Wednesday, September 1 2021 22:40

ArmInfo. Moody's Investors Service ("Moody's") has today affirmed the Government of Armenia's Ba3 local and foreign currency long-term issuer ratings and foreign  currency senior unsecured rating. The outlook remains stable, the  relevant statement is published on Moody's website.

The affirmation of the Ba3 ratings is driven by the credit profile's  resilience to the significant shocks of the coronavirus pandemic and  geopolitical and domestic political tensions, and Moody's  expectations that growth and fiscal strength will recover over the  medium term. The fiscal profile in particular has proven resilient  and will stabilize over the medium term, with debt consolidation  expected from 2021 onward as growth and revenue rebound, and as the  government adjusts expenditure downward in line with fiscal rules.   Meanwhile, Moody's assesses that the 2020 ceasefire agreement with  Azerbaijan and the June snap parliamentary election have reduced  near-term political risks, supporting economic recovery and  minimizing the impact to Armenia's fundamental growth outlook.  External deficits drive currency valuation risks that can transmit to  fiscal strength and financial stability, although external buffers  have increased to withstand these potential shocks.

The stable outlook reflects balanced risks to the Ba3 rating. While a  developing track record of policy effectiveness supports the  development of a diversity of higher productivity sectors, growth  potential remains constrained by demographic pressures and the small  scale of the economy. Upside risk stems from more effective reforms  that contribute to sustained growth at higher rates than Moody's  currently assumes over the medium term. Event risk remains the key  source of downside risk due to geopolitical tensions with neighboring  countries, and external vulnerability and banking system risks  resulting from the high share of foreign-currency debt, structural  current account deficits, and a highly dollarized banking system.   Armenia's local and foreign currency country ceilings remain  unchanged at Baa2 and Ba1, respectively. The four-notch gap between  the local currency ceiling and the sovereign rating reflects a  balance between the government's small footprint in the economy and  strong institutions, and geopolitical tensions with neighboring  countries and external deficits that expose the economy to external  shocks. The two-notch gap between the foreign currency ceiling and  the local currency ceiling incorporates Moody's assessment of  Armenia's policy effectiveness and transfer and convertibility  restrictions in times of stress.

RATINGS RATIONALE

The pandemic-induced shock to domestic and external demand led to a  7.4% contraction in real economic output in 2020, among the most  severe downturns among sovereigns in Central Asia and the Caucasus  region. With declining revenue and higher expenditure on  coronavirus-related relief measures, the government triggered an  escape clause in its debt management framework and suspended a fiscal  rule that prescribes public debt reduction to below 60% of GDP within  five years. Armenia's fiscal deficit widened to more than 5% of GDP  while government debt rose to 63.5% of GDP in 2020 from 50.1% in  2019.  Moody's expects a recovery in the economy and an adherence to  the authorities' expenditure plan to support a lowering of debt to  below 60% GDP by 2022, in line with the median for Ba3-rated peers.  Moody's expects the authorities to gradually reduce expenditure to  28% of GDP by 2022 from 31% of GDP in 2020 to reflect lower costs  associated with pandemic-related social assistance and the  re-allocation of expenditure savings from unspent funds for capital  investment. Revenue is likely to be stable as a share of GDP around  25% of GDP over the medium term, reflecting pre-pandemic revisions to  the tax code that are likely to increase income and property tax  collections, and will benefit from grant assistance from  international partners including the European Union.

While not Moody's baseline scenario, there remains some risk of  fiscal slippage depending on contingencies such as the further  flare-up in geopolitical risks or rising demands for social  expenditures to address subsequent waves of coronavirus infections.  However, Moody's expectation is for the authorities to prioritize  debt consolidation through 2024, with debt to GDP declining to 54% of  GDP by 2024.  While the level of public debt has increased, the  fiscal profile will be underpinned by a continued emphasis on  long-dated external concessional borrowing, occasional Eurobond  issuance, and increasingly, a focus on domestic financing sources,  that will support lower interest costs relative to Ba3 peers.  Accordingly, Moody's expects debt affordability to remain a credit  strength, with interest payments as a share of GDP remaining low at  below 2.5%, and interest payments as a share of revenue at around  10%. Even with a greater emphasis on domestic borrowing, the  authorities will likely maintain access to a broad array of external  financing sources, primarily on concessional terms from multilateral  and bilateral lenders.

GROWTH POTENTIAL RESILIENT TO PANDEMIC AND POLITICAL TURMOIL

Moody's expects a broad-based growth recovery over the next 12-18  months resulting from reduced lockdown measures driving private  consumption and investment, robust external demand and the return to  pre-pandemic levels of remittance inflows that will support  consumption and savings. Moody's forecasts real GDP growth of 4.5% in  2021, reflecting a rebound in activity in manufacturing, agriculture  and mining, offset by continued weakness in services sectors such as  tourism, which accounts for 13% of GDP, according to the World Travel  and Tourism Council.

Downside risks also relate to the risk of additional waves of  coronavirus infections that would weigh on domestic activity, as well  as reducing the prospects of a rapid rebound of the tourism sector.  As of late August, just 5% of Armenia's population has received at  least one vaccine dose, risking future spikes in infections. An  uptick in inflation has also prompted several policy rate hikes by  the Central Bank of Armenia since late 2020. However, these pressures  are likely to dissipate in 2022 through base effects and moderation  of inflation expectations, fostering a more pronounced recovery in  real growth to 7.5%.  Investments will also continue in nascent,  higher productivity sectors that will reduce Armenia's reliance on  physical commodities, including tourism and information and  communication technology (ICT). These sectors are poised to drive  productivity and income growth over the medium term, although they  may encounter labor and skills shortages due to Armenia's small  population and declining labor force. ICT in particular remained a  stable source of services export revenue through the pandemic. The  industry intends to pivot toward increasing technical capacity in  higher value offerings including artificial intelligence and  semiconductor design.

Despite near-term headwinds, Moody's expects tourism to be a key  source of growth over the medium term. Accordingly, the government  has announced plans to launch a national discount airline that will  be part of a broader strategy to encourage tourism as well as improve  Armenia's broader connectivity, given its landlocked geography and  the limited transportation and economic ties with several of its  neighboring countries.

EXTERNAL DEFICITS, INFLATION AND BANKING SYSTEM DOLLARIZATION  CONTINUE TO POSE 

EXTERNAL VULNERABILITY RISKS

Moody's expects Armenia to sustain current account deficits of  between 4% and 5% of GDP through 2022, resulting from improving  domestic demand, rising oil prices and the real appreciation of the  dram acting as a drag on exports. Deficits are likely to remain  predominantly financed by debt portfolio inflows, both commercial and  concessional, and bank liabilities, while foreign direct investment  (FDI) inflows will rebound gradually. FDI inflows have been volatile  and low as a share of GDP relative to Ba3 peers, at 1.9% of GDP on  average between 2014 and 2019. The significant share of external  public debt (75% of total public debt) and dollar-denominated bank  loans will keep Armenia's External Vulnerability Indicator, the  measure of short-term external liabilities as a share of total  foreign exchange reserves, above 100% through 2023.  Moody's expects  Armenia's large external deficits to drive the credit profile's  susceptibility to event risk.  These risks can manifest from a sudden  depreciation of the dram exchange rate or shifts in geopolitical  risks, which can result in inflation volatility and affect the debt  trajectory and financial stability, due to the sensitivity of  government debt to currency fluctuations and the high level of  dollarization in the banking system. While the ongoing economic  recovery is set to stabilize asset quality and liquidity conditions,  the ongoing risk of foreign-currency deposit outflows will continue  to pose banking system risks. Nevertheless, Moody's expects a healthy  reserves position and a moderate level of external debt service over  the next four years to ease pressures on the foreign exchange  reserves buffer. The International Monetary Fund's increased SDR  allocation, along with the February 2021 issuance of a $750 million  Eurobond, will also boost Armenia's reserves in 2021.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Armenia's ESG Credit Impact Score is moderately negative (CIS-3),  driven primarily by moderately negative social and environmental  risks, and low governance risk that is underpinned by a track record  of policy effectiveness and institutional reforms.

Armenia's exposure to environmental risks is moderately negative  (E-3), reflecting the country's moderate exposure to heat and water  stress, sizeable agricultural sector and its landlocked geography and  small land area, with low exposure to pollution, water constraints,  and carbon transition risk, given the economy's low dependence on  hydrocarbon revenue and exports. Armenia's score is largely in line  with regional neighbors.  Armenia's social risk exposure is  moderately negative (S-3) and is driven by demographic challenges  including a small, aging population and a high level of youth  unemployment that may act as a drag on long- term potential growth.  High emigration by higher skilled Armenians supports inbound  remittances, a mitigating factor, but also exacerbates demographic  dynamics. The pivot to higher productivity services sectors including  information technology may help to mitigate these risks. Moderate  risks stem from similar levels of housing and health care provision,  life expectancy, and access to basic services observed in other  sovereigns in the region.

Armenia's governance risk exposure (G-2) is neutral to low,  reflecting the relative strength versus peers in economic  policymaking, with a track record of fiscal and monetary prudence,  and initial progress toward institutional reforms. Ongoing challenges  include the control of corruption and rule of law compared to peers,  although perceptions have recently improved and institutional reforms  to address these issues, in large part with international technical  assistance, are among the government's top priorities. The banking  system's large size and significant dollarization level pose  challenges to the effectiveness of macroprudential and regulatory  policies to mitigate risks to financial stability.  The issuer's  fiscal or financial strength, including its debt profile, has not  materially changed. The issuer has become increasingly susceptible to  event risks.

FACTORS THAT COULD LEAD TO AN UPGRADE

Moody's would likely upgrade the rating in the event of further  reforms that were to raise economic competitiveness and institutional  credibility and effectiveness beyond Moody's current expectations.  This would in part materialize through greater levels of private  investment, reduced banking system risk, and increased transparency  of and trust in institutions, including in the judiciary.  A  structural narrowing of the current account deficit and improvement  in Armenia's external position, including through higher  competitiveness and foreign direct investment, would also contribute  to upward pressure on the rating. An increase in government revenue  arising from fiscal reforms beyond Moody's expectations, that would  support the government's debt carrying capacity, would additionally  put upward pressure on the rating.

A durable easing of tensions with neighboring countries that leads to  a material reduction in geopolitical risks and greater economic  connectivity would also be credit positive.

FACTORS THAT COULD LEAD TO A DOWNGRADE

Moody's would likely downgrade the rating if there was a loss of  reform momentum, which would likely transpire through weaker  confidence in institutions and fiscal slippage removing prospects  that the government debt burden will decline over the medium term.

An increase in external vulnerability risk, such as a sustained  increase in current account deficits that resulted in declining  foreign exchange reserve adequacy and/or significant depreciation of  the local currency, would additionally contribute to macroeconomic  and financial stability risks and put downward pressure on the  rating. An escalation of tensions with Azerbaijan over the  Nagorno-Karabakh territory and border demarcation into full-scale  conflict would also put negative pressure on the rating.