Azerbaijan: Regional Stability Wavers

Baku is rolling out ambitious plans for economic expansion and reform. But first, there are worsening regional tensions and currency woes to grapple with. And Covid.

Facing a volatile cocktail of pandemic, renewed hostilities with Armenia and economic slowdown, many Azerbaijanis may now view the February 9 parliamentary elections, held several months early to improve “legislative efficiency,” as a missed opportunity. The elections failed to yield the breakthrough for opposition figures some had hoped for following last October’s appointment of a more technocratic chief of staff and prime minister.

Fresh hostilities with Armenia have revived the simmering 26-year-old conflict between the two states, with both countries declaring martial law and mobilizing  their armed forces, amid fears the conflict could spiral further out of control. With the world preoccupied with tackling Covid-19, the risks of a full blown conflict near vital fuel and transport infrastructure are very real. “A lasting implication may be for the talks between Aliyev and Armenian Prime Minister Nikol Pashinyan,” says Zachary Witlin, senior analyst at the Eurasia Group.

Although Moscow continues to sell weaponry to both sides, Azerbaijan increasingly views Russia as pro-Armenia, worsening relations between Baku and Moscow, while Turkey has become more unequivocal in its support for Azerbaijan.

Covid-19, meanwhile, is working its ill effects on growth, public finances and confidence. Azerbaijan has recorded around 38,000 cases, 600 deaths and two lockdowns—the second lasting into August and accompanied by the closing of borders until September 30. The pandemic has meant a double whammy through the additional monies needed for health care and the impact on prices for Baku’s main revenue earners, oil and gas, which had already been affected by the price war between Saudi Arabia and Russia. An as-yet uncalculated impact is also expected on Azerbaijan’s foreign exchange earnings, which are being depleted as the authorities continue to support the manat at 1.7 to the US dollar. “Unlike other energy producers in the region, Azerbaijan hasn’t allowed the fall in oil prices and earnings to be reflected in the dollar exchange rate,” says Paul Gamble, head of Emerging Europe Sovereigns at Fitch Ratings. “The authorities seem committed to the unofficial peg.”

GDP is expected to contract this year, the European Bank for Reconstruction and Development (EBRD) forecasting a 3% decline while Fitch Ratings anticipates minus 4.2%. Neither would be much worse than the 2014-2016 downturn, when Baku had to twice devalue the manat due to a sharp drop in oil prices. One factor is a sharp rise in gas production and earnings—13% in 2019, with another 5% projected for this year—which has fed into the wider economy.

“Azerbaijan is actually more resilient now,” says Dimitar Bogov, the EBRD’s local economist for Azerbaijan. “The imbalances are not so severe and fiscal management is more prudent.”

Lingering concerns hover over the banking sector, which saw four of the 15 largest institutions—Atabank, AGBank, NBCBank and Amrakh Bank—taken under the wing of the Central Bank of the Republic on April 27. Bank capital requirements have had to be eased amid ongoing liquidity concerns, and deposit guarantees extended as nonperforming loans (NPLs) are currently estimated at 11%. However, the larger banks are now on firmer footing, notably IBA, which defaulted in May 2017; the government took over its bad assets and completed a restructuring in 2018.

Worries are growing over how much the authorities might have to spend to defend the manat, however. Coupled with concerns over the impact of low oil prices and the country’s high dependence on the energy sector—representing some 95% of export earnings and 75% of government revenue—this led Fitch to place a negative watch onto Azerbaijan’s sovereign BB+ rating in April.

“A Sound Crisis Response”

The general view seems to be that Aliyev’s government has matters under control for now, thanks in part to the small role that services and retail play in the domestic economy. And while Baku has adopted a more conservative fiscal response than some governments—equivalent to around 3% of GDP—the emphasis on lockdowns and border closures to bring the virus under control appears to be working.

“The authorities have put into effect a sound crisis response, helping companies and individuals impacted by the crisis,” says Bogov, who expects a return to GDP growth next year, forecasting 3%. “Year on year, we expect disposable income to remain flat, which is not bad considering the challenges being faced.”   

Azerbaijan’s secret weapon—one it has turned to at other times of acute crisis—is its sovereign wealth fund, Sofaz, which held some $43.2 billion of assets as of mid-July. This has acted as a buffer, keeping this year’s anticipated fiscal deficit of 12.4%—compared to a surplus of 9.1% in 2019—from rising more rapidly. Drawdowns from Sofaz are enabling Baku to finance both the deficit and the manat peg, despite the expected fall in oil earnings.

Later this year, the government is expected to unveil full details of its 2030 Vision alongside a revitalized plan to attract new capital, including foreign direct investment. However, with oil prices around $37 per barrel—well below earlier expectations of $55 and likely to remain low given the long-term falloff in demand and growth of sustainable energy—it’s clear that Baku will have to speed up economic diversification.

The government is already pushing ahead with a program to develop the petrochemical industry off the back of oil and gas.Azerbaijan ranks 34 out 190 countries in the 2020 World Bank Doing Business survey, and the authorities are intent on facilitating non-oil private sector activity. Areas targeted for growth include agriculture and agribusiness, trade and logistics and IT/telecoms as Azerbaijan aims to take fuller advantage of its Eurasian location. Infrastructure development is another potential growth area, with Chinese investment playing a growing role.

Prospects for Privatization

Privatization, historically something of a no-no in Azerbaijan’s top-down system, may also be in the cards once the Covid crisis subsides. In early August. Aliyev, a former head of national oil company Socar, criticized it and other big state-owned monopolies—including Azerbaijan Airlines, Azerbaijan Railways and electricity provider AzerEnergy—for inefficiencies and for drawing money from the state budget rather than using their own monies. He has suggested the entities be privatized, although no timetable has been set.

How likely are words to turn to action? Gubad Ibadoglu, economist at Rutgers University, has predicted that Socar could face bankruptcy by 2023 if serious restructuring doesn’t happen. Baku appears to be watching the example of similarly energy-rich Kazakhstan, which launched the Astana International Financial Corporation (AIFC) five year ago and started privatization in late 2018.

Close observers advise caution, however, noting that Azerbaijan’s energy-based economy isn’t an easy setting in which to undertake major changes, and that improvements don’t require privatization. Also, Baku doesn’t have an equivalent to the AIFC to enable asset sales.

“Before privatization, companies would need to make structural changes to improve management, operational practices and corporate governance,” says Fitch’s Gamble. “This would improve their performance and make them more attractive to private investors. Reform is clearly on the agenda, but in terms of privatization, it’s early days, and this isn’t an easy economy to reform.”

Others agree. “The main obstacles to privatization include the lack of a fiscal need to do so—fiscal savings are nearly 100% of GDP—difficulties in finding an independent buyer, energy security concerns and possible lack of support from the company management,” says Dmitry Dolgin, senior analyst at ING.

Dolgin suggests that as Azerbaijan moves into 2021, the focus will be on more immediate challenges, most urgently grappling with the pandemic and its consequences. “Other priorities include tackling the continued dependence on oil,” he says, “working within the limited room for macro maneuver due to the fixed exchange rate regime, and the tensions with Armenia.”