Moody's places Azerbaijan's Ba1 ratings on review for downgrade
(The following statement was released by the rating agency)
New York, May 19, 2017 -- Moody's Investors Service (Moody's) has today placed Azerbaijan's Ba1 long-term issuer rating and senior unsecured rating on review for downgrade. The rating outlook had been negative since April 29, 2016. The decision to initiate a review for downgrade was prompted by the unexpected announcement of a restructuring plan for the country's largest bank, state-owned International Bank of Azerbaijan (IBA, Caa3/on review for downgrade), which led to IBA's default on 10 May. While the intention to restructure the bank was announced in 2015, the mode of restructuring outlined last week was unexpected and could imply that Azerbaijan's credit profile is weaker than we had previously expected.
The government has announced plans to issue new foreign-currency denominated bonds and assume most or all of IBA's foreign-currency loans. Moody's also expects the government will have to provide additional funding to raise IBA's Tier 1 capital adequacy ratio. Despite an injection of another AZN600 million into the bank in January 2017, IBA still has negative equity.
The review will allow Moody's to assess whether the IBA restructuring announcement, shortly after significant financial support had been provided, indicates a higher level of financial stress than we previously assumed, which could lead to larger fiscal costs and worsen the government's debt profile beyond our previous expectations.
The review will also assess whether greater financial stress is likely to further delay Azerbaijan's economic recovery beyond our previous forecasts.
Moody's plans to conclude the review within 90 days of its announcement.
In a related rating action, Moody's has also placed on review for downgrade the Ba1 senior unsecured foreign currency rating for Southern Gas Corridor CJSC.
Azerbaijan's long-term local-currency bond and bank deposits country ceilings remain unchanged at Ba1. The long-term foreign-currency bond ceiling remains unchanged at Ba1 and the long-term foreign-currency bank deposits ceilings remain unchanged at Ba2.
RATIONALE FOR THE REVIEW FOR DOWNGRADE
HIGHER FINANCIAL STRESS COULD RAISE GOVERNMENT DEBT ABOVE PREVIOUS EXPECTATIONS
The unexpected announcement of IBA's restructuring plan implies that the financial health of the bank and the banking system in general may be weaker than we had previously assessed, raising the possibility of higher fiscal costs for the government of restructuring the banking system. Whilst we previously expected that government debt was at or near its peak, it is now possible that the government debt burden rises materially further.
Despite a relatively small banking system overall, with banking assets amounting to 52% of GDP in 2015, Azerbaijan's banking restructuring is likely to lead to large fiscal costs by historical and international standards. Already, the government's prior support to IBA combined with the impact of the depreciation of the manat currency (AZN) has contributed to the near quadrupling of its gross government debt-to-GDP ratio to 40% in 2016 from 11.2% in 2014.
Currency and maturity mismatches account for substantial losses for IBA and other Azerbaijani banks, which were hit hard by the collapse of oil and gas prices and the resulting depreciation and recession. Despite the shift of AZN10 billion (16.5% of 2016 GDP) in IBA's non-performing loans (NPLs) to a 'bad bank' (Aqrarkredit) owned by the central bank over the past two years, Moody's estimates that system-wide NPLs remain high at 30% of total loans.
Beside the direct fiscal costs of restructuring, the exacerbation of financial distress in Azerbaijan could renew downward pressure on the manat exchange rate, which had regained a small part of its lost ground since January. The Azeri government's direct and guaranteed debt is predominantly denominated in foreign currency and the economy and banking system are significantly dollarized, such that a further depreciation of the exchange rate would both raise the value of the government's foreign-currency debt and lead to additional weakness in the already fragile financial health of Azerbaijan's banks, raising contingent liability risks further.
Relative to peers, the Azerbaijan government's debt burden is not onerous at present. However, should the cost of IBA restructuring be combined with exchange rate depreciation in the context of very slow economic growth, the debt ratio could rise significantly.
HIGHER THAN EXPECTED FINANCIAL STRESS ALSO INCREASES UNCERTAINTY ABOUT THE MEDIUM-TERM GROWTH PROSPECTS
Azerbaijan's Economic Strength is low, reflecting the economy's dependence on hydrocarbons. In an era of "low for longer" oil and gas prices, the economy is not likely to grow quickly in the next few years. Whereas rapid GDP growth in the years from 2005-2013, at 11.4% per year on average, helped keep the debt that the Azeri government took on to improve the cost competitiveness of its hydrocarbons production, Azerbaijan's capacity to repay new investment through strong revenue growth is now much lower.
Moreover, even when the new gas pipeline to Turkey comes on stream in 1-3 years, allowing Europe to diversify its supply of gas away from Russia, and production starts at the Shah Deniz 2 development gas field in 2018-19, Azerbaijan will have to compete with sources of gas supply to Europe from other price-competitive suppliers.
Previously, Moody's had expected that GDP would contract by 1% in 2017, after a 3.8% fall in 2016, and then register positive growth of 1.8% in 2018. However, part of the support for GDP growth was expected to come from a resumption of credit extension by healing banks. In light of IBA's situation and the likelihood that more banks will need to undergo rehabilitation, the restoration of credit growth as well as economic recovery is likely to be delayed.
The review will assess whether the decision to allow IBA to default indicates a higher level of financial stress across Azerbaijan's financial sector than was previously expected, and the implications of that for medium-term growth prospects. Significant and prolonged stress in the banking sector may postpone the economic recovery further. Credit availability in the economy contracted by 24% in 2016. IBA's default may further undermine the availability of funding for the country's banks and the provision of credit. It may also indicate a higher level of financial stress in the economy than Moody's previously thought.
Azerbaijan has very large fiscal reserves, worth roughly 90% of GDP at the end of 2016, which could provide a significant buffer to economic shocks and constitute material support to the sovereign rating. At this stage however, the authorities' willingness and capacity to deploy these financial means to supporting the economy is uncertain.
WHAT COULD MOVE THE RATING DOWN
At the conclusion of the current review for downgrade, Moody's could downgrade Azerbaijan's government rating if the rating agency concluded that the increase in government debt resulting from the severe financial stress at IBA and other banks in the system would lead to a material weakening of Azerbaijan's fiscal strength beyond its current expectations.
Moody's could also downgrade the rating should it conclude that the effect of the banking sector restructuring and, more generally, the impact of the oil shock on the economy durably undermined Azerbaijan's economic strength to levels below its current assessment.
WHAT COULD LEAD TO A RATING CONFIRMATION AT THE CURRENT LEVEL
Moody's would confirm Azerbaijan's Ba1 government rating should it conclude that the banking system stress is not likely to meaningfully raise the government's debt burden, nor significantly constrain economic growth potential beyond what it currently anticipates.