Fitch affirms Armenia at 'BB-'; Outlook stable

 Fitch Ratings has affirmed Armenia's Long- term foreign and local currency Issuer Default Ratings (IDRs) at 'BB-'. The Outlooks are Stable.  The issue ratings on Armenia's senior unsecured foreign and local currency bonds have also been affirmed at 'BB-'. The Country Ceiling has been affirmed at 'BB' and the Short-term foreign currency IDR at 'B'.

According to Fitch Ratings's website, the affirmation of Armenia's sovereign ratings reflects the following key factors:

The general government deficit fell to 1.7% of GDP in 2013, against initial projections of 2.8%.  This was mainly due to under-execution and delays in the implementation of public investment.  The government expects the deficit to rise to 2.4% of GDP in 2014, although further under- execution is possible. The increase in public sector wages, effective from 1 July 2014, will increase public spending by about 0.4% of GDP in 2014 and 2015, but has already been budgeted for and will be compensated by an increase in tax collection.

The general government debt level is expected to remain stable at around 43%-44% of GDP in 2014-15, and could fall in 2016 if GDP growth picks up. However, with about 85% of public debt foreign-currency denominated, Armenia's debt profile is vulnerable to exchange rate shocks.  The administration's willingness to prioritise domestic financing will lead to a gradual pick-up in domestic issuance, where appetite for state bonds will be boosted by insurance and pension reforms. 

GDP growth slowed in 1H14, partly because of the slowdown of the Russian economy, but is expected to pick-up slightly in the second half to average about 4.5% for the year, mainly as a result of base effects and a pick-up in investment. Although the increase in public sector wages may have a positive impact on private consumption, the recurring under-spending of public investment will continue to act as a drag on domestic demand. Inflation is expected to remain close to the Central Bank's target of 4%.

Because of its high dependence on Russia in terms of gas supplies, remittances and military support, Armenia remains particularly vulnerable to developments and policy changes in Russia.  Despite the slowdown in Russia, remittances have held up. Net remittances account for about 15% of GDP, of which more than 80% come from Russia. Similarly, nearly 20% of Armenian exports are destined for Russia. The Armenian government has announced its intention to finalise negotiations for its accession to the Eurasian Economic Union, but diplomatic hurdles remain. 

The current account deficit (CAD) shrank slightly in 2013, but is expected to remain high at nearly 10% of GDP in 2014, partly because of the weak performance of the Russian economy.  The Central Bank of Armenia is allowing some exchange rate flexibility, but international reserves fell in 1H14, following pressure on the exchange rate and the still large CAD. Reserves are likely to decline slightly over the coming years. 

Armenia has benefited from a series of IMF programmes and has agreed a further USD128m extended fund facility for 2014-17, which will act as a policy anchor. Armenia has so far fulfilled most of the performance criteria. Armenia will continue to enjoy support from major international financial institutions, which have been instrumental in most large infrastructure projects. 

Armenia's geopolitical environment is a constraint on the rating. The latent conflict with Azerbaijan over the disputed Nagorno-Karabakh region entails the risk of escalating into a full- scale conflict. 
The Stable Outlook reflects Fitch's assessment that upside and downside risks to the ratings are currently well balanced. Consequently, Fitch's sensitivity analysis does not currently anticipate developments with a high likelihood of leading to a rating change. The main factors that, individually or collectively, could lead to positive rating action are:

-Further improvement in the CAD and a stronger reserve position.
-A substantial decline in the debt-to-GDP ratio would improve creditworthiness, especially given the strategy of relying more on relatively costly domestic issuance and the vulnerability of debt dynamics to external shocks, via the exchange rate.
-An easing of the tensions with Azerbaijan or an improvement in relations with other neighbouring countries.
The main factors that, individually or collectively, could lead to negative rating action are:
- A bigger than expected impact on GDP growth from economic and political developments in Russia.
- A sharp rise in net external debt and a weakening of reserves.
- Material slippage in the performance of public finances leading to a significant rise in the debt/GDP ratio.
The key assumptions are as follows:

The ratings and Outlooks are sensitive to a number of assumptions:

Fitch assumes continuation of good relations with Russia, given the importance of this relationship both economically and diplomatically.
Fitch assumes that a sharp downswing in metals prices is avoided. Mining exports, especially copper, account for about half of Armenia's goods exports.
Fitch assumes that Armenia continues to enjoy broad social and political stability, and that there is no significant worsening in tensions with Azerbaijan surrounding Nagorno-Karabakh.
Fitch assumes that the global economy performs broadly in line with Fitch's Global Economic Outlook and that the US Federal Reserve exit from monetary stimulus is orderly, so that Armenia retains external market access despite higher international financial volatility.