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Azerbaijan strives to move on from IBA default

With International Bank of Azerbaijan’s debt restructuring pushed through, the country can now begin focusing on addressing the roots of its problems. But the task of finding ways to grow its economy with less reliance on oil will not be easy, as Michael Turner reports.
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Baku

The restructuring of Azerbaijan’s largest bank has highlighted a major issue for the country’s economy: an overreliance on its oil reserves and the need to diversify the state’s revenue sources.

The default by state-owned International Bank of Azerbaijan (IBA) on its $3.3bn of debt, and the bank’s subsequent restructuring, followed sustained low oil prices that sent the country's economy and currency, the manat, reeling. But the ordeal surrounding IBA is far from over for the country’s financial sector.

Restructuring terms

After two months of heated debate that saw litigation threats from a group of US investors, 93.9% of bondholders agreed in July to IBA’s terms for restructuring. The Baku courts approved the deal on August 17. 

The Azeri state oil fund, Sofaz, will swap its $1bn of senior IBA debt for a new seven-year bond from the bank, while the vast bulk of senior creditors (equal to more than 92% of bondholders) will swap their IBA bonds for a new 15-year sovereign bond. Junior bondholders got a 50% haircut on $100m of debt, while trade finance debts – which are seen by banks worldwide as sacrosanct – will not see a haircut and will be swapped at par for sovereign debt. 

As part of the process, IBA will also shrink its liabilities by about 30% and sell its toxic assets to the government, which so far has spent about $6bn-equivalent on the task. “All these measures will make a very clean balance sheet,” said IBA chairman Khalid Ahadov on a conference call following investors’ approval of the restructuring. “All regulatory norms and Basel [III, regulatory] requirements will be in place.” 

He added that some financial institutions have already contacted IBA about the possibility of starting new business operations once the restructuring is complete.

The litigation group had not been in contact with IBA when the restructuring was pushed through. “None of those holders participated in the creditors’ meeting. They and all other creditors had the opportunity to attend but they did not attend,” says Ian Clarke, partner at White and Case, which acted as legal advisor to IBA. “We don’t have any further views on what their intentions are at this stage.”

The well runs dry

IBA’s default emphasises the wider problems in Azerbaijan’s banking sector, which can be linked directly to the fall in oil prices. In 2012, when Brent crude was trading at more than $100 a barrel, oil made up 46.5% of the country’s gross domestic product (GDP), according to Azerbaijan’s State Statistical Committee. By 2016, with Brent crude at about half of its 2012 levels, this had dropped to 34.1%. The gap was not plugged by other industries, and GDP fell from $75.24bn in 2014 to $37.85bn in 2016 according to research firm Trading Economics. 

The pace of the slowdown in GDP has declined in the first half of 2017, Samir Sharifov, Azerbaijan’s minister of finance, told ministers in July. He also told ministers that all state monetary obligations, which include things like wages and pensions as well as sovereign debt, were financed completely and in time for the first six months of this year, a trend expected to continue for the rest of 2017. 

Official figures from the Ministry of Finance put the income of the consolidated state budget for the first six months of 2017 at 11.6bn manat ($6.8bn) and expenditures at 11.5bn manat – suggesting the sovereign’s books, while tight, are balanced so far this year. This has mainly been achieved by slashing expenditures with a lower-than-planned use of a 7.5bn manat funds transfer from Sofaz to the central bank, which was agreed by presidential decree in January.

A shaken system

Azerbaijan might appear to be recovering but the path has been, and remains to be, far from smooth. Low oil prices and a crippled economy led to the central bank devaluing the manat twice in 2015, actions widely regarded by bank analysts and strategists in London as mishandled, with the Azeri currency devalued from 1.27 to 0.64 against the dollar over the year.

More than 10 lenders in the country had their licences revoked by the Central Bank of Azerbaijan in 2016 after being declared bankrupt. One of the larger casualties was mid-sized lender Bank Standard, which needed some $288m-equivalent of funds from the state’s Azeri Deposit Insurance Fund to repay its depositors. 

The problems in the banking sector have continued into this year, with non-performing loans (NPL) levels hitting 24% at the end of June, according to Fitch Ratings, a huge increase on the 5.25% gross loans to NPL ratio in the country in 2015, according to World Bank figures. For comparison, Poland had an NPL ratio of 7.5% in 2016. Bank capital in Azerbaijan has dipped to low levels as well, with the average capital adequacy ratio – the measure of a bank’s capital as a percentage of its assets weighted according to risk – tumbling to 11.8% in June this year, below the central bank’s 12% minimum requirement.

There have been some improvements in the banking sector. The sharp falls in domestic currency have ceased this year and the manat was trading at 0.588 to the dollar on August 16. The currency stability, alongside a smaller dollar demand and subdued growth in lenders’ loan books, has led to more money in the banking sector. “Compared with last year, [manat] liquidity has in fact substantially improved,” says Taleh Kazimov, chief executive and chairman at Azerbaijan’s Pasha Bank.

A high-profile restructuring

While the IBA restructuring was finally pushed through, its initial iteration released in May proposed to pay senior bondholders 80 cents for every dollar of debt they held. This led to a sharp backlash from investors, particularly as junior debt holders – who are supposed to absorb losses before senior creditors – would be getting half of their money back. At the time, senior creditors pointed out that if IBA went ahead with the haircut, it would negatively impact Azerbaijan’s standing in the capital markets and potentially make it harder for the sovereign to raise money.

However, hopes are rising that this has now been averted. “The fact that the plan was supported by the huge number of creditors is a clear indication that they consider the plan to be fair,” IBA’s Mr Ahadov told The Banker, adding: “I don’t believe the IBA case will have a negative impact on the country and other state-owned enterprises in capital markets.”

This will soon be put to the test; as part of the restructuring, the sovereign must sell one of its largest ever dollar bonds. IBA investors will then swap their IBA debt into holdings in the new sovereign bond.

“It will become the second largest sovereign bond [in Azerbaijan] after the [existing] 2024 because the [new] debt stock will be in excess of $1bn,” says Eric Lalo, managing director at Lazard, which acted as IBA’s financial advisor. “Some of the investment funds tracking indices will probably buy in, we have seen some trades on the grey market implemented on an if-and-when basis.”

Another test will come in 2016, when the Ministry of Finance plans to privatise the bank, according to Mr Sharifov, who said the success of the restructuring will “facilitate” the privatisation by the end of 2018.

But Azerbaijan has already sustained plenty of damage. After markets closed for the week on August 18, Moody’s cut the sovereign’s credit rating to Ba2 from Ba1, citing the “significant and long-lasting weakening of Azerbaijan's fiscal and economic strength, which is driven by the ongoing impact of lower oil prices, the country's declining oil production potential and its very weak banking system”.

Reputational damage

In theory, this should push up the cost of funding for the Azeri state on international debt markets, as investors will demand to be better compensated for the higher risk, at a time when the sovereign must print fresh debt to fulfil its side of the restructuring deal. However, when the bond markets opened on August 21, the sovereign’s outstanding $1.25bn 4.75% 2024 bonds were unchanged on their cash price in the secondary market, indicating that investors had already priced in the possibility of a rating downgrade. The 2024 bonds will be used as a main frame of reference when the sovereign negotiates the price of any new dollar debt with investors.

“[The IBA] restructuring did them no favours,” says Tim Ash, senior sovereign strategist at investment house BlueBay Asset Manager. “In the end, it was worst of both worlds. The bulk of the liabilities were dumped on the sovereign balance sheet, but the way the deal was done still left a bitter taste still in investors’ mouths.”

It is not just the state bearing the brunt of negativity about IBA’s default. Asked if the IBA restructuring has impacted his business, Pasha Bank’s Mr Kazimov says: “Saying ‘no’ would be an insincere answer to your question. Of course, it has affected our bank.”

In May, Fitch cut Pasha Bank’s rating from BB- to B+, specifically citing the IBA case as a demonstration that smaller Azeri banks might not receive as much state support as initially believed. Meanwhile, the State Oil Company of Azerbaijan – not to be confused with the oil fund Sofaz – is on review for a downgrade from its Ba1 rating at Moody’s. And in August, Fitch said the restructuring could still potentially come at the cost of reputational damage and “may not be sufficient to restore IBA's financial health”.

Anything but oil

Many in Azerbaijan, like oil producers around the world, have entered a period of introspection regarding the country’s economy and how it can reduce its dependence on oil.

“[We are] cautiously optimistic about long-term and short-term perspectives,” says Mr Kazimov at Pasha Bank.

The International Monetary Fund (IMF) has encouraged reforms in the country to reduce the costs of doing business and remove barriers to competition as a way to kick-start a private sector-led, non-oil economy. The IMF also said more needs to be done to improve corporate governance. 

Reforms already carried out by the Azeri authorities include speeding up the tax registering, filing and paying process by moving to an electronic system in 2015. This has made setting up a company easier by abolishing the need for a corporate seal for documentation in 2016, and this year the country improved its international trade efficiency by introducing an electronic system for submitting export and import documents.

“We need to further improve the business environment for small and medium-sized enterprises (SMEs) as they are key drivers of growing economies,” says Mr Kazimov. “Development of free trade zones… would be very helpful, with subsidies not just for large international players but also for local SMEs, stimulating domestic supply with a view to reduce import dependency.”

Once Azerbaijan can cover more of its domestic needs and cut imports, the government’s balance of payments will directly benefit, he adds. 

Threat to rating

This is good news for the country, as rating agency Standard & Poor’s has threatened to cut the sovereign’s BB+ rating if the pressure on the balance of payments does not recede. 

The central bank recorded a $380m surplus in the balance of payments for the first quarter of 2017 (though it has a current account deficit of $1.1bn in the same period). However, analysts at S&P note that official information is patchy, making it tough to get a full picture of Azerbaijan’s balance of payments and international investment positions.

One thing is certain: the move away from oil requires a complete sea change in the country’s economy. At the end of June this year, for example, Sofaz had assets totalling $34.8bn, equal to 88% of 2016’s GDP.

There are signs that other industries are starting to flourish, with the non-oil economy growing by 1.7% in the first six months of this year. Manufacturing and agriculture – two export-driven industries – led the charge, benefiting in part from better pricing competitiveness following the manat devaluations.

However, this only puts agriculture’s contribution to GDP at a little over 6%, despite the industry employing about 40% of Azerbaijan’s working population, according to a US export initiative led by the US Department of Commerce.

One of the largest hindrances to growing the agricultural industry in the country is a hangover from the Soviet Union. Azerbaijan has inherited a multitude of ageing food processing equipment and rudimentary packaging facilities that will require imported capital goods to update – goods that are now substantially more expensive with the diminished power of the manat. 

Other areas of the economy ripe for growth include food processing, petrochemicals, tourism and hospitality, according to Mr Kazimov. “The country realises that dependence on one sector of the economy or a single commodity can be restrictive and detrimental in the long term,” he says. “It is inevitable that Azeri businesses will eventually embrace this new paradigm and aim at outward growth through entering new markets.”

It will not be easy though, he warns, and domestic companies will need to raise all aspects of their game, as moving into new markets will expose them to “an area of stiff competition where winning and maintaining a market place will depend on introducing innovative thinking, new technologies, exceptional work ethics and employing qualified human resources”.

But as IBA’s case shows, greater diversification would not just benefit Azerbaijan’s economy but would also have a positive impact on the health of the country’s banking sector and the reputation of its capital markets.

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Read more about:  Central & Eastern Europe , Azerbaijan