Fitch Affirms Azerbaijan at 'BB+'; Outlook Positive

Fitch Ratings has affirmed Azerbaijan's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'BB+' with a Positive Outlook. A full list of rating actions is at the end of this rating action commentary.

Rating Fundamentals, Positive Outlook: The rating is supported by Azerbaijan's very strong external balance sheet, the lowest public debt in its peer group, and financing flexibility from large sovereign wealth fund assets. Set against these factors are weak governance indicators, lack of predictability of economic policy-making, high banking sector dollarisation, heavy dependence on the hydrocarbon sector, and geopolitical risk of conflict with Armenia.

The Positive Outlook reflects strengthening external and fiscal buffers due to high energy prices, as well as greater expenditure restraint than was the case in previous energy sector windfalls, which would be reinforced by consistent implementation of the reinstated fiscal rule.

Strengthening External Position: The current account surplus rose an estimated 14.6pp in 2022 to 29.7% of GDP, and we project a narrowing to average 17.6% in 2023-2024, in line with moderating energy prices, but still the highest in the 'BB' category. Oil and gas now comprise close to 93% of Azerbaijan's total exports. Sovereign foreign-currency assets grew by USD5.9 billion in 2022 to USD58.0 billion, 85% of which is held by the sovereign oil fund (SOFAZ) where higher energy revenues more than offset a 5.2% loss on its investment portfolio. Fitch projects Azerbaijan's net sovereign creditor asset position grows 10.9pp in 2023-2024 to 68.7% of GDP, comfortably the highest in the rating peer group.

Further Large Fiscal Surpluses: The general government surplus rose 2pp in 2022 to 6% of GDP (and compares with a deficit of 6.5% in 2020) driven by a 27% increase in revenue. Expenditure rose 14.5% in 2022, well below nominal GDP growth (which was boosted by a 37% deflator) and the non-energy primary fiscal deficit fell to 22.7% of non-energy GDP, outperforming the fiscal target of 25%. Fitch forecasts the general government surplus narrows to 4.8% of GDP in 2023 and 4.2% in 2024.

Fiscal Rule Helps Public Finances: Fiscal rules reintroduced last year target a further narrowing in the non-energy primary deficit to 17.5% in 2026, and cap public debt at 20% of GDP, but they lack institutional underpinnings. Moderating nominal GDP growth will make the deficit target more challenging, and its consistent adherence would provide greater confidence that Azerbaijan's strong public finances will be preserved. Fitch forecasts general government debt, which fell 4.5pp in 2022 to 11.6% of GDP, ends 2024 at 7.9% of GDP.

Moderate Contingent Liability Risk: Government on-lending and guarantees fell 9pp in 2022 to 16.6% of GDP, and 80% relate to the 2017 restructuring of International Bank of Azerbaijan, and the Southern Gas Corridor project where there has been a reduction in contingent liability risk. Lack of transparency and weak corporate governance in the large state-owned enterprise sector hinder public financial management and efforts to diversify the economy, although measures have been taken to centralise their oversight and reporting at Azerbaijan Investment Holdings.

Macro-Policy Framework Lacks Predictability: There remains a lack of policy predictability, institutional independence, and clarity of mandates for the Central Bank of Azerbaijan (CBA) and SOFAZ within the broader exchange rate framework, increasing the risk of a disruptive adjustment to a very severe shock. Recent progress has been made in broadening the CBA's liquidity tools, including use of one-day standing deposit and lending facilities. We consider there is still a strong political prioritisation to maintaining the 1.7 AZN/USD de facto exchange rate peg, despite the authorities' stated aim of allowing greater flexibility over the medium term.

Inflationary Challenge: Inflation moderated to 14.1% in February from a peak of 15.6% in October 2022, partly reflecting a 4pp easing of food price inflation to 17.1%. There is a somewhat greater domestic component than early last year, with nominal wages growing close to the headline rate. Fitch forecasts inflation falls to an average 10.3% in 2023 and 7.3% in 2024 on moderating global commodity prices, easing supply chain disruption and the stronger real effective exchange rate, but still above the CBA target (4% +/-2pp).

The main policy interest rate was raised only 100bp over the last year to 8.5% and there is relatively weak monetary policy transmission, although other measures have been taken to absorb banking sector liquidity, including through reserve requirements.

Weak Trend Growth: The economy expanded 4.6% in 2022, from 5.9% in 2021, driven by 9.1% growth in the non-energy sector. Energy sector GDP contracted 2.7%, with a 5.6% fall in oil production partly offset by 7.3% growth in gas output. Fitch forecasts GDP growth slows to an average 2.1% in 2023-2024, close to the trend rate, as terms of trade weaken, the pandemic reopening base effect falls out, and there is a slight decline in energy production. Sizeable new investment in the gas sector, potentially supported by the deal to near double EU exports by 2027, will take many years to feed through to production.

Continuing Geopolitical Risk: Tensions with Armenia have increased over the last year. The closure of the Lachin corridor to Armenia has exacerbated frictions, and followed September's more severe fighting that broadened the conflict from areas in and around Karabakh. Azerbaijan's relationship with Russia appears more strained, and the EU has adopted a limited monitoring role in Armenia.

Our base case is that Russia will retain its peacekeeping forces at least until the end of the committed period in late 2025, and that a peace agreement will be reached and ultimately lead to a deal on improved trade and connectivity. However, there could well be further sporadic clashes, and downside risk has increased since early last year.

Banking Sector Fundamentals Steadily Improve: The Azerbaijan banking sector has improved in recent years, but is still fairly weak, reflected by Fitch's Banking System Indicator score of 'b'. The non-performing loan ratio fell to 2.9% at end-2022, from 6.1% at end-2020, helped by strong loan growth. Return on average equity was 17.3% in 2022 and is likely to remain above 15% this year, Tier 1 capital is adequate at 15.2%, and there is low Russian presence in the sector. The deposit dollarisation ratio fell to 48% at end-2022, from 60% at end-1H20, but is well above the peer group median of 19%, and we view regulatory oversight as improving but still with several weaknesses.

ESG - Governance: Azerbaijan has an ESG Relevance Score (RS) of '5' for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Azerbaijan has a low WBGI ranking at the 32nd percentile, reflecting very poor voice and accountability, relatively weak rights for participation in the political process, uneven application of the rule of law and a high level of corruption.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

- Public Finances: Weaker confidence that fiscal reserves will be preserved, for example, due to sizeable fiscal loosening

- External Finances: Lower energy prices sufficient to have a material negative impact on external buffers

Factors that could, individually or collectively, lead to positive rating action/upgrade:

- Public Finances: Greater confidence that the strong public balance sheet will be preserved, for example, due to continued expenditure restraint in line with the fiscal rule, or prolonged high energy prices

- External Finances: Further strengthening of the external balance sheet, for example, due to sustained high energy prices

- Macro: Improvements in the effectiveness and predictability of Azerbaijan's policy framework, including exchange rate policy, to manage external shocks and reduce macro volatility

Fitch's proprietary SRM assigns Azerbaijan a score equivalent to a rating of 'BB+' on the Long-Term Foreign-Currency (LT FC) IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM score to arrive at the final LT FC IDR by applying its QO, relative to SRM data and output, as follows:

- Macro: -1 notch, to reflect relative weakness in Azerbaijan's macro-framework, including from the lack of institutional independence, policy predictability and clarity of mandates for the CBA and SOFAZ within the broader exchange rate framework, and a weak record of preserving the fiscal and external balance-sheet gains from previous energy windfalls. In addition, part of the improvement in the SRM score over the last year was due to temporary macroeconomic factors boosting GDP growth, whereas we assess trend GDP growth as much lower and a relative rating weakness.

- External Finances: +1 notch, to reflect large SOFAZ assets, which underpin Azerbaijan's exceptionally strong foreign-currency liquidity position and the very large net external creditor position of the country.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

The principal sources of information used in the analysis are described in the Applicable Criteria.

Azerbaijan has an ESG Relevance Score of '5' for Political Stability and Rights as WBGI have the highest weight in Fitch's SRM and are therefore highly relevant to the rating and a key rating driver with a high weight. As Azerbaijan has a percentile rank below 50 for the respective governance indicator, this has a negative impact on the credit profile.

Azerbaijan has an ESG Relevance Score of '5' for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as WBGI have the highest weight in Fitch's SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight. As Azerbaijan has a percentile rank below 50 for the respective governance indicators, this has a negative impact on the credit profile.

Azerbaijan has an ESG Relevance Score of '4' for Human Rights and Political Freedoms as the Voice and Accountability pillar of the WBGI is relevant to the rating and a rating driver. As Azerbaijan has a percentile rank below 50 for the respective governance indicator, this has a negative impact on the credit profile.

Azerbaijan has an ESG Relevance Score of '4'[+] for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver for Azerbaijan, as for all sovereigns. As Azerbaijan has a record of 20+ years without a restructuring of public debt, which is captured in our SRM variable, this has a positive impact on the credit profile.

Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or to the way in which they are being managed by the entity.