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BAKU, March 16 (Reuters) - Fitch Ratings sees a pick-up in Azerbaijan's economic growth this year, driven by signs of macroeconomic and exchange rate stability as well as a possible rise in capital spending.
The slide in the price of oil, which with gas accounts for about 75 percent of state revenues and 45 percent of gross domestic product, has hit growth, the budget, the balance of payments, the manat currency and foreign exchange reserves.
The ex-Soviet country's gross domestic product shrank by 3.8 percent year-on-year in 2016, after expanding 1.1 percent in 2015. But it has risen by 0.4 percent in the first two months of this year. The government expects the economy to grow by 1 percent in 2017.
"Our growth projection is 0.2 percent in 2017 and 1.7 percent in 2018," Paul Gamble, the senior director and head of emerging Europe department, told Reuters.
He said that one of the drivers for growth to pick up would be "gradual improvement in confidence, when you get more of a degree of macroeconomic stability".
"We should also see more stability in the exchange rate ... coming through the clean-up of the banking sector."
Fitch sees the manat average rate to be around 1.76 per dollar in 2017 and 1.70 in 2018.
Gamble said that other factors contributing to the economic growth might be pick-up in tourism and stabilisation or even slight increase in capital spending this year.
Gamble said inflation expectation remained uncertain, although "lower imported inflation was likely to bring inflation down".
Fitch forecasts annual inflation in Azerbaijan to decline to 9 percent in 2017 and 5 percent in 2018 from 12.4 percent recorded last year.
Gamble said that a clean-up of the banking sector, maintaining stable exchange rate, diversification of the oil-dependent economy and creation predictable business environment remained the main challenges for the government.
Fitch said it expected more bank failures this year, primarily due to material capital shortfalls driven by poor asset quality and foreign exchange risks.
"Banks have sizeable unreserved problem loans and probably more problem loans are still to come," Dmitri Vasiliev, the director of the Fitch's financial institutions' department, told Reuters.
The Azeri banking sector's net loss was 1.7 billion manats ($983 million) in 2016, while non-performing loans surged to 21 percent, up from 12 percent in 2015.
The Asian Development Bank sees the Azeri economy contracting by 1.1 percent this year, the bank's local manager told Reuters this week.
Editing by Alison Williams