Siranush Ghazanchyan
Fitch Ratings has affirmed Armenia’s Long-Term Foreign-Currency (LTFC) Issuer Default Rating (IDR) at ‘B+’ with a Stable Outlook.
Key rating drivers
Armenia’s ‘B+’ IDRs reflect fairly high government and external indebtedness, relatively weak external finances and geopolitical tensions that have the potential to escalate into military conflict. These are balanced against high income per capita; governance, development and ease of doing business indicators that outperform the ‘B’ rated median; and institutions that have facilitated orderly political transitions and weathered the 2020 pandemic shock and six-week war with Azerbaijan. It also has a robust macroeconomic and fiscal policy framework, and credible commitment to reform, both of which are underpinned by the IMF stand-by arrangement (SBA).
Fitch expects that prime minister Nikol Pashinyan’s ‘My Step’ alliance should be able to maintain a working majority coalition in parliament at the 20 June 2021 snap elections. After Pashinyan signed a Russia-brokered and maintained ceasefire agreement on 9 November 2020 to end the Nagorno-Karabakh conflict, the country has seen a period of heightened protests and political interventions by the military calling for his resignation. Although we expect Pashinyan to retain power, support for his government has diminished since the war and could exacerbate the challenges of implementing structural reforms and tackling corruption.
The effects of Armenia’s defeat in the Nagorno-Karabakh war are likely to persist, with the influx of refugees to Armenia numbering in the tens of thousands (Armenia’s 2019 population: 3 million), and the need to re-establish diplomatic efforts through the previously failed OSCE Minsk Group process. Despite the presence of Russian peacekeeping forces, tensions in Nagorno-Karabakh have the potential to reignite due to the absence of a demilitarize zone. The war has also further entrenched Armenia’s reliance on Russia for security and economic relations.
The impact of the twin Covid-19 pandemic and conflict shocks saw government indebtedness reverse its prior downward trend, with general government debt/GDP rising 13.8pp to 67.3% at end-2020, overtaking the current ‘B’ median (63.8%). We forecast debt/GDP to peak at 67.6% at end-2021, before falling gradually to 63.5% by end-2025 as the government re-implements its medium-term fiscal rules and targets to reduce the metric to 60% by end-2026. Weaker growth due to economic scarring from the 2020 shocks and spending pressures to support the economy constrain the potential for faster public debt reduction. Foreign-currency denominated debt represents 77% of public debt (‘B’ median: 61%), increasing the country’s vulnerability to dram depreciation.
The consolidated fiscal deficit widened to 5.1% of GDP in 2020 (compared with a forecast of 7.6% at our October 2020 review), from 0.8% in 2019, driven by higher expenditure, including to support the economy during the pandemic. A budget amendment in 4Q20 widened the state budget deficit and reallocated spending for the war effort, but under-execution of capital expenditures limited the 2020 deficit outturn. We forecast the consolidated fiscal deficit narrow gradually to 4% in 2021 and 2.8% in 2022, due to a continuation of several fiscal-support measures under the economic recovery plan in 2021, and our expectation of some improvement in capital spending execution.
Potential additional fiscal measures to support a weaker economic recovery is a key risk to our projections. The 2021 deficit will be financed primarily by a USD750 million Eurobond issued in February 2021, with 71% of the annual financing requirement completed by end-February.
Armenia has committed to key structural reforms relating to public financial management under the IMF SBA, including to maintain its medium-term fiscal trajectory, improve revenue mobilisation, fiscal risk management, and efficiency of capital expenditure budgeting and implementation. However, in Fitch’s view, additional recovery spending needs and diminished political support could slow progress of the reform agenda.
External finances are a key weakness for Armenia, with a high commodity export dependence (41% of 2020 current external receipts) that raises vulnerability to copper and precious metal price fluctuations, and fairly weak foreign direct investment (FDI) inflows. Net external debt (NXD) is high, at 55.1% of GDP at end-2020 (‘B’ median of 32.3%) and we forecast it to rise to 62.2% by end-2022.
The authorities’ overall commitment to exchange-rate flexibility resulted in the dram depreciating 9% in 2020. The Central Bank of Armenia maintains its commitment to intervene only to prevent disorderly adjustments in financial markets, making net foreign-exchange (FX) sales of USD147 million in 2020 (2019: net purchases of USD566 million). Broad adherence to the exchange-rate framework under the IMF’s SBA underpins strong access to international financial institutions (IFIs) and external commercial financing.
We estimate the current account balance in 2020 to have remained broadly resilient despite the shocks, improving to a deficit of 4.3% of GDP (2019: deficit 7.2%). This was due to sharp compression of goods and services imports, and a spike in non-resident transfers since 2Q20 driven by large diaspora transfers akin to the increases during the 2008 and 2013 election crises.
Fitch forecasts the current account deficit (CAD) to widen to 6.1% in 2021 and 6.8% in 2022 (‘B’ median average of 4.3%) as private consumption and capital expenditure recover and as anti-crisis diaspora transfers fade, more than offsetting the effect of stronger terms-of-trade from decade-high copper prices. Net FDI inflows are expected to cover only a quarter of the 2021 deficit, with the February 2021 Eurobond and IFI borrowing financing the bulk.
The twin shocks resulted in real GDP contracting 7.6% in 2020 (‘B’ median: 4.5% contraction), with construction and real-estate activities, trade and tourism-related services being worst hit, while public services, healthcare and financial services supported output. Fitch forecasts real GDP growth to rebound to 3.2% in 2021 and 4% in 2022, partly due to base effects and supported by expansionary policy stances, especially in public investments. The ongoing third-wave of Covid-19 infections based on official data is rising above the 2Q20 first wave but still below the peak of the 4Q20 second wave. Despite growing infection rates, and a vaccination programme slower than regional peers’, Fitch does not expect significant economic and travel restrictions to be reinstated.
A credible approach to inflation targeting by the CBA has kept inflation much lower (five-year average: 0.9% in 2020 vs. the historical ‘B’ median of 7.3%) and more stable than peers’. Inflation has picked up in the last three months, rising to 5.3%in February 2021, after averaging 1.2% in 2020, driven by food prices, pass-through from depreciation and rising price expectations. Fitch forecasts near-term inflation to moderate by 2H21 to average 3.5% in 2021, just under the CBA’s 4% target.
In response to rising inflation, the CBA increased its key policy rate by 125bp to 5.5% in two actions between December 2020 and February 2021. Fitch forecasts the CBA to tighten policy further in 2021 to choke off inflation.
Armenian banks are well positioned to weather the impact of the 2020 shocks. The banking system is well capitalised relative to similarly rated peers’ (capital adequacy ratio of 16.6% at end-January 2021), and asset-quality deterioration from the pandemic should rise only slightly from 7.3% (non-performing loans ratio) at end-January 2021, due to the authorities opting for just a brief two-month debt service holiday, while no regulatory forbearance has been applied for problem loan recognition and provisioning.
Banking exposure to the Nagorno-Karabakh conflict region is limited, with loans to the region roughly 3% of GDP (5.3% of bank loans) at end-2019, and the region’s deposits estimated at 1% of GDP or 1.5% of bank liabilities. Government-subsidised lending to banks has helped underpin private-sector credit growth of 18.3% on average in 2020, but which has since moderated to 11.4% in February 2021. Fitch’s macroprudential risk indicator for Armenia is ‘2’, indicating a moderate level of risk due to a positive credit gap in 2019-2020. Residents’ deposit dollarisation is high, at 42.3% at end-2020, in part reflecting sizeable non-resident foreign-currency transfers.
ESG – Governance:
Armenia has an ESG Relevance Score (RS) of 5 for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model (SRM). Armenia has a medium WBGI ranking at the 48th percentile, reflecting a recent record of peaceful political transitions, a moderate level of rights for participation in the political process, moderate institutional capacity, established rule of law and a moderate level of corruption.
Rating sensitivities
The main factors that could, individually or collectively, lead to positive rating action/upgrade are:
– Public Finances: Improved confidence in general government debt/GDP returning to a firm downward path over the medium term, for example due to a credibly defined fiscal consolidation plan.
– External Finances: A sustained improvement in external indicators, for example lower NXD, improved CAD or FDI inflows closer to the ‘BB’ median.
– Structural: Further improvement of structural indicators such as governance standards, leading to convergence towards the ‘BB’ peer median, and improvement in political stability.
The main factors that could, individually or collectively, lead to negative rating action/downgrade:
– External Finances: A worsening of external imbalances, potentially evidenced by higher NXD or wider CAD, or recurrence of external-financing pressures leading to a fall in reserves and a rise in the interest burden.
– Structural / Macro: Renewed escalation of the military conflict with Azerbaijan over Nagorno-Karabakh or an intensification of domestic political instability that leads to a weakening of macroeconomic and fiscal policy direction or credibility.
– Public Finances: A sustained upward trajectory in general government debt/GDP over the medium term, for example due to a structural fiscal loosening and/or further weakening in GDP growth prospects.
Sovereign rating model (SRM) and qualitative overlay (QO)
Fitch’s proprietary SRM assigns Armenia a score equivalent to a rating of ‘B+’ on the LTFC IDR scale.
Fitch’s sovereign rating committee did not adjust the output from the SRM to arrive at the final LTFC IDR.
Fitch’s SRM is the agency’s proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LTFC IDR. Fitch’s QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
BEST/WORST CASE RATING SCENARIO
International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance.
Key assumptions
Fitch expects macroeconomic indicators to move in line with its March 2021 Global Economic Outlook forecasts.
References for substantially material source cited as key driver of rating
The principal sources of information used in the analysis are described in the Applicable Criteria.
ESG considerations
Armenia has an ESG Relevance Score of 5 for Political Stability and Rights as WBGI have the highest weight in Fitch’s SRM and are therefore highly relevant to the rating and a key rating driver with a high weight.
Armenia has an ESG Relevance Score of 5 for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as WBGI have the highest weight in Fitch’s SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight.
Armenia has an ESG Relevance Score of 4 for Human Rights and Political Freedoms as the Voice and Accountability pillar of the WBGI is relevant to the rating and a rating driver.
Armenia has an ESG Relevance Score of 4 for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver for Armenia, as for all sovereigns.
Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity(ies), either due to their nature or to the way in which they are being managed by the entity(ies).
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