Azerbaijan

Solid macroeconomic fundamentals but high structural risks

Strengths & weaknesses

Economic overview

Sluggish growth, lower inflation and continued currency risk

Azerbaijan's high dependence on the hydrocarbon sector and global oil and gas prices has resulted in a regime of low and volatile GDP growth since 2011, with annual average real GDP growth of just +1.5% over the past 13 years.

Consumer price inflation accelerated from an average of 2.8% in 2020 to 6.7% in 2021 and 13.9% in 2022 on the back of surging global food and energy prices as well as supply disruptions, as seen elsewhere in the emerging market world. The Central Bank of Azerbaijan (CBA) responded with gradual monetary tightening; it hiked its key policy interest rate in ten steps from 6.25% in September 2021 to 9.00% in May 2023. Headline inflation peaked at 15.6% y/y in October 2022 and remained in double digits until mid-2023 before rapidly falling to 2.6% in November, because of higher interest rates, sluggish domestic demand and base effects. As the latter will wane this year and the CBA has begun with moderate rate cuts, we expect inflation to pick up to an average annual 3.5% to 5% in 2024-2025.

In April 2017, the CBA shifted back from a floating exchange rate regime to a “stabilized arrangement”, with the manat (AZN, the local currency) trading at 1.70:1.00 versus the USD, which has been maintained until early 2024. However, analysis of the real effective exchange rate has indicated a significant overvaluation of the AZN since Q3 2021, which amounted to around 12% at end-2023. Hence there is a considerable risk of a sudden sharp depreciation or devaluation of the AZN in the event of a domestic or external shock to the economy.

Comfortable public and external finances

Azerbaijan's public and external finances strongly benefited from the surge in global oil and gas prices in 2021-2022. After a crisis-response program to address the adverse effects of the Covid-19 pandemic and low oil prices moved the fiscal account into a deficit of -6.7% of GDP in 2020, the budget posted sizeable surpluses in 2021-2023. As hydrocarbon prices are forecast to remain broadly at the levels seen in 2023, we project continued annual fiscal surpluses in 2024­2025. Meanwhile, gross public debt should remain moderate at around 20% of GDP.

Azerbaijan's current account rebounded to a large surplus of +15% of GDP in 2021 after a tiny pandemic-related deficit in 2020.

The official foreign exchange (FX) reserves of the CBA (USD12bn at end-2023) cover a comfortable ratio of six months of imports. Moreover, combined with the assets held by the State Oil Fund of Azerbaijan (SOFAZ), they cover over 35 months of imports, providing a sufficient buffer for standard trade finance. The assets held by SOFAZ had declined in the wake of both the oil-price slump in 2014-2015 and the local banking crisis (IBA debt restructuring) in 2017, but they recovered thereafter and remained broadly stable during the Covid-19 crisis, reaching a new high of USD56bn at end-2023 (approximately 65% of expected GDP). This means that the sovereign will remain a solid net creditor in the coming years.

Structural and political weakness

The structural business environment in Azerbaijan is weak and has deteriorated in recent years. The World Bank Institute's annual Worldwide Governance Indicators surveys continue to indicate substantial weaknesses regarding regulatory quality and the rule of law and control of corruption. The Heritage Foundation's Index of Economic Freedom survey 2023 assigns Azerbaijan rank of 75 out of more than 180 economies, a significant worsening from rank 38 in the 2021 survey on the back of deteriorating property rights, judicial effectiveness and government integrity. Moreover, our proprietary Environmental Sustainability Index ranks Azerbaijan only 181 out of 210 economies, reflecting serious weaknesses regarding renewable electricity output, water stress and the recycling rate.

Political risk is set to remains high in the Caucasus region. After the conflict between Azerbaijan and Armenia over the Nagorno-Karabakh enclave had been ongoing for around 30 years, Azerbaijan eventually took over the previously de facto independent territory in 2023. However, this is unlikely to bring a stable peace. Azerbaijan and Armenia took a series of steps to reopen negotiations towards a peace settlement in late 2023, but a final settlement is unlikely to be achieved in 2024. A potential next flashpoint could result from Azerbaijan's intention to establish a transport corridor through Armenia to the Azerbaijani exclave of Nakhichevan.