OREANDA-NEWS. The devaluation of the Azerbaijani manat will hurt banking sector capitalisation, Fitch Ratings says. The banks have large numbers of foreign-currency denominated loans and are exposed to losses on short FX positions. Greater dollarisation of the economy and banks' balance sheets mean that FX risks are likely to be significant for the sector over the medium term.

The banking system had a large short on-balance sheet FX position of USD1.7bn, or 43% of system equity, at end-2014. We believe this was only partly closed by hedges with market participants, leaving the banks' capital significantly exposed to currency depreciation. Banks' on-balance sheet short positions are likely to have increased further since the beginning of 2015 as depositors have converted savings into foreign currency. This will have been partly offset by FX swaps offered by the central bank since January.

Several banks have booked considerable losses as a result of the devaluation and their own substantial open short FX positions. We estimate that some banks could have breached their regulatory capital adequacy ratios, but believe the authorities may introduce some regulatory forbearance to support banks' formal compliance, as was the case in Russia.

Foreign-currency loans comprised 27% of total lending at end-2014 for the sector (about 33% post-devaluation). We estimate that devaluation will have increased risk-weighted assets by around 9% for the banking system as a whole. This would cause a reduction of just under 2ppt in the sector's total regulatory capital ratio, which was high at 19% at end-2014. However, the impact is likely to vary between banks. Those with larger-than-average proportions of foreign-currency loans will be more affected.

A gradual deterioration in asset quality of foreign-currency loans is likely, especially as exposures are largely to borrowers with limited access to foreign-currency revenue. Potential vulnerability of banks' asset quality and capital positions and the cyclicality of the oil-dependent Azerbaijan economy are reflected in banks' low Viability Ratings, which are mostly in the 'b' category.

The devaluation is broadly neutral for the sovereign profile. It will assist fiscal and external adjustment to the lower oil price. The sharp appreciation of the manat's real effective exchange rate as a result of the depreciation in 2014-2015 of the Russian rouble and Turkish lira would, if sustained, have hampered efforts to develop the non-oil economy in Azerbaijan.

However, the surprise move will shake domestic confidence in the authorities. It also poses risks in terms of the crystallization of contingent liabilities, notably in the banking sector although Azerbaijan's very strong sovereign balance sheet provides a considerable buffer, with the State Oil Fund of Azerbaijan (SOFAZ), at USD37.1bn, equivalent to 49% of GDP at end-2014.

On 21 February, the Azerbaijani Central Bank set the manat at 1.05 against the US dollar, compared with 0.78 earlier, corresponding to 34% devaluation.