OREANDA-NEWS. Azerbaijan's move to a floating exchange rate regime for the manat will assist the sovereign's fiscal and external adjustments to lower oil prices and protect buffers, Fitch Ratings says. But exchange rate adjustments are not risk free. The manat's fall will hurt the already fragile banking sector, which could crystallise contingent liabilities for the sovereign.

The central bank abandoned its currency peg today, allowing the manat to fall by almost a half. The move is broadly neutral for the sovereign profile.

The sharp exchange rate adjustment eases the oil shock's fiscal impact by boosting the local-currency value of oil revenues and a floating currency should help stabilise reserves. Gross reserves fell around 18% in the first nine months of the year, partly through defending the currency following an earlier devaluation in February.

The approval of a tight 2016 budget on 7 December, which included a sizeable spending cut, is also consistent with our belief that the authorities are committed to making the adjustments to capital spending and tax revenue that will ensure the preservation of buffers. However, the fiscal consolidation and exchange rate adjustment will hit growth. High dependence on oil and gas is a key weakness for the sovereign profile, with hydrocarbons accounting for 95% of goods exports, 75% of budget revenues and 40% of GDP in 2015.

The devaluation will hurt the banking sector, which has large amounts of foreign-currency denominated loans. Capital ratios will drop across the board due to the inflation of risk-weighted assets related to these loans. Also, several banks run considerable unhedged short open-currency positions and will have to book significant one-off translation losses.

We expect that some banks will not meet minimum prudential capital adequacy ratios at end-2015. However, there is a track record of regulatory forbearance being available for the banking sector after February's devaluation and we believe that forbearance is likely to be extended in some form.

In the medium term, the devaluation will have a negative impact on banks' asset quality, as loan dollarisation is high. The share of dollar-denominated loans in the sector was around 50% at end-3Q15 and will probably rise above 60% following today's move. Because most of the country's borrowers do not have access to foreign currency revenues, their debt service capacity will be impaired. Asset quality in the sector is further undermined by the weak business climate in the broader economy.

Liquidity may tighten, particularly in local currency, due to only limited inflow of local currency funding. However, liquidity support to the banking sector should be available from the central bank, in case of need. The central bank already introduced a currency swap arrangement with the banks to bolster local-currency liquidity this year.

Although the banking sector is an area of weakness, its small size (with assets at 50% of GDP in 2015) allows the government to provide support as needed. Azerbaijan's very strong sovereign balance sheet provides a considerable buffer, with the State Oil Fund of Azerbaijan's assets at USD34.7bn at 1 October, equivalent to 65% of forecast end-2015 GDP.