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High Reliance On Russia Could Increase Economic Risk For Armenia's Banking System

This report does not constitute a rating action.

FRANKFURT (S&P Global Ratings) May 23, 2022--Following a recent review, S&P Global Ratings says that it is keeping its Banking Industry Country Risk Assessment (BICRA) of Armenia's banking sector in group '8'. Our BICRAs are on a scale of '1' to '10', with '1' denoting the lowest risk and '10' the highest.

In our view, economic risk for Armenian banks could potentially rise, due to weakening economic prospects for Russia, Armenia's most important trading partner, as a result of the conflict that started when Russian troops entered Ukraine in February 2022. Our baseline assumption is that the most acute impact of the war on key commodity markets, supply chains, and global confidence would occur in the first and second quarters of this year, with a lingering but lesser impact after that. Given the highly fluid and uncertain situation, the consequences for Armenia will be varied. Therefore, we now view the economic risk trend for Armenian banks as negative rather than stable.

Armenia has very strong economic ties with Russia, which accounted for about 40% of Armenia's foreign direct investment, about 28% of its exports, about 37% of imports, and about 41% of its remittances in 2021. A sharp recession in Russia in 2022 will have a negative impact on Armenia, reducing its real GDP growth to 1.3% this year versus our previous expectation of 4.7%. We forecast that GDP growth in Armenia will rebound and average 4.3% in 2023-2025, supported by robust domestic demand and ongoing growth of the services sector, including tourism and information technology. Russia serves as Armenia's security guarantor in Nagorno-Karabakh. Armenia is a member of the Collective Security Treaty Organization, which includes Russia and Belarus. At the same time, unresolved tensions between Armenia and Azerbaijan could become a source of political instability and social unrest.

Under our base-case scenario, Armenia will remain in an expansion phase this year. We expect inflation-adjusted growth of credit and real estate prices to be in the low single digits. We view credit risk as a weakness for the Armenian banking sector, taking into consideration the sector's much higher average amount of loans denominated in foreign currency (about 45% as of March 31, 2022) than that of peers, including to unhedged retail borrowers and companies; and its still-developing judicial and legal systems. We expect nonperforming loans could rise to 4.5%-5.5% over the next 24 months, from 3.7% at year-end 2021, due to the negative effect on borrowers that have business ties with Russia. We expect the cost of risk to remain elevated at about 1.5%-2.0% in 2022-2023.

Banking industry risks remain high in Armenia. We believe that Armenia's banking regulation and supervision compare well with those in peer countries in the Commonwealth of Independent States, but are weaker than those of other international banks. Nevertheless, we expect the Armenian banking system to remain stable despite some links to Russia, and market distortions to not increase materially. The Armenian banking system's exposure to Russia is mainly through correspondent relationships with Russian banks and financing of domestic exporters and importers trading with Russian counterparties. The subsidiary of sanctioned Russian bank VTB, which accounts for about 5% of the Armenian banking system's loans and about 8% of its deposits, continues to operate without restrictions in Armenia.

We expect continued pressure on net interest margins and an elevated cost of risk to strain profitability. We expect nonresident deposits and external debt will continue to account for a sizable share of Armenian banks' funding. We believe that, following an outflow of about 20% in 2021, nonresident deposits will remain broadly stable, comprising deposits from the Armenian diaspora and a temporary influx of Russian residents to Armenia due to the military conflict. We continue to see the industry risk trend as stable.

Armenia--BICRA Score Snapshot
To From
BICRA group 8 8
Economic risk 8 8
Economic resilience Very high risk Very high risk
Economic imbalances Intermediate risk Intermediate risk
Credit risk in the economy Extremely high risk Extremely high risk
Trend Negative Stable
Industry risk 8 8
Institutional framework Very high risk Very high risk
Competitive dynamics High risk High risk
Systemwide funding Very high risk Very high risk
Trend Stable Stable
*Banking Industry Country Risk Assessment (BICRA) economic risk and industry risk scores are on a scale from 1 (lowest risk) to 10 (highest risk). For more details on our BICRA scores on banking industries across the globe, please see "Banking Industry Country Risk Assessment Update," published monthly on RatingsDirect.

Related Criteria

Primary Credit Analyst:Annette Ess, CFA, Frankfurt + 49 693 399 9157;
Secondary Contact:Natalia Yalovskaya, London + 44 20 7176 3407;
Additional Contact:Financial Institutions EMEA;

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