Rating agency Standard & Poor's downgraded Azerbaijan's long- and short-term ratings from 'BBB-/A-3' to 'BB+/B' on January 29 following a difficult week for the oil-producing nation, which included more banking trouble and reports, later denied, about a possible $4bn emergency loan from the International Monetary Fund and the World Bank.

S&P justified its rating action by the decline in oil prices, which is expected to lead to budget deficits until 2018, rising external risks after the central bank's reserves dropped by two-thirds to $5bn over the last 18 months, and by an expected contraction of the Azerbaijani economy in 2016 on the back of weaker exports and consumption.

"We now expect the economy will contract by 1% in 2016 as exports decline and consumption falls in the wake of the sizable devaluation of the Azerbaijani manat at the end of last year," the rating agency said in its statement. "We also expect per capita GDP, in dollar terms, to almost halve between 2014 and 2016." 

Azerbaijan has had a rough start of the year. Its tanking currency and skyrocketing inflation so incensed its normally cowed citizens to take to the streets in a dozen regions, prompting the instability-averse authorities to forcefully disperse the demonstrations and commit themselves to social policies that they can hardly afford at this point.

The credit rating downgrades should be a reality check for Azerbaijan and other commodity exporters, according to Commerzbank analyst Simon Quijano-Evans, as commodity prices are not expected to bounce back for at least another year. These countries should actively pursue an economic diversification agenda. he adds. 

While the short-term outlook for consumption following the double devaluation of the Azerbaijani manat in 2015, declining oil production from ageing fields, and lower government spending in real terms is gloomy, S&P anticipates that gas production from the Shah Deniz II offshore gasfield, due to come on stream in 2019 and to be exported to Turkey and Europe via a network of pipelines currently under construction, will benefit the country's credit rating over the longer term.

After years of generous budget surpluses, Azerbaijan incurred a total budget deficit close to 7% of GDP in 2015, the rating agency estimates, and is expected to run deficits averaging 2% of GDP in 2016-2018. Despite the rating downgrade, Azerbaijan continues to maintain a strong fiscal position thanks to the sovereign wealth fund Sofaz, the assets of which almost equal the country's GDP after the devaluation. Having lost some $3bn of its assets in 2015, Sofaz is expected to lose another $3bn, down to $31bn, by 2017, according to S&P's forecast.

Meanwhile, monetary policy continues to be ineffective despite the regulator's relinquishing of control over the currency in 2015 due to the high dollarisation of resident deposits, which S&P estimates to have reached 80% at end-December. Expected bank bailouts in 2016 could push Baku's already unbalanced budget over the edge, Nomura Intenational's Tim Ash warned in a January 29 note.

Azerbaijan was expecting a rating downgrade, Finance Minister Samir Sharifov told journalists on January 28. While Sharifov denied Baku's urgent need to borrow money, more downgrades are likely to follow. Fitch last affirmed Azerbaijan's 'BBB-' rating in September and Moody's its 'Baa3' rating in December, but they are also likely to revise them down in the coming weeks.

Azerbaijan's domestic state and private entities have little exposure to foreign capital markets, with the exception of mining company Anglo Asian Mining that is listed on the London Stock Exchange. But national oil company Socar issued some $1.5bn in bonds in 2012-2013, and Baku raised some $1.2bn in its debut Eurobond issue in 2014. 

Borrowing from international financial institutions would be a prudential move that could help restore confidence in the economy, but there would need to be a trade-off in that the government would have to relinquish some of its tight control over the economy and public finances if it commits to such an arrangement, Ash concludes.