State-owned International Bank of Azerbaijan’s default on its debts is expected to cause extensive damage to the country’s financial sector and its international reputation, and could even imperil Baku’s search for funding for the landmark Southern Gas Corridor project.

IBA, Azerbaijan’s largest bank, announced on May 11 that it would halt foreign currency-denominated loan repayments in order to restructure its forex obligations and swap them for sovereign debt. The state-owned bank appears to be trying to put pressure on its creditors ahead of the restructuring. It has $3.33bn of outstanding debt, with US-based food giant Cargill and Citibank amongst its largest creditors, according to a list shown to bne IntelliNews.

The announcement was a shock because the struggling bank was rescued by the state in 2015 and was being recapitalised and cleaned up prior to a planned reprivatisation. That the bank has now defaulted demonstrates how severe its problems are – and how opaque its financial reporting was – and could also indicate that the state sovereign wealth fund Sofaz is not as liquid as previously thought.

While Azerbaijan's oil-dependent economy has been in recession for the last year and a half – and is expected to remain in recession this year – Baku sits comfortably on $33bn worth of reserves tucked away in Sofaz. Given the fact that the Azerbaijani government has already spent upwards of $6bn since 2015 on cleaning up IBA's bad assets and recapitalising the bank, that it would delay the repayment of hundred-million-dollar loans and affect the country’s thus-far impeccable reputation as a good borrower is perplexing.

Bankers and IBA clients are now waiting on tenterhooks for Khalid Ahadov, IBA's chairman, to give a much-awaited interview on May 16, during which he is expected to shed light on the lender's problems. More information should be revealed on May 23, when IBA is to present its debt restructuring plan in London, which has been prepared with the help of White & Case and Lazard.

There will also be unwelcome foreign publicity on the bank's woes at a court hearing on June 7 in New York, where IBA filed a petition under chapter 15 of the US bankruptcy code to keep creditors from pursuing legal action against it while it is restructuring its business. 

Since the default, yields on IBA’s Eurobond have shot up from 5% to 14.18%, before levelling off at 12.36%. Fitch Ratings downgraded IBA from 'BB' to ‘CCC’ on May 15, while Moody's downgraded it to Caa3, four notches above default. Fitch Ratings said a full default was now "a real possibility".

The expectation, a banking source told bne IntelliNews, is that the default of IBA – which accounts for more than a third of banking sector assets – would further contribute to the depreciation of the local currency against the dollar; that it would affect local banks' ability to raise foreign capital; and that it would create a “moral hazard in the system” and a deposit outflow from the banking sector.  All eyes are now on a biweekly currency auction scheduled for May 16, which will provide the first opportunity for other lenders to react to the IBA crisis.

The beginning

IBA's woes can be traced back to March 2015, when its then-chairman Jahangir Hajiyev – seen  as a promising young banker who could become central bank governor – quit unexpectedly citing health reasons. In the weeks after his resignation, IBA unravelled.

The bank's borrowing and lending modus operandi, which had consisted of borrowing in foreign currency and lending domestically in manats, had become insupportable following a 35% depreciation of the manat in February. The cost of servicing the bank's external debt reportedly increased by 20% straightaway after the depreciation. In the ensuing months, a snowball effect of further depreciations and defaults on loans pushed the rate of non-performing loans in IBA's asset portfolio up to 80%.

Azerbaijani authorities took over IBA, increasing their share in the bank from 51% to 81% by injecting some AZN600mn (€324mn) worth of capital to recapitalise the lender and absorbing AZN10bn worth of bad assets through state financial institution Aqrarkredit. 

Officials then started talking about privatisation. In November, Rufat Aslanli, chairman of Azerbaijan's financial markets regulator, said that the government was mulling an early privatisation for the lender as soon as it cleaned up its balance sheet.

But the process lacked transparency and many were left in the dark about the extent of the problems at IBA.  Fitch Ratings, upon finding out that Baku had actually spent three times more than it had originally anticipated on cleaning up the lender's balance sheet, downgraded the bank's viability rating to 'f' in November 2016.

The IBA scandal landed not only Hajiyev in jail – he is being tried for embezzlement and abuse of power while in detention – but also some of the most prominent businessmen in Baku, who had been accused of taking out loans from IBA that they had no way of repaying.

Among them were Ibrahim Nehramli, a quixotic tycoon who has been trying to build an ecosystem of glitzy islands and a 1km-high tower off the shores of Baku; Nizami Piriyev, former owner of the largest methanol plant in the country, Azmeco (the company has since been taken over by state-owned oil company Socar), and reportedly a friend of former British prime minister Tony Blair; Rashad Mammadov, co-founder of construction company Azimport and head of the State Flag Square Complex, a large plaza on Baku's seaside promenade; and Mehdi Aliyev, director of construction company Azerinshaat.

The IBA crisis in 2015 was only a foretelling of what was to follow. As the economy contracted by 3.1% in 2016 on the back of low oil and gas prices, Azerbaijan withdrew the licenses of a dozen smaller banks that it deemed insufficiently capitalised or in violation of prudential norms, exposing how IBA's loss-making business model had been used across the board in the banking sector. A further dozen small banks out of the 32 remaining are believed to experience financial troubles, after failing to meet the February deadline to submit their financial reports to the regulator. 

According to Fitch ratings, the ratio of non-performing loans in the sector climbed to 21% in 2017, as borrowers defaulted on foreign currency-denominated loans in increasing numbers. As trust in the currency and banking system collapsed and public spending tanked, generating new business to cover previous losses became ever more difficult. Even previously strong banks, such as Accessbank, which is partly owned by international financial institutions (IFIs), succumbed to the crisis earlier this year. 

Worst time

The short-term repurcussions of the default are still being felt. In response to IBA's May 11 announcement, Fitch Ratings downgraded the bank swiftly to 'CCC' on May 15 and placed it on an evolving rating watch. According to its report, "the downgrade of IBA's ratings reflects Fitch's view that default is a real possibility, either because the restructuring of senior obligations will constitute a distressed debt exchange under Fitch's criteria or there will be a significant extension of the moratorium on servicing obligations prior to the restructuring being completed".  

IBA's overall profile remains very weak, the report adds, due to negative equity, negative pre-impairment performance and a large short open currency position, which exposes the bank to substantial risks and results in liquidity mismatches.

In its May 11 announcement, IBA revealed that it was expecting losses of AZN1.9bn for 2016, despite the fact that it registered a profit in the first quarter of 2017.

In a telephone interview earlier this year, Dmitri Vasiliev, primary analyst at Fitch Ratings, told bne IntelliNews that IBA would still need substantial state support even after its balance sheet was cleaned, because the operating environment for banks remains difficult in Azerbaijan.

"Even after these measures are taken, IBA may remain structurally lossmaking in the near term, in the absence of insufficient loan production,” he said. “The bank has significant foreign liabilities, large amounts of funding from local depositors, and after it sells the remaining problem loans to the authorities, IBA will need to build up a new loan book. But there is currently limited visibility about IBA's new lending strategy, as the demand for credits is limited given the slowdown in the economy."

Much of this year's projected government deficit, expected to amount to 8.4% of GDP, is due to the funds provisioned to support the banking sector, primarily IBA. The price tag could now be even higher.

IBA's default on foreign loans comes at the worst time possible for Azerbaijan, as it could severely impact its ability to raise further capital from banks and international financial institutions (IFIs) for its landmark gas project, part of the Southern Gas Corridor project.

The project, which comprises offshore developments at the Shah Deniz II gas field and a network of three interconnected pipelines spanning the Caucasus, Turkey and Southern Europe, has been touted as a key piece in the puzzle of European energy diversification away from Russia.

Several governments – most notably Turkey's and Azerbaijan's, but also Georgia's, Greece's, Italy's, Albania's – as well as energy companies – BP, Socar, Turkey's Botas – are working on financing and constructing the $40bn project in order to ensure it is completed on time by 2019. Offshoot projects meant to connect the new gas corridor to smaller markets are being mulled in several Balkan countries.

Over the past year, Baku has asked the Asian Development Bank (ADB) for a $1.5bn loan for the gas project ­– it received $500mn in May– the World Bank for a $500mn loan, and the European Bank for Reconstruction and Development and the European Investment Bank for a €1.5bn loan, which is currently under consideration. Azerbaijan was also considering issuing a third Eurobond to raise another $1bn for the pipeline, following a successful issuance of a $1bn Eurobond in March 2016 and of a $1.2bn sovereign Eurobond in 2014.

Big debts

bne IntelliNews has been shown a list of the creditors that could be affected by the default. Cargill is top of the list.

On April 12, the bank defaulted on four loans worth $294.6mn that it owed to Cargill Trade and Structured Finance, the food giant’s trade finance arm. Neither IBA nor Cargill disclosed the fact at the time. In total, Cargill extended IBA 11 loans worth some $714.8mn. In addition to the four loans that matured on April 12, IBA is to repay another three loans to Cargill worth some $163mn by year-end, and four more in 2018 and 2019.

In an emailed statement to bne IntelliNews, the food company said: “Cargill is bound by confidentiality arrangements with its market counterparties and customers. As such, we are unable to provide any details of transactions that may have occurred and that have been reported on in the media.”

Citibank is IBA's second largest lender, having acted as an agent for a $205mn syndicated loan expected to mature on October 31 and as a trustee of the bank's $500mn Eurobond that will mature in June 2019.

IBA has also defaulted on repaying a $100mn loan to Rubrika Finance, a company owned by one of Ireland's richest men, Martin Noughton.

The list of large foreign creditors made available to bne IntelliNews also contains Credit Suisse, which acted as agent on five loans worth cumulatively $254mn and €28mn; UK's Emerald ($250mn private placement that matures in October 2024); and Tanzania's FBME Bank ($111mn bilateral loan). Among the less exposed creditors are Germany's Commerzbank, Landesbank Berlin and Bayerishe Landesbank; Italy's Banco Popolare, Intesa Sanpaolo and Banca Monte dei Pasci di Siena; Russia's Sberbank; the Netherlands' Rabobank and France's Societe Generale.