Chris Weafer -

In 2009 Russia took the easy path and waited for oil prices to recover rather than implement a comprehensive package of reforms to boost economic growth. That has directly led to the damaging results now visible. Today Azerbaijan faces a similar choice. Will the government in Baku take heed? Does it even have the option of waiting until oil prices recover or gas export volumes to the EU double?

Azerbaijan’s budget and economy are highly dependent on oil and gas exports to the European Union, Turkey and CIS states. Energy exports account for almost 95% of total exports, approximately 45% of GDP and 70% of budget revenues. Hydrocarbon revenues have helped sustain real GDP growth over the past five years and have improved the nation’s balance sheet. However, progress with reforms has been very slow, if at all. The country ranks badly in such surveys as Transparency International’s Corruption Perception Index and the World Bank’s Ease of Doing Business survey. FDI was a modest US$2.4bn last year and while investment spending reached US$27bn, almost half was in the oil and gas sectors.

The government in Baku keeps talking about the need to advance reforms so as to attract a higher and sustainable volume of investment into other parts of the economy and has even adopted a programme aimed at boosting investment into designated sectors by 2020. Inevitably, last year’s oil price collapse, which will lead to a lower pace of growth in the economy this year, has invigorated the debate over reforms and the need for faster change

The problem is that Azerbaijan is within three years of substantially boosting gas export volumes to the EU, and along with it, gas revenues into the budget. The danger, therefore, is that the government simply decides to take the easy path and wait until either the oil price recovers or the gas export volumes double.

Double whammy

The country’s over-reliance on oil and gas revenues led to a slower pace of growth in 2014. GDP expanded by 3% compared to 5.8% the previous year.  Forecasts for this year are lower still and concern about the double-whammy hit from lower oil and the collapse in Russia’s ruble forced the government to devalue the manat on February 21. A devaluation had been expected, but the scale of the hit, at 33% against the US dollar, was a surprise. It is a reflection of just how strong are the economic headwinds buffeting the country as a result of the oil price fall and the recession in Russia. The budget deficit will rise to approximately 5% of GDP from just above breakeven last year; while the current account is expected to shrink considerably, to 3% or 4% of GDP, as a result of lower oil and gas export revenues.

Although the oil price collapse should ordinarily be something of a wake up call, the government knows that by 2018 it will have the potential to double gas export volumes to the EU as a result of Phase 2 of the Shah-Deniz gas project and the TANAP-TAP pipelines coming online. Thus, it may take the view that it just needs to ride out this interim period of lower revenue and wait for the extra gas volumes. Hence the surprisingly large devaluation of the manat, which will reduce imports, protect budget revenues from the lower oil price and allow for a slower drawdown on national savings. October 2018 is also the date for the next presidential election and President Aliyev, who won a third consecutive five-year term in 2013, is known to want a fourth term. Stability, rather than taking reform risks, may seem like a sensible strategy to his advisors.

That said, according to the Azerbaijan 2020 development program, the key areas for future growth, as well as investment opportunities, should be in tourism, construction, telecoms, banking & financial services, real estate and agriculture related sectors. Having hosted the Eurovision Song Contest in 2012, Azerbaijan’s next major event will be to host the first European Games in June this year. By engaging in such high profile events, the government hopes to attract further foreign investment to the non-energy sectors.

The country is also in a relatively good position to use its low debt position, which is less than 15% of GDP, and its national savings to help create a more diversified economy, should it wish to. The success of the past two decades in the country’s hydrocarbon sector has enabled Azerbaijan to accumulate substantial reserves valued at more than $50bn, which are held at both the Central Bank and the national energy fund SOFAZ. With a strong reserve base, FX stability and a steady growth profile, Azerbaijan is actually in a relatively good position to weather any regional economic distress in the wake of a Russian recession. That of course is both a positive and a negative depending on how you view the pressure to get more serious about reforms.

Shaking assumptions

Apart from where the oil price trades and the contagion from Russia’s ruble collapse, two additional factors could shake the assumption that the country can simply wait until Shah-Deniz II comes to the rescue. One is the fact that rating agency S&P has perched Azerbaijan’s sovereign credit rating just above investment grade. A poor response to the slowing economy could pull that rating to sub-investment grade and reduce the pool of available investors. The government finalised its 2015 budget late last year but this remains optimistic unless the oil price rallies strongly in the second half of this year. The assumption is for total tax revenue of US$22.8bn and spending of US$24.8bn. The resulting deficit, of US$2bn, would equal 2.8% of planned GDP. However, most independent observers assume a worse outcome, i.e. a 5% budget deficit because of an assumed lower oil price. The country is expected to come to the external markets for new debt and use some of the near $40bn of savings in its sovereign wealth fund to cover the deficit. The former would be a lot more difficult if S&P were to cut to junk status, albeit the latter will now be less expensive after the big devaluation.

Currently Azerbaijan has only one sovereign Eurobond listing. That is the $1.25bn bond with a maturity in March 2024 and a coupon yield of 7.36%. It is rated BBB- by S&P and, in mid-February, it was yielding 4.9%. The next most liquid issue is from the state oil company, SOCAR. It has a $1bn bond, maturing in 2023, rated BBB- by S&P and with a coupon yield of 6.62%. It was yielding 6.1% in mid February. There are also some smaller issues from AzRail, International Bank of Azerbaijan and from SOCAR. The International Bank of Azerbaijan is reported to be planning a $200mn-300mn Islamic Bond (sukuk) in the coming months, a task which would also be more difficult with a lower credit rating.

The other risk is the continuing state of war with Armenia over Nagorno-Karabakh. That conflict always appears to be close to a much more serious escalation and the number of fatal cross border skirmishes has been increasing since last summer. More clashes, and more threatening rhetoric, are expected ahead of this year’s parliamentary elections, scheduled for November. Any return to full scale fighting would leave Russia, the US and the EU in a difficult position and might slow investment flows and hurt political relations.

One additional area of concern for the authorities and which could either spur a greater effort towards faster reforms or a tougher crackdown on political opposition is that social unrest has risen over the past 24 months with some large-scale protests held in several major cities across the country. Although poverty has more than halved over the past fifteen years, from 30% in 2001 to 8% in 2014, the significant disconnect in the living standards enjoyed by the country’s elite and ordinary citizens remains the key complaint.

One way to address those concerns of course is to focus on economic reforms and create a more diversified economy. The other way is to stamp harder on protests and opposition groups and wait for the oil price to recover and Shah-Deniz II to start pumping more gas to the EU. Choosing the latter path would result in more international criticism and impact on non-energy sector investment but, as plenty of examples show, it would not diminish the EU’s appetite for gas imports.

Chris Weafer is Senior Partner at Macro-Advisory, which offers bespoke Russia-CIS consulting.