although Azerbaijan’s transport and logistics sector benefits from the higher quality of physical infrastructure compared to regional peers in the South Caucasus, as well as potential for oil and gas transit revenue from other producers in the region, the size of the sector remains too small to have a significant impact on economic growth. Similarly, the agriculture sector is also dwarfed by the oil and gas sector, despite steady demand for Azerbaijan’s food produce from large markets including Russia. The tourism sector, which had shown some potential before the coronavirus shock, may take time to recover even as borders gradually reopen.

The diversification prospects are in part limited by institutional and governance constraints, including weaknesses in rule of law and control of corruption as reflected in Azerbaijan’s Worldwide Governance Indicator rankings, skills shortage, the dominance of large domestic holding companies that hinder entrepreneurship, and unresolved geopolitical tensions with Armenia over Nagorno-Karabakh — despite last year’s peace agreement — that have the potential to weigh on foreign investor sentiment outside of the oil and gas sector.

The government aims to address some of these constraints, including through governance-related reforms with the help of development partners. Notably, the government has set up a holding company — Azerbaijan Investment Holding (AIH) — to better manage the SOEs, introduce stricter corporate governance, financial disclosure and audit rules, and enhance oversight through a supervisory board. The SOE reforms are being undertaken with support from international financial institutions such as the Asian Development Bank and the World Bank, and have the potential to raise the level of governance, transparency and financial health of SOEs, in turn reducing the contingent liability of the sector to the government. However, Moody’s expects tangible effects to take time to materialise.


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