Fitch affirms Armenia at ‘B+’; outlook positive

Fitch Ratings has affirmed Armenia’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at ‘B+’ with a Positive Outlook.

A full list of rating actions is at the end of this rating action commentary.

According to Fintch, Armenia’s ratings balance a credible monetary policy framework, reduced external imbalances and stronger income per capita and governance indicators relative to peers against high fiscal deficits leading to a rising public debt burden, high external debt and tensions in relations with some neighbouring countries.”

The Positive Outlook reflects Armenia’s stronger growth outlook relative to peers, the start of a fiscal consolidation process that we expect will deliver a gradual decline in government debt over the medium term, and moderate current account deficits. Armenia’s credible monetary policy framework also helped underpin macroeconomic and financial stability through the political crisis in April.

The economy has recovered at a faster-than-anticipated pace and is expected to maintain higher growth than rating peers. After growth of 7.5% in 2017, Fitch expects growth to moderate, reaching 4.7% in 2018 and 4.0% in 2019, but remain above that of ‘B’ and ‘BB’ peers. Growth is supported by strong external and domestic demand, driven by a recovery in consumption and investment, reflecting still favourable export prices and continued growth in remittances and tourism inflows.

The state budget deficit declined to 4.8% of GDP in 2017, from 5.5% in 2016, but overshot the revised budget of 2.7% and Fitch’s 3.3% December 2017 projection. This deviation was the result of the disbursement and execution of a Russian defense loan of USD170 million (1.5% of GDP). Underlying fiscal dynamics reflect current expenditure reductions across budget lines, except for the interest bill, which rose to 2.2% of GDP. Capital expenditure rose to 4.3% of GDP, from 3.5% in 2016, driven by the execution of the above-mentioned loan. Barring further unanticipated external loan disbursements, Fitch expects the budget deficit to narrow further to 3.5% of GDP in 2018 and 3% in 2019, below the ‘B’ and ‘BB’ medians.

Fitch’s projections for the budget deficit and growth performance are consistent with a gradual government debt reduction over the medium-term. Public debt rose to 59% of GDP in 2017, slightly below the 60% ‘B’ median but 10pp above the ‘BB’ median. We expect debt to decline marginally to 58.4% in 2018 and maintain a gradual decline thereafter. As 81% of public debt is foreign currency-denominated, it is exposed to exchange rate volatility.

Armenia is in the process of revamping its fiscal framework to increase policy flexibility, improve expenditure composition in favor of capital spending and smooth fiscal consolidation to avoid an excessive impact on growth. The country amended its debt and budget laws at the end of 2017, and will present a fiscal strategy later in the year to outline the pace of fiscal consolidation consistent to bringing debt below 50% of GDP in the medium term.

Fitch will assess the strength and credibility of the new fiscal framework by evaluating the capacity of the new fiscal strategy to deliver sustainable fiscal consolidation and debt reduction in the medium term. In addition, Fitch will focus on the authorities’ ability to increase fiscal predictability by delivering on budgeted fiscal targets, most notably through improved coordination in the execution of external loan disbursements.

Armenia’s transition from a presidential to a parliamentary system has been a catalyst for broader political changes. Large scale protests led to the resignation of the recently appointed Prime Minister Serz Sargsyan in April. Nikol Pashinyan was elected Prime Minister on 8 May. The peaceful character of the demonstrations facilitated a smooth transfer of power within constitutional mechanisms. The new government has signaled broad macroeconomic policy continuity.

Armenia maintained macroeconomic and financial stability despite heightened political uncertainty, reflecting the policy framework’s credibility and improved capacity to absorb economic and political shocks. Inflationary pressures remain under control (1.6% yoy in May) and headline inflation is well below the central bank’s medium-term target of 4%. The CBA has kept interest rates at 6% since February 2017 and stated its readiness to tighten policy if demand side pressures increase. Fitch expects inflation to average 3% in 2018 and converge to the medium-term target in 2019.

The banking system remains stable and did not experience destabilizing liquidity pressures in April-May. Capitalization levels are adequate and non-performing loans (up to 270 days overdue) equaled 6.6% in April, up from 5.4% in March but down from a peak of 10% in March 2016. Despite a gradual declining trend, financial dollarisation remains high at 54% for deposits and 60% for credits. The CBA has discouraged foreign currency loans (through differentiated reserve requirements and risks weights) and required banks to maintain a balanced FX position.

External imbalances remain moderate despite higher growth. After reaching 3.5% of GDP in 2017, Fitch expects the current account to increase to 3.8% of GDP in 2018 and remain close to that level in 2019; below ‘B’ rated peers and much lower than Armenia’s 9.5% average deficit in 2010-2014. Continued growth in exports and remittances, albeit at a more moderate pace than in 2017, will partly balance strong import demand and rising energy prices. A moderate current account deficit mitigates external vulnerability arising from commodity dependence and the small size of the economy.

Fitch estimates that Armenia’s liquid assets as a share of short-term liabilities (at 125% in 2018) will remain below the ‘B’ category median. International reserves have declined from USD2.3 billion to USD2.0 billion since the beginning of the year, but these will likely be shored up by the end of the year by external disbursements. Exchange rate flexibility, reduced external imbalances and access to external financing reduce the risk of near-term balance-of-payment pressures. After completing its IMF EFF agreement this year, Fitch expects the authorities to seek continued engagement with the fund.

The government intends to move ahead with reforms to the electoral code and call for snap elections in order to strengthen its parliamentary support for broader reform agenda. Despite a weakened opposition, the new government faces the challenge of delivering results in line with heightened supporters’ expectations, maintain a united coalition and move ahead with reforms that challenge entrenched economic interest groups. The new government has maintained a balanced geopolitical approach. In terms of the conflict with Azerbaijan regarding Nagorno-Karabakh, negotiations leading to a resolution are not expected in the near term. Hence, escalation remains a real risk.

Fitch’s proprietary SRM assigns Armenia a score equivalent to a rating of ‘B+’ on the Long-Term Foreign Currency (LTFC) IDR scale. Fitch’s sovereign rating committee did not adjust the output from the SRM to arrive at the final LTFC IDR.

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