Monday, February 26 2024 15:37
Karine Melikyan

S&P affirms Armenia`s sovereign rating at `BB`; Outlook Stable,  projectting GDP growth of 6.2% in 2024

S&P affirms Armenia`s sovereign rating at `BB`; Outlook Stable,  projectting GDP growth of 6.2% in 2024

ArmInfo. S&P Global Ratings affirmed its 'BB-/B' long- and short-term foreign- and local-currency sovereign credit ratings on Armenia. The outlook on the long-term ratings is stable.

This is noted in the message from S&P Global Ratings, which states,  in particular:

Overview

We project Armenia's real GDP growth will moderate to 6.2% in 2024,  from an annual average of 11.0% in 2022-2023, as migrant and  financial inflows from Russia ease.

The budget deficit will likely rise to 4.3% of GDP in 2024 on  increased expenditure related to refugees from the Nagorno-Karabakh  region, leading us to anticipate a slight uptick in Armenia's  moderate government debt levels over the coming three years.

We see persisting security and geopolitical risks stemming from the  pending peace deal with Azerbaijan and gradually deteriorating  relations with Russia that could affect the substantial economic ties  between the two countries.

We affirmed our 'BB-/B' long- and short-term sovereign credit ratings  on Armenia. The outlook is stable.  Rating Action

On Feb. 23, 2024, S&P Global Ratings affirmed its 'BB-/B' long- and  short-term foreign- and local- currency sovereign credit ratings on  Armenia. The outlook on the long-term ratings is stable.  Outlook

The stable outlook reflects a balance between Armenia's favorable  economic growth prospects over the next year and comparatively modest  net general government debt, against existing balance of payments  vulnerabilities and elevated geopolitical risks.

Upside scenario

We could take a positive rating action should Armenia's fiscal or  external balance sheets are stronger than our current expectations  while geopolitical risk remain contained.

Downside scenario

We could lower the ratings if a pronounced reversal in accumulated  financial and labor inflows from Russia slows growth, causes exchange  rate depreciation, and weakens fiscal and external balance sheets.  Additionally, although it is not our base-case scenario,  repercussions from escalating geopolitical tensions with either  Azerbaijan or Russia could constrain the ratings.

Rationale

Armenia faces a complex economic and political landscape,  characterized by the recent influx of immigrants from Russia and  Nagorno-Karabakh amid geopolitical uncertainty. Recent developments  include:

Tensions with Azerbaijan over the delimitation of borders and the  establishment of a transit corridor, following the transfer of  control of the previously disputed Nagorno-Karabakh region to  Azerbaijan in September 2023.

Armenia has started to reassess its security alliances, including  with Russia, and strategies by exploring closer ties with Western  partners and reevaluating military collaborations to adapt to  evolving regional dynamics.

Fiscal pressures are intensifying as the authorities increase  spending to accommodate the recent influx of refugees from  Nagorno-Karabakh. Nevertheless, Armenia's prudent fiscal management,  in our view, keeps net general government debt at modest levels.

Absent the significant escalation of geopolitical tensions, Armenia's  economic prospects remain strong, reflecting higher productive  capacity on the back of capital and labor inflows into the domestic  information and communication technology (ICT) sector.

Our ratings on Armenia are constrained by weak, albeit improving,  institutional settings, moderate per capita income levels, as well as  balance of payments and fiscal vulnerabilities. Armenia's exposure to  geopolitical and external security risks also constrains the ratings.

The ratings are supported by Armenia's strong growth outlook, its  continued availability of external official funding, and a prudent  policy framework that has helped preserve economic and financial  stability in recent years despite multiple external shocks.

Institutional and economic profile: The economy will likely  decelerate in 2024 compared with the high average real growth rate of  10.7% over 2022-2023

We project real GDP growth will slow to 6.2% in 2024, from 8.7% in  2023, because of weaker external demand and a decrease in migrant and  financial inflows.

Despite the cessation of conflict in Nagorno-Karabakh, tensions  between Azerbaijan and Armenia remain.

Emerging tensions between Armenia and Russia could introduce an  additional layer of uncertainty, given the country's substantial  economic and energy dependence on Russia.

We expect Armenia's real GDP growth to ease to 6.2% this year from a  high 10.7% on average in 2022-2023; this was the third highest growth  rate among the 137 sovereigns we rate. This slowdown is primarily due  to reduced demand from major external trading partners, base effects,  and the ebbing of Russian migrant and capital inflows. We project  domestic consumption will support growth on the back of a buoyant  tourism sector, positive real wage growth, and government fiscal  stimulus. We also expect investment to underpin growth, spurred by an  increase in government capital expenditure and construction  activities aimed at accommodating the recent influx of migrants from  the Nagorno-Karabakh region and those fleeing the conflict between  Russia and Ukraine. However, we anticipate a negative impact on  growth from net exports from weakening demand from main trading  partners, especially countries in the Commonwealth of Independent  States, such as Russia, which saw a surge in Armenian exports last  year.

Although Russian labor and capital inflows to Armenia have  decelerated from their peaks in 2022 and early 2023, the risk of a  sharp reversal has diminished, in our view. This is due to prevailing  domestic political and economic uncertainties in Russia that are  reducing the incentives for its citizens who left to return.  Moreover, a considerable number of migrants from Russia who now  reside in Armenia are employed in the ICT sector, continuing to serve  global clients. Their return to Russia could disrupt their business  activities.

As a result, we project Armenia's economy will expand by a high  annual rate of about 5% on average through to 2027, partly reflecting  higher productive capacity on the back of capital and labor inflows  into the domestic ICT sector. This growth rate is higher than in the  decade preceding the pandemic.

That said, uncertainty persists around Armenia's growth prospects in  the next few years.  Downside risks stem from the global  macroeconomic developments and, more importantly, persistent regional  geopolitical volatility.

Tensions between Armenia and Azerbaijan over the previously disputed  Nagorno-Karabakh region date back to the early 20th century and  intensified following the dissolution of the Soviet Union. A full war  lasted six weeks in September-November 2020. More recently, in  September 2023, Azerbaijan undertook a military offensive against  Nagorno-Karabakh with a ceasefire agreement brokered just one day  after the conflict's onset, effectively transferring Nagorno-  Karabakh to Azerbaijani control. A mass exodus ensued, with over  100,000 residents seeking refuge in Armenia.

Despite the cessation of military conflict, geopolitical tensions  persist between Armenia and Azerbaijan, notably over the delimitation  of borders and the establishment of a transit corridor.  Although  Azerbaijan has control over the region, neither Azerbaijan nor  Armenia have fully agreed on the bilateral borders, and ongoing  discussions have yet to yield a definitive peace deal. Key among the  unresolved issues is Azerbaijan's pursuit to create a corridor  through Armenia's Syunik Province to link with its exclave,  Nakhichevan, despite proposals for an alternative route through Iran,  known as the Aras corridor. There are additional initiatives  underway, including "Crossroads of Peace."

Further complicating the regional security settings are emerging  tensions between Armenia and Russia. Issues are partly related to  Russia's reluctance to intervene in the Nagorno-Karabakh conflict,  despite having peacekeepers in the region. This situation has led  Armenia to express dissatisfaction with the effectiveness of Russian  peace-keeping efforts in Nagorno-Karabakh, particularly after  Azerbaijan imposed a blockade on the sole land corridor between the  disputed region and Armenia in December 2022. Since then, Armenia has  been reconsidering its previous security strategy, cancelling  military drills with the Russia-led Collective Security Treaty  Organization (CSTO), and exploring closer ties with the West,  including holding joint military exercises with the U.S. These  developments could reflect Armenia's strategic shift toward enhancing  its international alliances and strengthening defense capabilities  and diplomatic ties amid changing regional dynamics.

In our opinion, these developments would underpin a level of  geopolitical uncertainty for Armenia given its significant economic  and energy reliance on Russia. In 2023, approximately 40.0% of  Armenia's total exports were directed to Russia, while about 31.5% of  imports originated from Russia. Additionally, almost 70% of  remittances came from Russia, underscoring the financial  interconnections between the two countries. This dependency extends  into the energy sector as well, with Russia supplying almost 90% of  Armenia's natural gas through pipelines (which constituted 60% of the  country's total energy needs in 2022).

Flexibility and performance profile: The budget deficit will likely  widen this year before narrowing as refugee-related spending  decreases

We expect the budget deficit to increase to 4.3% of GDP in 2024, from  an estimated 2.2% in 2023, primarily due to increased spending on  refugees from the Nagorno-Karabakh region.

Net general government debt will increase to a still-moderate 44% of  GDP through 2027, from an estimate of 40% in 2023.

After peaking in August 2023, the Central Bank of Armenia's (CBA's)  foreign reserves have gradually declined due to government external  debt repayments.

The government has set a budget deficit target of 4.6% of GDP for  2024, an increase from the previous year's estimated level of 2.2% of  GDP. This expansion in the fiscal deficit is primarily attributed to  elevated capital expenditure and increased defense spending.  Additionally, a notable allocation within the budget is the  approximately 1.5% of GDP to cover housing, utilities, and one- time  stipends, among other expenses, for refugees from the  Nagorno-Karabakh region. The authorities plan to finance these  expenditures by repurposing about 1.5% of GDP from the funds Armenia  previously provided to the Nagorno-Karabakh government in the form of  budget loans.  We anticipate a general government fiscal deficit of  4.3% of GDP which is slightly below the government's projection. This  expectation is based on the government's record of underusing funds  allocated for capital expenditure.

In late 2023, following the ceasefire in the Nagorno-Karabakh region,  the Armenian government opted to directly assume 70% of the debts  owed by the authorities, entities, and individuals in  Nagorno-Karabakh to Armenia's financial institutions, totaling AMD  315 billion (about 2.4% of GDP).

Over the medium term, we anticipate the authorities will adhere to a  fiscal consolidation strategy.  As a result, we expect the budget  deficit to decrease, averaging 3.4% of GDP in 2024-2027.   Consequently, we project general government debt net of liquid assets  will average a moderate 44% over the same period. Approximately 54%  of the government's debt is denominated in foreign currency (FX),  making Armenia's debt stock susceptible to exchange rate  fluctuations.  However, a considerable portion of the FX-denominated  debt is from bilateral lenders and International Financial  Institutions (IFIs), granted at concessional and fixed interest  rates.

Despite recent improvements, Armenia's balance of payments position  remains vulnerable. The country has recorded consecutive current  account deficits in recent years (except for 2022), leading to a net  external liability position of approximately 90% of current account  receipts (CAR).  With external demand moderating, imports rising, and  inward remittances falling, we anticipate the current account deficit  will expand to 3%-4% of GDP in the coming years, up from a small  deficit of 0.3% in 2023. We forecast that the current account  deficits will be financed through a combination of government  external borrowing and net foreign direct investment inflows. We  expect this financing mix will result in Armenia's narrow net  external debt as a percentage of CAR remaining near 50%.

In late 2022, the IMF approved a $171 million Stand-By Arrangement  (SBA) for Armenia. This 36- month-long program was established to  safeguard Armenia against potential balance-of- payments  difficulties. Following the recent completion of the second review,  the Armenian authorities have been granted access to a cumulative  amount of $73.3 million. Despite the availability of funds, the  government continues to treat the SBA as precautionary financing line  and no withdrawals have been made so far. We believe the Armenian  government is leveraging the program to maintain confidence in its  commitment to economic reforms and fiscal discipline.

Foreign reserves stood at $3.6 billion in January 2024, marking a 3%  decrease from the same period a year earlier. Notably, reserves had  reached a peak of $4.2 billion in August 2023 largely due to the  CBA's net purchases of FX to absorb excess FX inflows. These inflows  were primarily driven by increased tourist arrivals and higher  remittances. However, reserves declined following sizable external  debt repayments, including the government's buyback of Eurobonds  worth $186.8 million in the second half of 2023. For the coming three  years, we expect reserves to remain broadly stable.

The consumer price index (CPI) in Armenia decreased by 0.9% in  January 2024, marking a pronounced reduction from the 8.1% a year  ago. This decline can be attributed to a combination of factors  including an appreciation of the dram leading to reduced import  prices and the CBA's tight monetary policy stance. We expect CPI to  rise and average 3.7% in 2024, spurred by base effects and a  potential weakening of the dram. We anticipate that average inflation  will return to the CBA's target of 4% in 2025. Given our outlook on  inflation, we expect the CBA to continue taking steps to gradually  decrease 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  adequately capitalized and fairly profitable with flows from Russia  fueling profitability over 2022-2023. Credit growth has been strong  over the past few years, particularly in second half of 2023 reaching  21% year over year on a currency-adjusted basis and resulting in  asset price appreciation, specifically real estate. The sector has  been stable from asset quality perspective with the exception of  exposures to the previous Republic of Nagorno-Karabakh, which have  been subsequently partially assumed by the government of Armenia."

According to the Central Bank's forecast, Armenia's GDP growth will  slow down to 6.1% in 2024. The IMF and the World Bank expect a more  noticeable slowdown in Armenia's GDP growth in 2024, to 5% and 4.7%,  respectively.

In particular, the World Bank, forecasting stable growth of 3.3% for  the South Caucasus region in 2024- 2025, expects that the influx of  remittances from Russia will continue to decline, and re-exports and  tourism will continue to support economic activity. However,  according to the World Bank, long-term growth will continue to be  hampered by dependence on raw materials, weak transport  communications and logistics, as well as the likelihood of escalation  of relations between Armenia and Azerbaijan.  According to IMF  expectations, in the medium term the growth of the Armenian economy  will reach its potential of approximately 4.5%. The IMF believes that  the authorities' efforts to increase labor force participation and  reduce structural unemployment, improve access to finance, diversify  exports and strengthen governance will improve economic resilience  and potential growth. 

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