OREANDA-NEWS. May 26, 2010. Fitch Ratings has upgraded Azerbaijan's Long-term foreign and local currency Issuer Default Ratings (IDRs) to 'BBB-' from 'BB+'. The Outlooks on both ratings are Stable. Fitch has also upgraded Azerbaijan's Country Ceiling to 'BBB-' from 'BB+' and upgraded its Short-term foreign currency IDR to 'F3' from 'B'.

"Fitch's upgrade of Azerbaijan's sovereign rating to investment grade reflects the rapid increase and prudent management of oil revenues that are being used to build a strong public and external net creditor position," says Andres Klaar, Associate Director in Fitch Sovereigns Group. "The strong sovereign balance sheet provides a powerful buffer against potential shocks emanating from the country's structural weaknesses."

The prudent use of the oil windfall has brought about an accumulation of assets in the State Oil Fund of Azerbaijan Republic (SOFAZ), the sovereign wealth fund, to USD16.2bn as of end-March 2010 (38% of 2009 GDP). Despite volatile international oil prices and the global financial crisis, Azerbaijan ran a general government budget surplus of 6.3% of GDP in 2009, as the authorities' cut budget expenditures rather than increasing transfers from SOFAZ, delivering an increase in SOFAZ assets of USD3.7bn. The current account surplus was 20.7% of GDP in 2009, while inflation fell to 1.5% in 2009 from 20.8% in 2008.

As an oil exporting country, virtually every external finance indicator in Azerbaijan is superior to the peer group median. Its sovereign net foreign assets reached 37% of GDP at end-2009, similar to Kazakhstan's 41% and Russia's 33%. However, the moderate private sector indebtedness in Azerbaijan is strength relative to its two CIS peers, as illustrated by Azerbaijan's strong net external creditor position of 36% relative to Russia's 26% and Kazakhstan's net external debt position at 27%. The Central Bank of the Republic of Azerbaijan (CBRA) has successfully maintained the manat's exchange rate against the USD during the global financial crisis.

However, Azerbaijan's oil windfall is relatively moderate. Fitch calculates that at the 2009 production level, the country's oil reserves will be depleted in 18 years compared with Kazakhstan's 54 years. Oil production is projected to be roughly stable from 2010 to 2014 and decrease slowly thereafter. Fitch forecasts that this will lead to a slowdown in real GDP growth to 3% in 2010 and 2% 2011, after an average of 21% in the five-years to 2009.

The relatively limited life span of the oil windfall underscores the importance of both prudent fiscal management and diversification of the economy. Fitch believes the fiscal rule that limits the annual expenditure of oil revenues to a level consistent with the "permanent income" from the oil endowment is appropriate. The agency also draws comfort from the transparency of the SOFAZ, underlined by Azerbaijan being the first country to be fully compliant with the international Extractive Industries Transparency Initiative. Fitch forecasts assets in SOFAZ to increase to around USD22bn at end-2010 (45% of GDP).

Diversifying the economy and boosting the non-oil growth rate will require structural reforms to reduce corruption and improve the non-oil business climate which is poor, notwithstanding a reasonable ranking of 38 in the World Bank's Ease of Doing Business Survey. GDP per capita is only two-thirds of the 'BBB' category median. Political risks also weigh on the rating. Although Fitch does not anticipate a significant increase in instability, the frozen conflict with Armenia over the Nagorno-Karabakh region and the centralised and opaque structure of political power, weak institutions and governance, and high level of corruption carry event risk.

Applicable criteria, 'Sovereign Rating Methodology', dated October 16, 2009, are available on Fitch's website at www.fitchratings.com