Fitch says Azerbaijan capital controls may hit growth and banks

Azerbaijan's introduction of capital controls does not automatically have consequences for its 'BBB-'/Stable sovereign rating, Fitch Ratings says. 

Low debt and substantial external assets still support the rating, although the capital controls could damage the sovereign's credit profile through their impact on growth and financial stability. 

The authorities this week imposed a 20% tax on some transactions where foreign currency leaves the country, in response to manat depreciation following the switch to a floating exchange rate regime last year. 

The move reflects the challenge of dual policy goals - preserving the value of State Oil Fund of Azerbaijan (SOFAZ) assets, and supporting the currency to maintain price and social stability. The measures will support the manat and reduce the pressure on buffers, which are a key strength of Azerbaijan's credit profile. 

But this may be offset by the impact of devaluation, capital controls, and low oil prices on the economy, budget, and banking sector. Azerbaijan's external balance sheet is strong. SOFAZ assets were nearly USD35bn, 16 months of the country's total imports, at end-3Q15, but the government may be reluctant to use them to defend the manat as SOFAZ finances around half of the state budget and is also meant as a fund for future generations. 

Manat devaluation in 2015 almost exactly offset the first-order fiscal impact of the dollar fall in oil prices. But the resulting social pressures have their own fiscal cost. Pensions, benefits and public-sector salaries have been increased and VAT on bread and flour removed. 

On 20 January the finance minister announced that the 2016 budget will be revised to incorporate a USD30/b oil price assumption, from the USD50/b in the initial budget, while keeping the benefit and public sector salary rises. This implies further cuts, particularly in capital spending, which would be an additional drag on growth. 

Damage to confidence from devaluation, capital controls, and low oil prices will limit the scope for non-oil growth and economic diversification, and therefore improved non-oil revenue collection. 

We do not think capital controls will have a material effect on the banking sector due to its already high dollarisation (75% of deposits). Moderate outflows of manat-denominated deposits are possible in anticipation of further depreciation, although the outflow of retail funding in the banking sector in December and January (5%-10% at most rated banks) was manageable because of liquidity buffers. 

The authorities have increased deposit insurance coverage to an unlimited amount to improve confidence, but almost all deposits were covered by the existing threshold. We think the Central Bank of Azerbaijan (CBA) would provide liquidity support if needed. 

The CBA has used regulatory forbearance to support the sector again following December's devaluation, lowering minimum regulatory capital adequacy requirements for Tier 1 and total capital adequacy ratios. This may bring some banks that breached ratios last month back into formal compliance, without changing their core economic capital position. 

The small banking sector (assets at 50% of GDP in 2015) gives the government scope to support it, but direct capital support would be another fiscal cost. An escalation of banking sector pressures would further hit growth. The announcement that the authorities plan to inject an additional ANZ600m equity into International Bank of Azerbaijan (BB/Rating Watch Positive) this year shows greater propensity to support the country's largest bank. The Country Ceiling has long been in line with the sovereign rating, reflecting the risk of capital controls.