Monica Ellena in Tbilisi -

The recent currency instability across the Commonwealth of Independent States (CIS), triggered by the collapse in the Russian ruble’s value in December, has rattled energy-rich Azerbaijan and prompted a rapid dollarization of its economy.

After 20 years of a fixed exchange rate policy, Azerbaijanis awoke on February 21 to discover that their currency, the manat, had been devalued 33.4% against the dollar by the Central Bank of the Republic of Azerbaijan (CBA). The manat's decline had actually started a week earlier, but the central bank’s surprise move undermined confidence in the national currency, leading savers to suddenly switch their deposits into dollars. The US currency now accounts for 70% of total deposits in the banking sector, up from about 50% in 2014 – the highest proportion in a decade.

According to Alim Hasanov, Baku-based economist for Georgian investment bank Galt & Taggart (G&T), Azerbaijanis’ faith in the currency has taken a big hit. “Wouldn’t you [distrust it] if you had your savings in manat suddenly slashed by 33.4%, would you still keep them?” he asks rhetorically. “Azerbaijan didn’t experience a radical devaluation for over 15 years, people were not ready for that and many simply panicked.”

The central bank’s international reserves were another casualty of falling oil prices. Its reserves fell from $11bn at the start of the year to $8.43bn in May. In May 2014 the central bank sat on a cushy pile of $15bn. Heavy spending for June’s European Games in Baku has further dwindled reserves.

However, the level of reserves in May increased slightly for the first time since September 2014, suggesting that the situation has stabilised somewhat. “The central bank announced it is working on some kind of mechanism to support or increase trust in the local currency, but did not explain the details,” Hasanov tells bne IntelliNews. ‘Maybe it is a temporary adjustment, but… based on those figures we can say that movement from the manat to the dollar has stopped. Eventually the market will have to move back to the manat.”

The devaluation nevertheless brought some relief to the Azerbaijani economy, as it partially compensated for the steep fall in oil prices that had begun in 2014, thus helping to balance its public finances. In a research note published on June 5, G&T The fiscal balance remained in deficit in the first quarter as oil-related revenues continued to decline, resulting in a $0.7bn deficit, corresponding to 5.2% of GDP. "Rough calculations indicate that the deficit may have reached 7.2% of GDP in the absence of devaluation," it said. "Our calculations show that devaluation will probably balance budget in 2015 (for the whole year)," adds Hasanov.

A regional phenomenon, and beyond

Azerbaijan is not alone – the re-dollarization of CIS economies is a regional phenomenon. Armenia and Georgia wrapped up 2014 with 72.6% and 65.2% respectively of bank deposits in dollars. Georgia has been focusing on “larization” since 2010 and managed to tame the level of dollars in both deposits and loans, but de-dollarizing the economy can’t happen overnight.

Oleg Kouzmin, Moscow-based economist at Renaissance Capital, explains that a de-dollarization could be achieved by improving public confidence in national currencies, but this cannot be achieved by just ensuring exchange rate stability, and Azerbaijan is a good example. “Better control over inflation and more flexibility to the exchange rate result in predictability of domestic rates, while the general public feels more comfortable with fluctuations, understanding that the rate can go up and down.” In his view Azerbaijan has “good chances to take the level of dollarization lower. The move to a managed floating rate is the important step.”

The lack of trust inevitably creates a vicious circle: customers do not want to keep deposits in their currency, so banks end up not having local currency to lend to their clients. Dollars are being increasingly used in loan and real estate transactions to reduce devaluation risks, and banks also prefer to offer loans in dollars rather than manat, according to local reports.

International financial institutions are on the lookout to help. In May, the European Bank for Reconstruction and Development (EBRD) announced plans to issue its first manat-denominated bond, following similar initiatives in neighbouring Georgia in March 2014 and Armenia last January. Other multilateral lenders – the International Finance Corporation (IFC) and the Asian Development Bank (ADB) – followed with Georgian lari-denominated bonds in February this year, a sign of the need for local financing.

The aim is to encourage borrowing in local currencies, which have been caught by a sharp devaluation, squeezing already meagre household savings across the region. “We are working right now with the [Baku] authorities to create the appropriate legal and regulatory framework [because] it is very important that our bonds are placed in the market at the same [conditions] as the government’s, not to create an unfair market between the two instruments,” Bruno Balvanera, who heads the EBRD office for the South Caucasus, told bne IntelliNews last month.

While Hasanov agrees the plan would support the local currency, he stresses that “at the moment there are just not enough manats in the market”, so he sees the placement as an “open-ended plan.”

Better-than-expected growth, for now

For an oil revenue-dependent country whose currency was devalued by about a third, Azerbaijan’s economy performed better than expected in the first quarter, growing by 5.3%.

However, the G&T report highlights that the growth rate was mainly fed by one-off factors: inaugurations of major sporting complexes, lower oil production base of last year, and an immediate post-devaluation run on shops by those seeking to benefit from manat prices still reflecting the old value against the dollar.

“With reserves falling and the banking sector being ‘stress-tested’ by post-devaluation developments, we do not expect similar growth rates in the coming quarters,” the note reads. “Moreover, the lack of credible forward-looking assurances regarding future monetary policy, particularly exchange-rate policy, is acting as a brake on the new investment needed to drive growth.”