Christine Lagarde says troubled petrostates keep her up at night. In early January the managing director of the International Monetary Fund visited Nigeria and said the country needs “a new business model.” One month later she showed up at the Arab Fiscal Forum in Abu Dhabi to urge Gulf countries to adopt new taxes to reduce their economies’ dependence on volatile oil and gas revenues.
One oil state that occupies a prominent spot on Lagarde’s radar screen is Azerbaijan. Fund representatives spent a week in Baku in late January and early February, and media reports indicated that Azerbaijan was seeking a bailout of up to $4 billion. Both Azeri officials and the IMF have denied those reports, but it’s clear that the country faces growing financial pressures.
The state is highly dependent on oil and gas. In 2013 the two commodities generated 73.2 percent of government revenue, according to a prospectus for its 2014 eurobond offering. With crude prices having tumbled by two thirds since then, the government in January revised its budget for 2016 based on a projected average oil price of just $25 a barrel over the course of the year. At those prices, hydrocarbons will provide only 55 percent of revenue.
Since late January, the three major ratings agencies have stripped Azerbaijan of its investment-grade rating, cutting it by one notch to Ba1 (Moody’s Investors Service) and BB+ (Standard & Poor’s and Fitch Ratings). After a decade of budget surpluses, plunging oil prices pushed the government budget to a deficit of 5 percent of GDP last year, S&P said. It forecasts the deficit will shrink to 2 percent of GDP a year over the next three years, thanks largely to the currency’s collapse, which means foreign gas sales bring in more manat; on the flip side, the currency’s slide will push inflation up to 15 percent this year, it added. The downgrade will make it more costly for the government to finance the development of a pipeline to expand its natural gas exports, which are critical to its economic outlook.
Sizable oil savings and policy flexibility are keeping the state afloat — and out of the arms of the IMF — for now. The government last year tapped its sovereign wealth fund, State Oil Fund of Azerbaijan, to help contain its deficit, reducing the fund by $3.5 billion, to $33.6 billion currently. The revised budget assumes a $4.6 billion drawdown from the fund this year, according to Samuel Bevan, a London-based credit analyst for Aberdeen Asset Management.
”We don’t need the money, but what we really want from the IMF is the technical assistance,” Shahmar Movsumov, CEO of the sovereign fund, told Institutional Investor at a conference of the Extractive Industries Transparency Initiative in Lima, Peru, last month. The government wants the Fund’s assistance in diversifying its economy and cutting spending without throttling the economy.
Quick action is needed. Although the sovereign wealth fund is significant, Azerbaijan has already seen how quickly money can evaporate at a time of low oil and gas prices. Since July 2014, the Central Bank of the Republic of Azerbaijan has spent nearly three quarters of the country’s foreign exchange reserves to shore up the manat, reducing its stock of hard currency to $4 billion at the end of February. The authorities also sought to defuse the pressure by devaluing the currency twice last year, in February and December, slashing its value by 50 percent against the dollar, the biggest decline of any currency in 2015. In late December, the central bank shifted from a fixed exchange rate to a managed float, allowing the currency to drift 5.6 percent lower, to 60.412 cents on March 10.
Lagarde praised the authorities’ approach last month, saying the exchange rate shift and efforts to trim spending were an appropriate response to the drop in oil income. “Letting the manat fall has led to a loss of confidence, but in the long term it should help the economy to adjust,” says Aberdeen’s Bevan.
Barring a sudden shift in oil and gas prices, real relief isn’t expected to come for several years. In 2018 the second phase of the country’s giant Caspian Sea gas field, Shah Deniz, is due to come onstream. It is projected to roughly double Azerbaijan’s natural gas output, to 32.9 billion cubic meters a year, according to the field operator, British Petroleum. BP considers Shah Deniz to be its biggest find since Prudhoe Bay in Alaska in 1968.
The additional supply is expected to be exported to Western Europe through the Southern Gas Corridor, a network of pipelines from the Caucasus through Turkey and Southern Europe to the European Union. It’s not clear yet how much revenue Azerbaijan will get, and how fast, because gas sale contracts are typically linked to oil prices. In addition, the consortium of oil companies developing the field with BP will be entitled to recover costs before revenues flow to the Treasury.
On March 10 a state-owned company, also named Southern Gas Corridor, began an investor road show for a $1 billion eurobond offering to help finance its portion of the pipeline network. In January the government had said the company would seek to borrow $2 billion in the first half of this year for the project. The Azerbaijan government last tapped the eurobond market in 2014, paying a coupon of 4.75 percent on $1.25 billion worth of ten-year bonds. The yield on those bonds had risen to 6.60 percent after the country’s recent ratings downgrade.
The government hopes to diversify its economy in the long run by promoting agriculture and tourism, but officials have yet to put any policies in place, said the sovereign fund’s Movsumov. “We have not reached a consensus on whether the government should take the lead in diversifying the economy or the private sector,” he said.
“Getting a tourist visa is still complicated, so making it easier would show they are serious about diversifying,” says Paul Gamble, London-based co-head of emerging Europe sovereign ratings at Fitch Ratings.
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