Azerbaijan

Azerbaijan’s high dependence on the hydrocarbon sector and global oil and gas prices has resulted in a regime of low and volatile GDP growth since 2011, with annual average real GDP growth of just +1.4% over the past 12 years. In 2021-2022, the country experienced a strong rebound from the double whammy of the global Covid-19 pandemic and the slump in oil prices in 2020. Real GDP grew by +5.6% in 2021 and +4.6% in 2022 after dropping by -4.2% in 2020. The rebound was broad-based, driven by domestic demand and a strong expansion in the non-oil-and-gas sector as Azerbaijan recovered from the pandemic.  The oil and gas sector was boosted by rising global oil and gas prices due to the war in Ukraine. Looking ahead, the economy will benefit from increasing European demand for Azeri oil and gas but elevated inflation and higher interest rates will restrain domestic activity. As a result, we forecast annual real GDP growth to moderate to around +3% in 2023-2024.

Consumer price inflation accelerated from an average of 2.8% in 2020 to 6.7% in 2021 and 13.8% in 2022 on the back of surging global food and energy prices as well as supply disruptions, as seen elsewhere in the emerging market world. The Central Bank of Azerbaijan (CBA) has responded with gradual monetary tightening; it hiked its key policy interest rate in eight steps from 6.25% in September 2021 to 8.50% in February 2023. Headline inflation peaked at 15.6% y/y in October 2022 but we expect it to remain sticky and to ease only gradually, with annual averages forecast at around 10% in 2023 and 6% in 2024. The balance of risks to these forecasts is on the upside, with local currency risk and global food price shocks being potential triggers.

In April 2017, the CBA shifted back from a floating exchange rate regime to a “stabilized arrangement”, with the manat (AZN, the local currency) trading at 1.70:1.00 versus the USD, which has been maintained until early 2023. However, analysis of the real effective exchange rate has indicated a growing overvaluation of the AZN since Q3 2021, which amounted to around 20% at end-2022. Hence there is a significant risk of a sudden sharp depreciation or devaluation of the AZN in the event of a domestic or external shock to the economy.

With ample natural resources in the hydrocarbon sector, Azerbaijan is highly dependent on mineral products, which account for about one-third of GDP, half of fiscal revenues and nearly 90% of goods exports. As a result, the economy is very vulnerable to external shocks. This was reflected very explicitly, for example, amid the sharp drop in global oil prices between 2014 and 2016. That shock caused: (i) a sharp annual recession of the Azerbaijani economy in 2016; (ii) annual fiscal deficits in 2015-2017 (after huge surpluses since 2000); (iii) two sharp devaluations of the AZN and its eventual de-pegging from the USD in 2015 (AZN lost around -60% in value) and that after (iv) the Central Bank of Azerbaijan (CBA) had burned around two thirds of its foreign exchange (FX) reserves in an attempt to preserve the peg; (v) a banking sector crisis as the International Bank of Azerbaijan (IBA) – a largely state-owned bank, holding some 40% of total bank assets at the time – had to file for a large-scale restructuring of its debt in 2017. Again in 2020, the oil-price slump caused a recession and twin deficits. Meanwhile, IBA has been restructured with the support of the government, but the overall banking sector continues to show weaknesses, according to the latest IMF reports. Capital adequacy and profitability are comparatively modest, and non-performing loans, although well below record highs in 2017, are expected to rise by 2023. According to the IMF, systemic banks appear resilient against credit risks but vulnerable to FX risks.

The structural business environment in Azerbaijan is weak and has deteriorated in recent years. The World Bank Institute’s annual Worldwide Governance Indicators surveys continue to indicate substantial weaknesses with regard to regulatory quality and, in particular, the rule of law and control of corruption. The Heritage Foundation’s Index of Economic Freedom 2022 survey assigns Azerbaijan rank of 75 out of 184 countries, a significant worsening from rank 38 in the 2021 survey on the back of deteriorating property rights, judicial effectiveness and government integrity. Moreover, our proprietary Environmental Sustainability Index ranks Azerbaijan only 188 out of 210 economies, reflecting serious weaknesses regarding renewable electricity output, water stress and the recycling rate.

Political risk remains high in Azerbaijan’s as the military escalation of the ongoing conflict between Azerbaijan and Armenia over the Nagorno-Karabakh enclave in 2020 had highlighted once again. A trilateral ceasefire agreement brokered by Russia was established in November 2020 and shall last at least for the next five years, guarded by Russian peacekeeping forces. Yet occasional flare-ups of violence in 2021 and more serious clashes since 2022 – after Russia has been occupied with its war against Ukraine – indicate that security risks in the region remain heightened and another return to military conflict cannot be ruled out in the short- to medium-term.