S&P upgrades Armenia`s sovereign rating to `BB-` with `Stable`  outlook, expecting 7.5% GDP growth in 2023

ArmInfo.On Aug. 25, 2023, S&P Global Ratings raised its long-term foreign and local currency  sovereign credit ratings on Armenia to 'BB-' from 'B+' and affirmed its short-term foreign and local currency sovereign credit ratings at 'B'. The outlook is stable.  

S&P also agency revised Armenia's  transfer & convertibility assessment to 'BB' from 'BB-'. S&P Global  Ratings reports, indicating  that the stable outlook balances  Armenia's strong economic growth prospects and improved fiscal  balance sheet against its moderately weak external position and  elevated geopolitical risks.  Rationale for Upgrading Armenia's  Sovereign Rating

The Agency also notes that the stable outlook balances Armenia's  strong economic growth prospects and improved fiscal balance sheet  against its moderately weak external position and elevated  geopolitical risks.  S&P analysts noted that th The upgrade reflects  the improvements in Armenia's GDP per capita and fiscal performance.  The country's close geographic, economic, and cultural ties with  Russia have positioned it as one of the preferred destinations for  Russian individuals and businesses seeking refuge from their home  country's economic and political stresses. As a result, migrant and  capital inflows have propelled economic growth, with real GDP in  Armenia increasing by 12.6% in 2022, and have narrowed Armenia's  persistent fiscal and current account deficits. Financial inflows  also resulted in a 22% appreciation of the Armenian dram against the  U.S. dollar in 2022.  This substantial currency appreciation has  helped to shrink the government debt stock in U.S. dollar terms.   Tensions between Armenia and Azerbaijan over the disputed region of  Nagorno-Karabakh have also reduced, with a shaky peace deal so far  holding up.

"A sharp reversal in financial and labor inflows into Armenia from  Russia within the next few years appears unlikely.  Firstly, the  ongoing Russia-Ukraine war seems protracted and, even if a settlement  is achieved, sanctions and stresses on the Russian economy are likely  to linger. Secondly, anecdotal evidence from Russian emigrants  suggests they have no immediate plans to return home from Armenia,  and alternative destinations for them are limited. Barring extreme  scenarios--such as a new direct military conflict with Azerbaijan--we  expect Armenia's economic growth prospects in the coming years to  remain robust, with projected real-term growth of approximately 7.5%  in 2023 and averaging 4.0% in 2024-2026. Moreover, we anticipate that  the country's external and government balance sheets will remain  stronger than pre-war levels.

Our ratings on Armenia are constrained by weak, albeit improving,  institutional settings, moderately low income levels, weak external  and fiscal positions, and its exposure to geopolitical and external  security risks. The ratings are supported by Armenia's strong growth  outlook, continued availability of external official funding, and a  prudent macroeconomic policy framework that has helped preserve  economic and financial stability in recent years despite multiple  external shocks.  Institutional and economic profile: Economic growth  is set to slow in 2023 on base effects but will otherwise remain  robust until 2026

-We anticipate that moderating financial and migrant flows will  result in real GDP growth decelerating to 7.5% in 2023 from 12.6% in  2022.

-Inflows of capital and labor could significantly boost Armenia's  medium-term economic growth rate to approximately 4%-5% per year in  real terms.

-External security threats stemming from the Nagorno-Karabakh region  conflict continue to pose a risk. However, the recent increase in  momentum in peace talks is positive in addressing and mitigating the  potential threat of conflict.

After a stellar year for Armenia's economic output in 2022, we expect  growth will slow but remain at a robust 7.5% in 2023. This mild  slowdown can be attributed to weaker external demand, more  restrictive financial conditions, and moderating financial and  migrant inflows.

Last year, spillovers from the Russia-Ukraine conflict helped  Armenia's economy to expand significantly by 12.6%.  This surge is  primarily attributed to inward migration from Russia, which boosted  the economy through various channels. A substantial portion of  migrants from Russia are skilled and young IT professionals. As such,  the influx of skilled labor, coupled with the establishment of over  1,000 foreign-owned companies, has contributed significantly to the  growth of sectors such as IT, which expanded by 51% in 2022 (the  country's most productive sector).  Significant financial inflows,  particularly through money transfers from Russia, have also benefited  Armenia's economy. Gross inflows of money transfers from Russia  equated to 18.4% of Armenia's GDP in 2022, up from 6.2% in 2021.  However, these transfers have begun to stabilize in recent months,  which we expect to continue given that immigration flows have  dissipated. Migration from Russia has also boosted Armenia's  catering, real estate, and transportation sectors. In 2022, Armenia  received 1.67 million tourists, though this is still 14% below 2019  levels. That said, tourism remains strong, with a 79% increase in  arrivals in the first quarter of 2023, compared with the same period  last year. Despite the recent appreciation of the Armenian dram  against the U.S. dollar reducing tourists' purchasing power, we  expect tourism levels to remain robust.

Russia remains a key trader partner for Armenia. In 2021, 28% of the  country's total exports went to Russia, surging to 45% in 2022,  largely due to the Russia-Ukraine conflict and Russia's diminished  trading opportunities. However, distinguishing between  Armenian-origin exports and re-exports via Armenia is challenging due  to limited data.  Exports to Russia have begun to stabilize and we  anticipate this will continue due to Russia's weaker economic  prospects and the implementation of stricter Armenian export controls  on certain product categories such as semiconductors.

From 2024, Armenia's growth outlook could face several possible  challenges. Firstly, labor and capital inflows from Russia could  reverse. However, this seems unlikely in the near-term as recent  domestic political and economic stresses in Russia are reducing the  incentives for its citizens to return. Secondly, a sharp slowdown in  economic growth in Russia and the EU, which are key trading partners  for Armenia, could weigh on Armenia's own economic growth prospects.  Lastly, persistent external security risks along the  Armenian/Azerbaijan border could spill over into Armenia and affect  economic performance. Nevertheless, we note that the recent increase  in human and financial capital could strengthen Armenia's potential  growth rate. In our base-line scenario, we anticipate an average  annual real GDP growth rate of around 4% until 2026.

Tensions between Armenia and Azerbaijan have persisted over the  disputed Nagorno-Karabakh region since fighting reignited in November  2020, leading to some territorial gains for Azerbaijan. Since then,  besides the occasional flareup--including a bout of fighting in late  2022--the situation has largely been contained. The U.S. and the EU,  and separately Russia, have been encouraging both countries to pursue  a peace agreement. Armenia recently stated it is ready to recognize  Nagorno-Karabakh as a part of Azerbaijani territory with certain  conditions.  Given this development, recent months have shown some  momentum in peace talks, raising the possibility of an agreement in  the medium term. However, given Nagorno-Karabakh's historical  significance, any peace deal will likely face public opposition in  Armenia; previous peace negotiations with Azerbaijan sparked protests  against the government. Such political tensions could escalate and  influence the government's policy direction.

Flexibility and performance profile: The budget deficit is set to  widen this year, but will narrow thereafter as the authorities  prioritize fiscal prudence

-In our view, the budget deficit will increase to 2.8% of GDP in 2023  and then narrow gradually in the subsequent periods.

-We therefore expect  net general government debt is estabilize at a  moderate 42% of GDP through 2026.

-Armenia's current account deficit will widen to 2.0% of GDP in 2023,  from a modest surplus of 0.8% in 2022, but then shrink in 2024-2026.

The government targets a budget deficit of 3.1% of GDP in 2023,  widening from an estimated 2.4% in 2022. The 2023 budget target  encompasses an economic growth forecast of 7% in real terms. We  estimate a significantly smaller budget deficit of 2.8% of GDP given  strong growth this year. Beyond 2023, we expect gradual consolidation  on the back of the government's efforts to improve revenue collection  and increase compliance with fiscal rules, resulting in average  annual general government deficits of 2%-3% of GDP through 2026. We  expect the three-year stand-by arrangement (SBA) program with the IMF  will underpin the fiscal path.

Armenia's net government debt-to-GDP ratio declined to 42% in 2022  from 54% in 2021. This was driven by a lower-than-planned budget  deficit, a 22% appreciation of the dram against the U.S. dollar, and  high nominal GDP growth of 22%. We expect net general government debt  levels to remain relatively stable given our fiscal projections,  averaging 42% of GDP in 2023-2026.

Armenia is somewhat insulated from the effect of high energy prices.  The country's economy relies heavily on natural gas (61%) as its  primary energy source, with a smaller dependence on oil (12%). Russia  supplies most of Armenia's natural gas (85%) through long-term  contracts, which helps protect Armenia from the effect of the  elevated spot prices experienced in 2022.

Despite recent improvements, Armenia's balance of payments position  currently remains pressured. The country has run current account  deficits consecutively in recent years, translating into a sizable  net external liability position of some 87% of current account  receipts (CAR). Owing to lower external demand (for both goods and  services) and lower inward remittances, we expect the current deficit  to widen to 2.0% of GDP in 2023, from a surplus of 0.8% in 2022. We  project the current account deficits will be financed through a  combination of government external borrowing (mostly concessional),  net foreign direct investment inflows. As a result of this funding  mix, Armenia's external debt net of liquid external assets (narrow  net external debt--our preferred measure of external leverage) is set  to gradually increase in the medium term to 52% of CAR, but to stay  below 100% of CAR.

In December 2022, the IMF approved a $171 million 36-month SBA for  Armenia as a precautionary measure to protect against  balance-of-payments shocks. The first review of the program was  completed recently, granting Armenian authorities access to an  additional round of funds. The authorities continue to treat the  program as precautionary (and have made no withdrawals to date).

Armenia's official reserves reached $4.1 billion in June, up 16%  compared with the same period last year. Reserves have generally  increased on the back of the Central Bank of Armenia's (CBA)'s net  purchases of foreign currency (FX) last year to absorb excessive FX  inflows, stemming from higher tourist arrivals and significant  capital and remittances transfers. We expect the dram to begin to  depreciate as the current account deficit widens and transfers slow.  That said, we expect the exchange rate to act as a key shock absorber  and the FX reserve buffer to remain broadly stable.

Inflation peaked at approximately 10% in mid-2022 but has since  transitioned into deflation, decreasing to -0.5% in June. Among other  factors, the decrease can be attributed to base effects, the  appreciation of the dram, and the CBA's tight monetary policy stance.  From 2024, robust consumer demand fueled by tourist arrivals and a  tight labor market may cause inflation to rise. However, we  anticipate these risks will be contained by the CBA's restrictive  monetary policy stance and the lagged impact of the dram's  appreciation on prices. Therefore, we project inflation to average  2.5% this year, below the CBA's inflation target (of 4%). Our  inflation outlook leads us to expect the CBA will continue to  gradually reduce its benchmark policy rate.

We classify the banking sector of Armenia in group '8' under our  Banking Industry Country Risk Assessment, with an economic risk score  of '8' ('1' denotes the lowest risk and '10' the highest) and an  industry risk score of '8'.  Armenia's banking sector appears well  capitalized, profitable, and liquid. Its direct exposure to Russia  and Ukraine is relatively moderate, and nonperforming loans remain  low at 2.6% as of May 2023. Risks remain around the mortgage market,  which has grown by roughly 30% over the last year, alongside rising  house prices. In response to potential pain points, the authorities  increased the countercyclical capital buffer and introduced  loan-to-value ratios.  Another macroprudential tool set to be used is  a draft law restricting U.S. dollar mortgage lending. Overall, the  risk to the government of contingent liabilities from the banking  sector remains limited."