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Republic of Azerbaijan: Staff Report for the 2014 Article IV Consultation

Author(s):
International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
June 2014
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Background and Context

1. Since the last consultation in early 2013, the government has succeeded in concluding historic agreements in the gas sector and in tapping the international financial markets. The agreements extend cooperation with a BP-led consortium over the next 40 years and enable the implementation of the Shah Deniz-2 gas project, including the construction of pipelines to facilitate the delivery of Azeri gas to Europe beyond 2018. These positive developments in the gas sector along with the strong external position of the country paved the way for the issuance of a debut Eurobond by the Azerbaijani government last March, which was well received by investors amid market turbulence in the region.

2. Notwithstanding these achievements, the overarching challenge for Azerbaijan remains to reduce its heavy dependence on the oil and gas sectors while fostering sustainable private sector-led growth. Diversification is a priority given the relatively short horizon of oil reserves and the fact that the wealth associated with gas discoveries is estimated at about one-third of the oil wealth.1 A more broad-based growth strategy will also help sustain the rapid decline in poverty and inequality since the early 2000s.2

Recent Developments, Outlook, and Risks

3. Recent developments and near-term economic prospects are favorable (see panel charts):3

  • The growth of non-oil GDP reached almost 10 percent in 2013 supported by high public spending and a rapid increase in consumer loans. Non-oil GDP growth will remain strong albeit somewhat slower in 2014-15, mostly reflecting the recently announced fiscal consolidation process. Oil output is likely to be flat for a number of years following the stabilization in 2013 that ended two consecutive years of decline.

  • Inflation increased slightly to 2.4 percent in 2013, on the back of adjustments to the regulated price for petroleum products toward the end of the year.4 Though the output gap turned positive in 2013, inflation is projected to remain in low single-digit levels during 2014–15, mainly on the back of the fiscal consolidation.

  • The de facto exchange rate regime is classified as a stabilized arrangement and is the key anchor for monetary policy. The manat exchange rate has appreciated by less than 2 percent relative to the U.S. dollar since November 2010. The impact of depreciation pressures in a number of neighboring countries has been limited, with few signs of lower manat demand or capital flight. Moreover, the CBA has continued to intervene to prevent appreciation of the manat since the beginning of this year, increasing reserves by about $0.5 billion in the first quarter of 2014.

  • Fiscal policy. Preliminary information suggests that the 2013 non-oil primary deficit in percent of non-oil GDP remained at 2012 levels at about 45 percent, but still well above the 35 percent sustainability level implied by the permanent income rule under a conservative scenario of oil and gas production.5 The deficit would have been even larger had it not been for spending restraint towards the end of 2013 and some under-execution of spending at the state budget level and, particularly, on investments financed by the oil fund outside the budget. The spending restraint helped reduce the break-even fiscal oil price slightly to $77 dollars per barrel. Parliament approved a consolidated budget for 2014 that lowers the government-spending-to-GDP ratio and implies a decline in the non-oil fiscal deficit by about 2 percent of non-oil GDP. The overall fiscal surplus declined to 1 percent of GDP, on flat revenues, but this allowed the oil fund to continue to grow (its size now stands at 48 percent of GDP).

  • Monetary policy. The Central Bank of Azerbaijan (CBA) kept the refinancing rate steady between February 2013 and end-April 2014, when it lowered the rate by 50 basis points to 4.25 percent and decreased the lower and upper limits of the interest rate corridor by 50–100 basis points (setting the floor at 0.5 percent and the ceiling at 6 percent). In August 2013, the CBA prompted a reduction in lending rates by cutting the interest rate ceiling of the Azerbaijan Deposit Insurance Fund (ADIF) from 12 percent to 10 percent. Following this reduction, private sector credit accelerated while remaining highly concentrated in personal loans. The CBA though has followed through with plans to stop lending to the real economy.

  • Several financial indicators of the banking system excluding the largely state-owned International Bank of Azerbaijan (IBA) improved in 2013. The capital ratio increased to 21.6 percent boosted by a fivefold increase in banks’ minimum regulatory capital requirement. Though liquidity declined, bank profitability also improved on the back of the recent consumer lending boom. Disclosed nonperforming loans (NPLs) as a percentage of total loans decreased slightly to 4.5 percent, despite the rapid increase in consumer loans, reflecting the write-off of fully provisioned loans. NPL figures, though, only include the overdue portion of principal and interest, suggesting that NPLs are higher.

  • Recent changes in the regulatory framework of the banking system include measures to tighten consumer loans and strengthen the provisioning rules and requirements for the accurate classification of NPLs.6 The CBA also extended the deadline on the new capital requirements until January 1, 2015, giving some banks (comprising about 8 percent of total banking system assets) more time to fulfill this requirement. The largest bank, IBA, is in compliance with the capital adequacy ratio.7 But as the financial position of IBA remains fragile, the shareholders’ assembly decided to increase the bank’s statutory capital over the next four years, even in the absence of clear plans for the restructuring of the bank. This increase will bring an additional burden of about $300 million (about 0.5 percent of GDP) on the government, which may double if the other (private) shareholders do not participate in the increase.

Azerbaijan: Banking Sector Excluding IBA—Financial Soundness(In percent)
201120122013
1. Regulatory Capital to Risk-Weighted Assets21.019.921.6
2. Liquid Assets to Total Assets17.415.013.2
3. Nonperforming Loans to Total Loans 1/5.45.64.5
4. Bank Return on Assets1.30.72.0
5. Bank Return on Equity7.74.911.4
Source: Central Bank of Azerbaijan.

Disclosed NPLs are somewhat underestimated, as only the overdue portion of principal and interest is disclosed as NPL.

Source: Central Bank of Azerbaijan.

Disclosed NPLs are somewhat underestimated, as only the overdue portion of principal and interest is disclosed as NPL.

4. The baseline scenario reflects the authorities’ plans to sustain the recent change in the course of economic policies and tackle fiscal vulnerabilities over the medium term. The government’s plans to rein in spending, particularly in the public investment program, would enable a decline in the non-oil primary deficit to non-oil GDP ratio to the sustainable level of 35 percent by 2019. Over the medium term, non-oil GDP growth could be in the 5 percent range, if it is underpinned by fiscal consolidation and supported by non-oil foreign direct investment (FDI).

Azerbaijan: Selected Economic and Financial Indicators, 2012–19
Est.Proj.
2012201320142/20152016201720182019
Current Policies Scenario
(Annual percentage change)
Overall GDP2.25.85.04.63.53.24.04.2
Non-oil GDP9.69.98.37.55.55.05.05.0
Consumer price index (period average)1.02.43.54.04.35.04.95.0
(In percent of GDP, unless otherwise specified)
Overall fiscal balance4.91.00.3−3.1−4.8−6.3−6.6−6.4
Non-oil primary balance 1/−45.4−45.0−43.2−41.8−40.4−38.3−36.9−34.2
Current account balance21.819.715.09.95.65.55.04.6
Oil Fund Assets (in billions of U.S. dollars)34.135.437.738.537.634.730.428.8
Sources: Azerbaijani authorities; and Fund staff estimates and projections.

In percent of non-oil GDP.

Based on the 2014 approved budget.

Sources: Azerbaijani authorities; and Fund staff estimates and projections.

In percent of non-oil GDP.

Based on the 2014 approved budget.

5. Azerbaijan’s external position is strong. External buffers, namely the CBA reserves and the oil fund, now amount to about 33 months of import cover and provide strong support to the peg. The current account surplus is high and sovereign foreign assets are expected to reach $55 billion, or 64 percent of overall GDP, by 2015. These assets are projected to decline to about 40 percent of GDP by 2019 as the oil fund engages in the financing of some energy-related projects of strategic importance. Although the planned fiscal consolidation would tend to increase the current account surplus over the medium term, the dominating influence is expected to be a decline in oil exports, as oil prices soften and production begins to tail off. Staff projections assume moderate returns from the energy-related projects given the inherent uncertainty, but further investment in the oil sector could keep revenues higher than in the baseline scenario.

6. Against this backdrop, which implies a lower underlying current account, there is no conclusive evidence of exchange rate misalignment (Box 1). The fact that Azerbaijan has been able to broadly maintain its share in global non-hydrocarbon exports also suggests that competitiveness is balanced. The authorities agreed with this assessment and stressed that improving competitiveness is a top policy priority. They saw public spending on infrastructure as critical to easing physical constraints on the business climate and improving the productivity of private investment.

7. Risks to the baseline scenario are tilted to the downside but financial buffers are comfortable (Annex 1). Slippages in the fiscal adjustment and further deterioration of IBA would undermine prospects for reducing vulnerabilities and fostering sustainable growth. A disruption in oil production or a sustained decline in global oil prices associated with a potential deterioration in the global outlook and emerging markets could expose fiscal vulnerabilities.8 Sharply slower growth in Russia would have, however, a relatively small impact. Azerbaijan’s direct real linkages to Russia have substantially declined over the past decade, following the oil boom. The impact of the tapering of the quantitative easing of monetary policy in the United States on Azerbaijan should also be limited, given the low reliance on external savings and capital inflows (Box 2). While the authorities have room to use financial buffers if such risks materialize, strengthening the non-oil fiscal position and tightening financial supervision will also be crucial to help mitigate the impact of future shocks. The potential for higher oil prices is also possible given the risks of gas supply disruptions resulting from the geopolitical situation in Ukraine and the Middle East.

8. The authorities broadly agreed with the general assessment of risks to the medium-term outlook but did not rule out the near-term possibility of some inflows of capital from Azeris living in Russia if the situation deteriorates considerably. On the oil production time horizon, they mentioned that new wells and ongoing discussions on a possible extension of the production sharing agreement between the BP-led consortium and the government could help slow the decline in oil output. The authorities also downplayed the risks of the considerable softening of oil prices, given the trend of oil prices in recent years and geopolitical considerations going forward (if the level of oil prices over the last three years is maintained over the medium term, sovereign government assets could be near 55 percent of GDP by 2019).

Box 1.Azerbaijan: Exchange Rate, External Stability, and Competitiveness Assessment

The manat real effective exchange rate (REER) appreciated during the oil boom years of 2004–8 though it has since stabilized, and there is no conclusive evidence of a loss of competitiveness. Between early 2004 and late 2008—the peak of the oil boom—the REER appreciated by about 78 percent. Following a sharp drop in inflation after the global financial crisis, the REER has been broadly steady. In terms of the competitiveness of non-oil exports, the share of non-oil exports to total exports has remained broadly stable, at about 5 percent, since the end of the oil boom. However, Azerbaijan has fairly steadily increased its share in global non-oil exports.

Azerbaijan: REER and Non-Oil Exports, 2000–13

Sources: Azerbaijani authorities; and IMF staff estimates.

The exchange rate assessment with three CGER-like methodologies provides a mixed picture. The Macroeconomic Balance (MB) approach, following the methodology set out in Beidas-Strom and Cashin (2011), suggests that with current policies, the exchange rate is broadly in line with fundamentals (slightly overvalued by two percent).1/ This assessment is corroborated by the external stability (ES) approach, factoring in the need to stabilize the ratio of the net foreign asset position to output. However, estimating the equilibrium real exchange rate as a function of a number of medium-term fundamentals (ERER), finds a 20 percent undervaluation. The degree of undervaluation using the ERER has fluctuated between 10 and 20 percent since the beginning of the oil boom in the mid-2000s and is now at the levels observed in 2007 and 2010. This approach, however, does not incorporate diminishing oil reserves, an important fundamental, which may worsen the fit for Azerbaijan.

Macroeconomic Balance Approach

Contributions to Current Account Norm (In percent of GDP)

Sources: Azerbaijani authorities; and IMF staff estimates.

Azerbaijan: Exchange Rate Assessment
MB1/2/ES3/ERER
Underlying current account4.6−8.6
Current account norm5.3−8.9
ER assessment, percent (-: undervalued) 1/4/1.8−0.6−19.5
Source: IMf staff estimates and projections.

Exchange rate elasticity is assumed to be 0.4.

Current account as share of GDP.

Non-oil current account as share of GDP.

MB and ES approaches measures misallignment in 2019, ERER approach is for 2013.

Source: IMf staff estimates and projections.

Exchange rate elasticity is assumed to be 0.4.

Current account as share of GDP.

Non-oil current account as share of GDP.

MB and ES approaches measures misallignment in 2019, ERER approach is for 2013.

1/ See Beidas-Strom, S. and P. Cashin, 2011, “Are Middle Eastern Current Account Imbalances Excessive?” IMF WP/11/195.

Box 2.Azerbaijan: International Linkages and Spillovers

The oil price is the essential channel linking Azerbaijan to the global economy.1/ With the oil boom since the mid-2000s, export-to-GDP ratios have increased and remained highly concentrated on the oil sector (94 percent of total exports in 2013). The exit from unconventional monetary policy in advanced economies along with its impact on the policy mix of most emerging market economies, will determine changes in global oil prices. A sharp slowdown in major emerging economies, for example, could reduce global GDP by 1¾ percent and oil prices by almost 20 percent.

Table 1:Openness Has Increased(In percent of GDP)
Exports
1993-20022003-12
CCA Exporters3748
MENAP Exporters3753
Azerbaijan3657
Sources: National authorities; and IMF staff estimates.
Sources: National authorities; and IMF staff estimates.

Azerbaijan would share the adverse consequences of a fall in the oil price. The impact of such a shock in the GDP could be similar to the estimate for MCD oil exporters, at about 1 percent in the first year. The impact of a slowdown in emerging markets will be relatively small. Azerbaijan’s non-oil export linkages to Russia and Turkey are substantial (44.6 percent and 7.5 percent respectively on average between 2007 and 2011), but total non-oil exports account only for 6 percent of total exports.

GDP Impact of Emerging Market Slowdown

(First Year, Percent change relative to baseline)

Sources: National authorities; and IMF staff calculations.

Azerbaijan’s financial sector should be able to withstand moderate shocks. Azerbaijan’s financing needs are generally low by international standards, given external and fiscal surpluses. Lending by global banks to Azerbaijan’s financial sector is small and corporations rely mainly on their own resources. Higher global interest rates for Azerbaijan would be mostly felt through temporary changes in the book value of the oil fund—with assets close to $35.5 billion or about 50 percent of GDP in 2013, as about 40 percent of its portfolio has a maturity between one and five years, though higher rates will in general benefit the oil fund over time. Exposure of capital markets is nil given its underdevelopment. FDI, focused on the energy sector, will remain strong due to new gas developments.

Gross External Financing Needs in 2013 1/

(In percent of GDP)

Sources: National authorities; and IMF staff calculations.

1/ Calculated as the sum of current account deficit (excluding official current transfers) and amortization scheduled, with a floor of zero.

2/ Excludes nonresident deposits.

An escalation of the Russia-Ukraine crisis will have a relatively small impact as Azerbaijan’s direct real linkages to Russia have substantially declined over the past decade following the oil boom. Lower GDP growth in Russia could directly impact about less than 3 percent of total exports (or half of the total non-oil exports). The direct exposure of the financial sector is mainly through small assets of the state oil fund (SOFAZ) and the Russian subsidiary of the International Bank of Azerbaijan (IBA). Migrants’ remittances originating from Russia are also relatively small.

Share of Non-oil Exports by Destination

(In percent, period average 2007-11)

Sources: UN Comtrade; and IMF staff calculations.

1/ This box tailors the 2013 Fall MCD REO Annex 2 on International Linkages and Spillovers to Azerbaijan.

Entrenching Sound Policies

A. Ensuring Growth-friendly Fiscal Consolidation

9. Pursuing the planned fiscal consolidation should not significantly dampen growth and will help address fiscal vulnerabilities. While welcoming the approved 2014 consolidated budget, staff noted that sustained further efforts would be needed to bring the non-oil fiscal position to the sustainable level implied by the permanent income rule. Staff noted that with energy revenues set to sharply fall off, leading to a rising overall deficit and depletion of oil fund balances over the medium-term, it would be important not to delay the adjustment. To this end, staff advocated a cumulative reduction of about 5 percentage points in the non-oil primary deficit over 2014–15 and a further adjustment of at least 8 percentage points over 2016–19. Cutting investment projects with small growth returns as a main component of the adjustment should not hurt growth markedly as the public investment rate is well above the optimal path suggested by a precautionary saving and investment model (Box 3). Making the fiscal position sustainable could also entail rationalizing tax exemptions, better enforcing tax procedures, and to revamp non-oil tax revenue collection.9 Efforts are also needed to streamline current spending while providing resources to expand the Targeted Social Assistance (TSA) program to help reduce the impact of shocks, including recent fuel price increases, on the most vulnerable groups.10 Such measures should be complemented by reforms in the business environment (as discussed in section D) so that the private sector could use the freed-up financing from fiscal consolidation for growth-enhancing private investment.

10. The authorities stressed their commitment to consolidating the non-oil fiscal position. They noted their plans to further reduce the transfers from the oil fund in the context of the 2015 budget, as announced in the medium-term indicative targets presented to parliament in the context of the 2014 budget process. They also indicated that the recent agreement achieved with the World Bank and the European Commission to complete a public expenditure and financial accountability assessment (PEFA) by October 2014 will contribute to strengthen control over public spending and will help guide efforts in prioritizing and improving the efficiency of public investment. In this latter context, staff noted that along with a strong public investment management system, the selection of investments could place more emphasis on the impact of spending on the long-term growth of the non-oil export sector and fiscal revenue.

11. Staff highlighted the risks stemming from the absence of a fiscal rule given the oil revenue volatility and the unsustainable level of public investment. Additional fiscal risks are associated with the heavy oil dependence of the consolidated budget, the pension system, and government activities outside the budget (Box 4). A rules-based fiscal framework (e.g., a structural primary balance rule with price smoothing) could help entrench fiscal discipline and mitigate the volatility of oil revenue while promoting intergenerational equity.11 A statement of fiscal risks as part of the budget process could highlight the threats to macro stability and the government’s resilient net asset position, and foster fiscal risk-reducing actions.

Box 3.Azerbaijan: In Pursuit of Optimal Fiscal Policy

The application of, the “Silo” model of Cherif and Hasanov (2012), a finite horizon precautionary saving-investment model under uncertainty, suggests that the current government consumption and investment in Azerbaijan are well above the optimal levels.1/ The results are consistent with the application of the IMF’s Sustainable Investing Tool underpinning the 2013 Article IV Consultation. The analysis stressed the need for a more moderate investment path to increase investment efficiency and sustain the growth benefits.

Average Consumption, SWF, and “Cash on Hand,” 2014–60

(Wealth before consumption; expected values)

Source: IMF staff calculations.

The Silo model suggests that in the face of highly volatile revenues, the optimal investment rate is 15 percent of total revenues while saving in safe assets is 37.3 percent initially. Given the expected decline in oil prices and production in the baseline, the projected current and capital spending exceed the optimal amount over the period 2014–18. The model also indicates that the Azeri government is saving less than optimal through its sovereign wealth fund.

The gap between projected and optimal investment is very large in 2014—around 20.5 percent of non-oil GDP—but it will start to shrink in 2015 to reach around 4.3 percent of non-oil GDP in 2018. The model also shows that government consumption is higher than the optimal level, and the gap is expected to widen over the period 2014–18, to reach around 7 percent of non-oil GDP) in 2018.

The results call for a rules-based fiscal policy framework that promotes fiscal discipline.

Optimal vs. Projected Investment Spending, 2013–18

(In millions of Azeri manats)

Source: IMF staff calculations.

Optimal vs. Projected Current Spending, 2013–18

(In millions of Azeri manats)

Source: IMF staff calculations.

1/ Cherif, R. and F. Hasanov (2012), The Volatility Trap: Precautionary Saving, Investment, and Aggregate Risk, IMF Working Paper 12/134 (Washington: International Monetary Fund).

Box 4.Azerbaijan: A Framework for Managing Fiscal Risks

Sound management of fiscal risks could supplement the rules-based fiscal framework recommended to the authorities in the context of the 2013 Article IV Consultation by enforcing fiscal discipline and bringing attention to threats to macro stability and to the state’s resilient net asset position.

Managing fiscal risks in Azerbaijan in line with best practices entails:1/

  • Identifying and quantifying key sources of fiscal risk: there are four key sources of fiscal risks to the consolidated budget in Azerbaijan:

    Exposure to adverse oil sector developments: A US$20 decline in the oil price assumption for 2014 could worsen the fiscal balance in percent of GDP by 5 percent and entail a withdrawal of $4 billion from the oil fund. A similar impact on the budget would arise with a 12 percent decline in the assumption for oil production in 2014 (about 100,000 barrels per day).

    Implicit liabilities associated with pension obligations: Despite successive reform efforts, the funding gap of liabilities inherited from the Soviet regime is projected to increase to 2 percent of GDP by 2024. The NPV of these liabilities through 2050 was estimated by an IMF technical assistance mission in the order of 54 percent of 2012 GDP.

    Activities of the State Oil Company (SOCAR): Since 2008, SOCAR’s net liabilities (including trade credits and excluding tax payments) have doubled, reaching about 12 percent of GDP in 2013. SOCAR successfully issued international bonds in 2012 and 2013.

    Activities of the systemic and largely state-owned bank: IBA holds about a third of the assets and loans of the banking system. IBA’s financial situation remains fragile despite receiving government support. The new capitalization plan approved by the shareholders will bring an additional burden of about $300 million (about 0.5 percent of GDP) to the government over the next four years.

  • Disseminating a “Statement of Fiscal Risks” as part of the budget to inform the fiscal policy decisions with sensitivity analysis to oil-related shocks and quantifying contingent liabilities arising from public entities.

  • Integrating fiscal risks in the fiscal analysis, and in the medium-term fiscal framework and the public debt sustainability analysis (DSA) to prepare for the possibility that the risks may materialize. Under the assumption of a moderate level of government investment, the DSA points to an increase in the gross debt to GDP ratio from 13 percent in 2013 to 20 percent in 2018. The simulation of a contingent liability shock entailing a one-time increase in non-interest expenditures equivalent to 20 percent of banking sector assets (about half of the assets held by IBA) could add 4 percentage points of GDP to the stock of debt by 2018. The net asset position, while deteriorating, is projected to remain strong to about 20 percent of GDP by 2018.

  • Adopting a legal framework to support the management of fiscal risks by requiring sensitivity analysis to key assumptions and an annual statement of fiscal risk as part of the budget process.

Azerbaijan Public DSA - Alternative Scenarios

Source: IMF staff.

1/ See Aliona Cebotari et. al. (2009), Fiscal Risks: Sources, Disclosure, and Management, Fiscal Affairs Department (Washington: International Monetary Fund). This box reflects helpful comments from A. Mineshima (FAD).

12. The authorities agreed on the need to entrench fiscal discipline. They noted that an informal fiscal rule aimed at keeping the oil fund balance broadly unchanged will help gradually reduce the reliance of the state budget on oil revenue. Ongoing actions to develop a debt management strategy for the national oil company in line with international best practice will also help contain associated risks from major investment projects. Plans are also advanced to approve a reform of the pension system this year—consistent with recent IMF Technical Assistance (TA)—that would ensure a sustainable pension system that provides a sufficient degree of income replacement.

B. Increasing the Role of Monetary Policy as Anchor for Inflation Expectations

13. Staff supported the CBA’s intention to keep monetary policy in a neutral stance and welcomed recent measures to slow consumer lending. The anchor of monetary policy is the maintenance of the stabilized exchange rate arrangement. Nonetheless, with Azerbaijan’s exposure to large and destabilizing capital inflows from non-government sources quite limited to date, owing to the low level of development in the financial and capital markets, there is some room for monetary policy to operate. During the mission, the CBA stated its plans—with the staff concurring—to retain a neutral stance, given expectations for stable and low inflation amid tighter fiscal policy, soft international food prices, and slowing consumer credit growth. In the event, in late April the CBA lowered the policy rate by 50 basis points, noting that the rate cut was based on low inflation expectations and the need to diversify the economy and to boost investment activity. Staff cautions the CBA against further policy rate cuts in light of risks of slippages in the fiscal consolidation, implementation problems of recent measures to slowdown consumer lending, or potential reversals in soft global food prices due to regional tensions. Indeed, monetary tightening would be warranted in case slippages in implementing the fiscal consolidation plan caused demand pressures.

14. Strengthening the interest rate transmission mechanism is a precondition to making monetary policy more effective. Staff noted that this would entail continuing with plans to scale down the CBA’s direct lending to the real economy, including to non-financial public entities, with a view to discontinuing such lending on a permanent basis. Actions in line with recent IMF technical assistance, including the publication of inflation notes and balance of payments projections, along with efforts to deepen the financial markets could pave the way for the adoption of greater exchange rate flexibility over the longer term. Staff stressed that steps to improve monetary-fiscal policy coordination and develop currency risk mitigation instruments will also facilitate a move toward inflation targeting and greater exchange rate flexibility. Notwithstanding the benefits of maintaining a managed exchange rate, including by providing an anchor for monetary policy, a flexible exchange rate regime would increase policy options (e.g. to deal with potential capital inflows as financial development proceeds) and contribute to reduce inflation and output volatility.12

15. The CBA plans to sustain the unwinding of its directed lending and concurred that preparing for greater exchange rate flexibility over the medium term is important to develop a more independent monetary policy. The CBA is confident that its directed lending to the real sector will continue to decline over the next couple of years. In addition, by this summer, the CBA plans to launch the implementation of an action plan to prepare for greater exchange rate flexibility over the medium term, developed on the basis of IMF TA advice.

C. Promoting a Sound Deepening of the Financial Sector

16. Staff encouraged the CBA to further strengthen banking sector regulations to ensure financial stability. Staff stressed that notwithstanding the government’s strong financial position and the relatively underdeveloped banking sector, actions are needed to tackle vulnerabilities. Recent measures taken on the strengthening of provisioning rules and requiring the accurate classification of NPLs are steps in the right direction and will help ensure correct capital needs but further efforts are needed to strengthen the regulatory framework. As pointed out by recent IMF technical assistance, developing the interbank money market, reducing connected lending and exposure to single large borrowers, and discouraging banks from taking on foreign-exchange exposure to un-hedged borrowers would go a long way to increase the resilience of the system. The relatively small size of the banking system by international standards, combined with recent increases in capitalization, lessen somewhat the concerns that these foreign exchange, credit, and interest rate risks give rise to. A thorough assessment of financial stability and development aspects of the financial sector will be carried out in the upcoming 2015 FSAP update.

17. Developing the banking system requires measures by the CBA to increase competition in the banking sector. The ongoing capitalization process provides an opportunity for the CBA to encourage some consolidation in the system. This could entail reducing bureaucratic and judicial formality for mergers and acquisitions of healthier banks, introducing debt/equity swaps, and offering incentives to banks in the form of lower deposit insurance premia or tax advantages. Banks that do not meet the minimum capital requirement by the newly established deadline should be liquidated or converted into non-bank financial institutions. Restructuring the largely state-owned bank IBA so as to reduce its dominance of the sector is also a priority for achieving a more level playing field in the banking system. Actions by the CBA to increase competition in interest margins (e.g., creating a private credit bureau) and help banks reduce their costs (e.g., protecting creditors’ rights) would also place the system in a better position to support private sector–led growth, particularly for SMEs, which face high costs of borrowing (Boxes 5 and 6).

Box 5.Azerbaijan: Determinants of Bank Spreads

Bank-level data on 20 commercial banks can shed light on the determinants of bank interest spreads in Azerbaijan over the period 2002–13.1/ The application of the dealership model of Ho and Saunders, supplemented by market structure and macroeconomic environment variables, helped assess the extent to which high spreads of banks in Azerbaijan are related to bank-specific variables or to a low degree of competition, controlling for macroeconomic factors.

Financial Deepening and Interest Spread

(In percent)

Sources: Global Financial Database; and IMF staff calculations.

The analysis suggests that lowering bank interest margins would require reducing operating costs, increasing competition, consolidating the small bank segments and maintaining a stable macroeconomic environment. Specifically, reducing operating costs could be achieved by strengthening bank corporate governance, adopting the best banking technologies, improving staff productivity, and introducing organizational changes. Enhancing competition in the banking sector would need actions to downsize the IBA (either by sale of assets or by splitting it into areas of businesses), promote non-banking financial institutions and capital markets, reduce loan concentration though stricter supervision of large exposures, and improve transparency and disclosure of bank products. As small banks in Azerbaijan are operating with significant unrealized economies of scale, the authorities could allow for market-led consolidation of smaller banks, which will contribute to greater cost efficiency and lower interest rate spreads. Promoting a stable macroeconomic environment (low and stable inflation) should contribute to lower equilibrium interest rates; lowering reserve requirements is likely to reduce the cost of intermediation.

1/ See Selected Issues Paper “Determinants of Bank Spreads in Azerbaijan”.

18. The CBA noted that plans are underway to sustain the recent progress in strengthening banking sector regulations. While indicating that liquidations should not be ruled out, the CBA stressed that only a few banks may be unable to meet the new capital requirement by end-2014. The authorities also mentioned that exposures of banks to foreign exchange risks are well contained in light of the low share of external debt liabilities in bank balance sheets (below 20 percent) and did not see it possible to extend further the January 1, 2015 deadline for the minimum capital requirement. They looked forward to the upcoming FSAP, as a useful roadmap for further improvements in this area.

Box 6.Azerbaijan: Financial Development and Non-Oil Growth

The deepening of financial systems is particularly important for natural resource–exporting economies.1/ Cross-country analyses suggest that hydrocarbo–rich developing economies (HRDCs) often have lower levels of financial development, perhaps due to weaker financial and business climate policies and institutions. Robust financial systems can support economic diversification by promoting private sector development. Moreover, the relationship between financial depth and diversification can be mutually reinforcing so that increased diversification can spur further financial development.

Credit to the Private Sector

(In percent of GDP)

Sources: National authorities; and IMF staff estimates.

Azerbaijan lags behind other transition economies in credit to the private sector and the level of deposits. Cross-country comparisons assembled by the EBRD show that Azerbaijan may be on par with other economies in Central Asia and the Caucasus in financial development, yet Azerbaijan lags other transition economies in Central and Eastern Europe and Russia by large margins.

Moreover, much of the financial sector growth experienced in the past decade or so has been in consumer credit. Growth in credit to the private sector increased from just under 5 percent of GDP in 2000 to around 13 percent in 2013. Yet, a large portion of the growth in credit came from growth in household lending which accelerated from around 9 percent of total bank lending in 2000 to around 40 percent in 2013. Mortgages have been an important component of banks’ credit to consumers as these comprised about 14 percent of banks’ portfolios in 2013, up from 8 percent in 2006.

Empirical tests conducted by Fund staff found that the Azerbaijan financial sector is not contributing to the development of the non-oil economy. Despite some caveats, time series regressions found that public spending is highly correlated with the growth of the non-oil economy, yet credit from the banking system was not correlated when controlling for growth in public spending and real changes in oil prices.

The absence of a link between finance and non-oil growth may reflect a number of factors, including the lack of adequate lending opportunities and institutional bottlenecks. Given the importance that the financial sector needs to play in supporting the growth of the non-oil economy, looking at constraints on the development of the sector, and designing a well sequenced program that supports financial development while also managing the risks that come with financial sector policy reform all require the attention of policy makers.

1/ See Selected Issues Paper “Azerbaijan: Financial Development and Non-Oil Growth”

D. Developing a Competitive Economy

19. The authorities noted ongoing efforts to improve the business climate. Azerbaijan continues to move up in the Global Competitiveness Index list and is ahead of most transition economies, owing to its strengths in the areas of macroeconomic environment and labor market efficiency.13 In addition, the successful sovereign issuance will contribute to the development of a yield curve and support the development of the capital market and the financing of companies in the non-oil sector. 14 The authorities also mentioned the progress in tackling corruption with the implementation of initiatives such as e-government, the one-stop window, and the “easy service centers” (ASAN). As part of the anti-corruption program, the authorities are working on a legislative initiative to establish and develop a national mechanism for asset recovery, including possible amendments to the Criminal Procedural Code. In addition, the fourth assessment by MONEYVAL began in October 2013 and is ongoing. The authorities also noted they plan to conduct an AML/CFT risk assessment during 2014.

Bond Yields

(In percent)

Sources: Bloomberg.

20. While noting recent progress, staff stressed that accelerating structural reforms in governance and the business climate is critical to diversifying the economy and promoting private non-oil investment (Box 7). Azerbaijan’s low rank on governance-related indicators in surveys of firms carried out by the World Bank and the World Economic Forum suggests considerable scope for improving government effectiveness and widening anti-corruption efforts. Measures to put in place an effective anti-monopoly policy, including by creating an independent competition agency, will help reduce formal and informal barriers to competition. The authorities will also need to ensure that the ongoing education reform brings curricula in line with market needs and removes the existing bottlenecks in higher education to take advantage of relatively flexible labor market regulations. Such measures could help foster non-oil private investment, including FDI, particularly if combined with World Trade Organization (WTO) accession over the near term to facilitate the opening of new markets. This latter process seems to be gaining momentum following the adoption of the new customs code in line with WTO requirements and the 11th meeting of the working party in February 2014.

Box 7.Azerbaijan: Business Environment and Governance

Azerbaijan continues to move quickly up the Global Competitiveness Index (within the top 40) list. But crosscountry comparisons suggest that challenges posed by informal monopolies, access to finance, and corruption are still substantial. Despite some progress in tackling small-scale corruption, the country continues to rank poorly on the World Bank’s governance-related indicators (in the bottom third, globally).

Ease of Doing Business

(Percentile Rank)

Sources: World Bank, Doing Business (2010, 2014); and IMF staff calculations.

Anti-Monopoly Policy Effectiveness and Trade Barriers

(Rank)

Source: World Economic Forum, Global Competitiveness Report 2013-14.

Change in Governance 1/

(Percentile rank)

Sources: World Bank, Worldwide Governance Indicators; and IMF staff calculations.

1/ Average of government effectiveness, regulatory quality, rule of law and control of corruption.

Global Competitiveness Index

(Rank)

Sources: World Economic Forum, Global Competitiveness Report 2013-14; and IMF staff calculations.

Small Firms Finance

(In percent of total small firms)

Sources: The World Bank, Enterprise Surveys (http://www.enterprisesurveys.org); and IMF staff calculations.

Control of Corruption

(Percentile rank)

Source: World Bank, Worldwide Governance Indicators.

Other Issues

Data Provision to the Fund

21. Azerbaijan’s data provision to the Fund has some shortcomings but is broadly adequate for surveillance. Actions are underway to bring fiscal and external sector statistics in line with international standards. Ongoing efforts supported with IMF technical assistance will help strengthen the production of statistics, particularly for GDP, fiscal accounts, and the International Investment Position. The authorities noted that joint work by the Ministry of Finance, State Statistics Committee, and the CBA will help speed up the legislation needed for the compilation and dissemination of external debt and the IIP. The CBA thus expects to start the compilation and dissemination of International Investment Position (IIP) in coming months. Staff urged the authorities to resume the compilation and dissemination of the IIP by the CBA, as required under Article VIII, Section 5, ahead of the next Article IV Consultation.

Staff Appraisal

22. The government’s recent achievements provide an impetus to advance toward the goal of becoming a dynamic emerging market. Recent agreements in the gas sector will help transform Azerbaijan into a strategic gas supplier for the European market. In addition, the government’s successful debut Eurobond, issued amid market turbulence in the region, is testimony of investors’ confidence in the prudent management of the oil revenues as reflected in large buffers and macroeconomic stability. This vote of confidence, along with the benign environment of high oil prices, provides an opportunity to build on the recent progress in changing the course of macroeconomic policies and take decisive steps to improve governance and the business climate. Actions in these areas will be crucial to fostering sustainable and diversified private sector-led growth that will ensure a sustained improvement in living standards.

23. Continued efforts to rein in government spending are needed to reduce fiscal vulnerabilities and achieve sustainability of the non-oil fiscal position in the medium term. Staff welcomes the approved 2014 budget that contains government spending, and encourages the authorities to complement their plans to improve public investment efficiency with decisive business climate reforms to create opportunities for private investment. Moving ahead decisively with the planned reform of the pension system, along with the adoption of a rules-based fiscal framework and sound fiscal risk management, will also help safeguard the consolidation efforts and preserve fiscal sustainability over the medium term. Given the prospects of flat oil production and softer oil prices, public announcement of and strict adherence to the informal fiscal rule would help build a track record for the adoption of a formal fiscal rule.

24. The current monetary policy stance is appropriate if supported by prudent fiscal and financial sector policies. Inflationary pressures are likely to remain subdued if the authorities’ plans to tighten fiscal policy and cool down consumer credit growth are fully implemented. Monetary tightening would be warranted if demand pressures arise in the event of slippages in the fiscal consolidation plan or a reversal in soft global food prices due to regional tensions. Going forward, strengthening the role of monetary policy as anchor for inflation expectations requires discontinuing the CBA’s direct lending on a permanent basis and decisive progress to develop the interbank money and foreign exchange markets in line with past IMF technical assistance. These actions would facilitate a move toward inflation targeting and pave the way for adopting greater exchange rate flexibility over the medium term when the costs of the current exchange rate regime will increase as Azerbaijan further diversifies its economy and increases its financial integration.

25. Enhancing the regulatory framework while promoting financial deepening is critical for the development of the non-oil economy. Recent measures by the CBA to strengthen banking regulations will help ensure correct capital needs; but increasing the resilience of the banking system also requires reducing the exposure of banks to connected lending and to un-hedged borrowers. Strengthening the banking system to facilitate a sustainable and broad-based growth led by the private sector will require actions aimed at encouraging market-led consolidation of banks without extending the new deadline to meet the capital requirement; creating a private bureau to promote competition in interest margins; protecting creditors’ rights to help banks reduce their costs; and ensuring a level playing field in the banking system by further reducing the IBA’s dominance in the system. Restructuring the IBA is also needed to help strengthen the monetary transmission mechanism and contain the associated fiscal risks.

26. Achieving sustainable growth of the non-oil output and export diversification in the medium term also entails accelerating reforms to attract private investment. Building on recent efforts to reduce corruption, including the introduction of e-government and “ASAN” public services, the authorities could broaden the anti-corruption efforts beyond small-scale corruption, strengthen the rule of law, and reduce formal and informal constraints to business environment in the non-oil sector. Such efforts will be crucial to foster a competitive economy and reap the full benefits of complementary efforts aimed at developing the domestic capital market and opening up new export markets.

27. It is recommended that the next Article IV consultation with Azerbaijan will be held on the standard 12-month cycle.

Figure 1.Azerbaijan: Output and Inflation

Sources: Azerbaijani authorities and Fund staff estimates.

Figure 2.Azerbaijan: External and Fiscal Sectors

Sources: Azerbaijani authorities and Fund staff estimates.

Figure 3.Azerbaijan: Monetary and Financial Sector Developments

Sources: Azerbaijani authorities and Fund staff estimates.

Table 1.Azerbaijan: Selected Economic and Financial Indicators, 2009–15
Prel.Proj.
2009201020112012201320142015
(Annual percentage change, unless otherwise specified)
National income
GDP at constant prices9.35.00.12.25.85.04.6
Of which: Oil sector 1/14.85.0−9.8−5.30.5−0.1−0.1
Non-oil sector 2/3.07.69.49.69.98.37.5
Consumer price index (end of period)0.77.95.6−0.33.63.44.5
Consumer price index (period average)1.65.77.91.02.43.54.0
Money and credit
Net foreign assets−18.534.668.75.619.916.43.4
Net domestic assets63.413.52.840.38.713.838.2
Domestic credit42.28.47.939.64.310.815.4
Of which: Credit to private sector25.66.618.120.827.610.315.1
Manat base money1.731.629.427.110.712.79.5
Manat broad money9.934.832.525.519.014.714.1
Total broad money16.621.932.120.615.413.920.0
Foreign currency deposits ratio to broad money28.721.220.917.715.114.513.2
Velocity of total broad money (M3) 3/3.02.82.62.32.32.32.3
External sector (in US$)
Exports f.o.b.−31.025.530.3−5.4−1.0−1.9−5.8
Of which: Oil sector−31.525.730.9−6.7−1.0−1.9−6.7
Imports f.o.b.−14.03.650.73.10.27.28.8
Of which: Oil sector−34.219.635.5−5.96.831.032.1
Export volumes6.2−1.4−3.3−6.0−0.1−1.90.0
Import volumes−5.4−4.038.26.10.99.29.9
Terms of trade−28.627.130.73.6−0.21.8−4.9
Real effective exchange rate14.01.12.60.83.0
(In percent of GDP, unless otherwise specified)
Gross investment18.418.521.222.723.723.222.6
Consolidated government12.312.516.016.117.317.016.5
Private sector6.16.15.16.76.46.36.1
Of which: Oil sector1.91.92.13.13.02.92.8
Gross domestic savings47.752.554.150.748.243.937.2
Gross national savings41.446.647.644.543.438.232.5
Consolidated government19.327.129.720.918.317.313.3
Private sector 4/22.119.518.023.625.121.019.2
Consolidated central government finance
Total revenue and grants40.445.745.540.539.539.236.1
Non-oil primary balance, in percent of non-oil GDP−35.5−36.3−40.3−45.4−45.0−43.2−41.8
External sector
Current account (- deficit)23.028.026.521.819.715.09.9
Foreign direct investment (net)0.30.61.41.1−0.90.51.9
Public and publicly guaranteed external debt outstanding7.77.47.39.211.714.014.2
Memorandum items:
Gross official international reserves (in millions of U.S. dollars)5,3646,72110,88711,58713,98715,98716,487
Nominal GDP (in millions of manat)35,60242,46551,15853,96857,70861,63867,473
Nominal non-oil GDP (in millions of manat) 2/19,53622,24325,39329,76634,05138,14442,850
Nominal non-oil GDP (in millions of USD) 2/24,32627,87732,28637,91943,40549,61455,735
Nominal GDP per capita (in U.S. dollars)4,9335,8477,1067,5388,1608,8239,679
Nominal GDP (in millions of U.S. dollars)44,28952,91364,81968,70073,53779,36387,763
Oil Fund Assets (in millions of U.S. dollars)14,90022,76629,80034,05835,44837,72338,484
Population (mid-year, in millions)9.09.09.19.29.39.39.4
Exchange rate (manat/dollar, end of period)0.8030.7980.7870.7850.785
Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes the production and processing of oil and gas.

Includes the transportation of oil and gas (except transportation through the western route).

Defined as gross domestic demand (excluding oil sector-related imports) divided by average broad money.

Historical data includes statistical discrepancy.

Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes the production and processing of oil and gas.

Includes the transportation of oil and gas (except transportation through the western route).

Defined as gross domestic demand (excluding oil sector-related imports) divided by average broad money.

Historical data includes statistical discrepancy.

Table 2.Azerbaijan: Balance of Payments, 2009–15(in millions of U.S. dollars, unless otherwise specified)
Prel.Proj.
2009201020112012201320142015
Exports, f.o.b.21,09726,47634,49432,63832,30531,67529,824
Oil and oil products19,97025,10832,87130,65930,36229,78127,783
Other1,1271,3681,6231,9791,9431,8942,041
Imports, f.o.b.−6,514−6,746−10,166−10,480−10,501−11,261−12,250
Oil sector−700−838−1,135−1,067−1,140−1,493−1,973
Others−5,814−5,908−9,031−9,412−9,361−9,767 -10,277
Trade balance14,58319,73024,32822,15821,80420,41517,574
Services, net−1,608−1,734−2,995−2,915−3,772−4,021−4,760
Credit1,7502,0772,7204,2853,2393,4143,198
Debit−3,358−3,811−5,715−7,200−7,011−7,435−7,958
Oil sector−1,205−1,240−1,594−2,945−2,374−2,477−2,609
Income−3,519−3,657−4,859−4,258−3,291−4,252−3,851
Investment income, net−3,476−3,618−4,840−4,196−3,211−4,152−3,729
Of which: profit of oil consortium−2,884−3,199−4,622−4,359−3,757−4,684−4,469
Compensation of employees, net−43−39−-−62−80−100−123
Transfers, net722495673−27−252−227−248
Of which: Private686470649−50−275−254−275
Current account balance10,17814,83417,14614,95814,48811,9148,715
Non-oil currenct account balance−5,002−4,996−8,374−7,330−8,602−9,213−10,016
Capital account, net5141813151514
Direct investment, net147331933787−6434321,632
Of which: In reporting economy, net4735631,4651,6061012,1083,126
Oil sector, net−274−187489906−7991,6081,986
Others, net7487509767009005001,140
Portfolio investment, net−139−139413298−1,2828892,609
Other investment−6,018−3,784−4,655−9,102−8,838−8,976−11,705
Financial account, net−6,009−3,591−4,038−8,017−10,763−7,656−7,464
Capital and financial account balance−6,004−3,577−4,020−8,005−10,748−7,640−7,450
Errors and omissions−1,464−990−770−1,880−-−-−-
Overall balance2,71010,26812,3565,0733,7404,2741,265
Financing−2,710−9,236−11,519−4,972−3,800−4,279−1,269
Change in net foreign assets of CBA (increase -)963−1,370−4,185−714−2,410−2,004−508
Change in Oil Fund assets (increase -)−3,681−7,866−7,034−4,258−1,390−2,275−761
Memorandum items:
Current account balance (in percent of GDP)23.028.026.521.819.715.09.9
Non–oil Current account balance (in percent of Non–oil GDP)−20.6−18.0−26.0−19.3−19.8−18.8−18.0
Gross official international reserves5,3646,72110,88711,58713,98715,98716,487
in months of next year’s non-oil imports c.i.f.7.66.19.69.911.412.310.7
Oil Fund assets14,90022,76629,80034,05835,44837,72338,484
Public and publicly guaranteed external debt (in percent of GDP)7.77.47.39.211.714.014.2
Oil price (US$ per barrel)61.879.0111.0110.0110.1109.2102.9
Sources: Azerbaijani authorities; and IMF staff estimates and projections.
Sources: Azerbaijani authorities; and IMF staff estimates and projections.
Table 3a.Azerbaijan: Consolidated Central Government Operations, 2009–15(in millions of manat)
Prel.Proj.
2009201020112012201320142015
Total revenue and grants14,36819,38623,29221,83222,80724,15324,385
Total revenue14,36819,38323,28521,83222,80724,15324,385
Tax revenue5,5915,8347,0167,0047,7398,2529,097
Income taxes1,9112,0202,8503,0653,0383,0083,067
Social security contributions582697744158380407436
Value added tax (VAT)2,0132,0822,2232,3672,6883,0413,487
Excise taxes485515480531607665746
Taxes on international trade421292440590686750933
Other taxes179227280293340381428
Nontax revenue 1/8,77713,54916,26914,82815,06715,90115,287
Of which: Oil Fund revenues 2/8,27413,08715,52114,18314,13214,87414,153
Total grants (current)0370000
Total expenditure12,02813,45017,36819,78222,33224,13026,387
Current expenditure7,6498,1579,16011,10812,36013,68015,272
Interest363921098172177124
Investment expenditure and net lending4,3795,2938,2098,6749,97110,45011,115
Domestically-financed4,0934,7687,4427,6978,8958,4279,988
Foreign-financed2865257679771,0762,0231,126
Statistical discrepancy−142−277−1,043−581−247−159121
Consolidated government balance, cash basis2,4826,2136,9672,630722183−2,123
Non-oil primary balance 3/−6,942−8,070−10,245−13,504−15,171−16,355−17,905
Financing−2,482−6,213−6,967−2,630−722−1832,123
Domestic (net)−2,705−6,686−7,654−3,502−1,286−2,0921,115
O/w Banking system−25−133−1,63193−240−370700
Oil Fund (includes treasury balances)−3,018−6,700−6,088−3,608−1,091−1,767−585
External (net)2234736878725641,9091,008
Loans2885267689771,0762,0231,126
Amortization due655381105512114118
Memorandum items:
Oil revenue9,46114,32317,42216,23116,06516,71415,907
Non-oil revenue 4/4,9075,0635,8705,6006,7417,4398,478
Non-oil tax revenue 5/3,9424,0334,5084,9245,3395,9116,707
Non-oil GDP (in billion of manats)19,53622,24325,39329,76634,05138,14442,850
Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes contingent revenues accrued on the “deposit account” of budgetary organizations.

Includes profit oil, acreage fees, and income earned on Oil Fund assets.

Defined as non-oil revenue minus total expenditure (excl. interest payments) and statistical discrepancies.

Excludes AIOC profit tax, profit oil, and SOCAR profit tax. but includes VAT and excise taxes on oil and gas, tax withholding on the AIOC’s subcontractors.

Tax revenue excluding AIOC and SOCAR profit tax, and social contributions.

Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes contingent revenues accrued on the “deposit account” of budgetary organizations.

Includes profit oil, acreage fees, and income earned on Oil Fund assets.

Defined as non-oil revenue minus total expenditure (excl. interest payments) and statistical discrepancies.

Excludes AIOC profit tax, profit oil, and SOCAR profit tax. but includes VAT and excise taxes on oil and gas, tax withholding on the AIOC’s subcontractors.

Tax revenue excluding AIOC and SOCAR profit tax, and social contributions.

Table 3b.Azerbaijan: Statement of Consolidated Government Operations, 2009–15(in millions of manat, presented in line with GFSM 2001)
2009201020112012201320142015
Prel.Proj.
Revenue14,82819,82423,73022,40323,37824,66324,385
Tax revenue5,0095,1376,2726,8467,3598,7629,097
Income taxes1,9112,0202,8503,0653,0383,0083,067
Value added tax (VAT)2,0132,0822,2232,3672,6883,0413,487
Excise taxes485515480531607665746
Taxes on international trade421292440590686750933
Other taxes179227280293340381428
Social security contributions1,0421,1351,182730952917436
Nontax revenue 1/8,77713,54916,26914,82815,06715,90115,287
Of which: Oil Fund revenues 2/8,27413,08715,52114,18314,13214,87414,153
Expense8,1098,5959,59811,68012,93214,18926,988
Compensation of employees1,8251,8841,9341,8632,1052,4422,663
Use of goods and services3,1053,5403,8705,4845,8336,5347,140
Social benefits2,2872,3282,7473,2013,7143,9344,735
Subsidies289239210289330370416
Grants557552571715730683684
Interest363921098172177184
Other expense10145730474951
Net operating balance (-, deficit)6,71911,22914,13310,72310,44610,4748,511
Net Acquisition of Nonfinancial Assets4,3795,2938,2098,6749,97110,45011,115
Statistical discrepancy−143−277−1,043−581−247−159−480
Consolidated net lending and borrowing, cash basis2,4836,2136,9672,630722183−2,123
Non-oil primary net lending and borrowing 3/−6,941−8,070−10,245−13,504−15,171−16,355−17,845
Financing−2,483−6,213−6,967−2,630−722−1832,123
Net acquisition of financial assets−3,100−6,938−7,563−3,466−1,651−2,0771,115
Domestic−3,100−6,938−7,563−3,466−1,651−2,0771,115
Oil Fund−3,018−6,700−6,088−3,608−1,091−1,767−585
Net incurrence of liabilities6177245968369291,8942,308
Domestic395252−90−35365−151,300
External2234736878725641,9091,008
Memorandum items:
Oil revenue9,46114,32317,42216,23116,06516,71415,907
Non-oil GDP (in billion of manats)19,53622,24325,39329,76634,05138,14442,850
Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes contingent revenues accrued on the “deposit account” of budgetary organizations.

Includes profit oil, acreage fees, and income earned on Oil Fund assets.

Defined as non-oil revenue minus total expenditure (excluding interest payments) and statistical discrepancies.

Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes contingent revenues accrued on the “deposit account” of budgetary organizations.

Includes profit oil, acreage fees, and income earned on Oil Fund assets.

Defined as non-oil revenue minus total expenditure (excluding interest payments) and statistical discrepancies.

Table 4a.Azerbaijan: Consolidated Central Government Operations, 2009–15(in percent of non-oil GDP)
Prel.Proj.
2009201020112012201320142015
Total revenue and grants73.587.291.773.367.063.356.9
Total revenue73.587.191.773.367.063.356.9
Tax revenue28.626.227.623.522.721.621.2
Income taxes9.89.111.210.38.97.97.2
Social security contributions3.03.12.90.51.11.11.0
Value added tax (VAT)10.39.48.88.07.98.08.1
Excise taxes2.52.31.91.81.81.71.7
Taxes on international trade2.21.31.72.02.02.02.2
Other taxes0.91.01.11.01.01.01.0
Nontax revenue 1/44.960.964.149.844.241.735.7
Of which: Oil Fund revenues 2/42.458.861.147.641.539.033.0
Total expenditure61.660.568.466.565.663.361.6
Current expenditure39.236.736.137.336.335.935.6
Primary current expenditure39.036.535.237.035.835.435.4
Interest0.20.20.80.30.50.50.3
Investment expenditure and net lending22.423.832.329.129.327.425.9
Domestically-financed20.921.429.325.926.122.123.3
Foreign-financed1.52.43.03.33.25.32.6
Statistical discrepancy−0.7−1.2−4.1−2.0−0.7−0.40.3
Consolidated government balance, cash basis12.727.927.48.82.10.5−5.0
Non-oil primary balance 3/−35.5−36.3−40.3−45.4−44.6−42.9−41.8
Financing−12.7−27.9−27.4−8.8−2.1−0.55.0
Domestic (net)−13.8−30.1−30.1−11.8−3.8−5.52.6
Banking system−0.1−0.6−6.40.3−0.7−1.01.6
Oil Fund−15.4−30.1−24.0−12.1−3.2−4.6−1.4
External (net)1.12.12.72.91.75.02.4
Loans1.52.43.03.33.25.32.6
Memorandum items:
Oil revenue48.464.468.654.547.243.837.1
Non-oil revenue 4/25.122.823.118.819.819.519.8
Non-oil tax revenue 5/20.218.117.816.515.715.515.7
Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes contingent revenues accrued on the “deposit account” of budgetary organizations.

Includes profit oil, acreage fees, and income earned on Oil Fund assets.

Defined as non-oil revenue minus expenditure (excluding interest payments) and statistical

Excludes AIOC profit tax, profit oil, and SOCAR profit tax. but includes VAT and excise taxes on oil and gas, tax withholding on the AIOC’s subcontractors.

Tax revenue excluding AIOC and SOCAR profit tax and social contributions.

Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes contingent revenues accrued on the “deposit account” of budgetary organizations.

Includes profit oil, acreage fees, and income earned on Oil Fund assets.

Defined as non-oil revenue minus expenditure (excluding interest payments) and statistical

Excludes AIOC profit tax, profit oil, and SOCAR profit tax. but includes VAT and excise taxes on oil and gas, tax withholding on the AIOC’s subcontractors.

Tax revenue excluding AIOC and SOCAR profit tax and social contributions.

Table 4b.Azerbaijan: Statement of Consolidated Government Operations, 2009–15(in percent of non-oil GDP, presented in line with the GFSM 2001)
2009201020112012201320142015
Prel.Proj.
Revenue75.989.193.575.368.764.756.9
Tax revenue25.623.124.723.021.623.021.2
Income taxes9.89.111.210.38.97.97.2
Value added tax (VAT)10.39.48.88.07.98.08.1
Excise taxes2.52.31.91.81.81.71.7
Taxes on international trade2.21.31.72.02.02.02.2
Other taxes0.91.01.11.01.01.01.0
Social security contributions5.35.14.72.52.82.41.0
Nontax revenue 1/44.960.964.149.844.241.735.7
Of which: Oil Fund revenues 2/42.458.861.147.641.539.033.0
Expense41.538.637.839.238.037.263.0
Current expenditure41.538.636.839.238.037.237.0
Primary current expenditure41.338.536.438.937.536.736.6
Interest0.20.20.80.30.50.50.4
Other expense0.00.10.20.10.10.10.1
Net operating balance (-, deficit)34.450.555.736.030.727.519.9
Net Acquisition of Nonfinancial Assets22.423.832.329.129.327.425.9
Statistical discrepancy−0.7−1.2−4.1−2.0−0.7−0.4−1.1
Consolidated net lending and borrowing, cash basis12.727.927.48.82.10.5−5.0
Non-oil primary net lending and borrowing 3/−35.5−36.3−40.3−45.4−44.6−42.9−41.6
Financing−12.7−27.9−27.4−8.8−2.1−0.55.0
Net acquisition of financial assets−15.9−31.2−29.8−11.6−4.8−5.42.6
Domestic (net)−15.9−31.2−29.8−11.6−4.8−5.42.6
Net incurrence of liabilities3.23.32.32.82.75.05.4
Domestic2.01.1−0.4−0.11.10.03.0
External1.12.12.72.91.75.02.4
Memorandum items:
Non-oil GDP (in billion of manats)19.522.225.429.834.138.142.8
Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes contingent revenues accrued on the “deposit account” of budgetary organizations.

Includes profit oil, acreage fees, and income earned on Oil Fund assets.

Defined as non-oil revenue minus total expenditure (excluding interest payments) and statistical discrepancies.

Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes contingent revenues accrued on the “deposit account” of budgetary organizations.

Includes profit oil, acreage fees, and income earned on Oil Fund assets.

Defined as non-oil revenue minus total expenditure (excluding interest payments) and statistical discrepancies.

Table 5.Azerbaijan: Summary Accounts of the Central Bank, 2009–15(in millions of manat, unless otherwise specified)
Prel.Proj.
2009201020112012201320142015
Net foreign assets4,2575,4888,5499,41111,90713,44813,839
Net international reserves of the CBA4,2575,4888,5499,41211,90713,44313,832
Gross international reserves4,3085,5278,5729,42511,91313,45013,838
Foreign liabilities−50−39−23−13−5−7−6
Other items, net 1/000−1056
Net domestic assets6511,033−591,249499−169702
Domestic credit8751,087−71,3888522831,055
Net claims on consolidated central government−591−828−2,083−1,934−2,677−3,032−2,912
Claims on banks1,4731,5506079721,3061,5002,401
Credit to the economy23991,5202,4702,0891,7761,510
CBA notes−8−34−50−120−204057
Other items, net−225−54−52−139−353−453−353
Reserve money4,9086,5218,48910,66011,79313,27914,541
Manat reserve money4,8616,3978,27510,51511,64213,12114,374
Currency outside CBA4,5135,7937,6589,77811,03312,15213,473
Bank reserves and other deposits345602612723555958891
Reserves in foreign currency47124214145194158167
Sources: Central Bank of Azerbaijan; and IMF staff estimates and projections.

In 2009, Azerbaijan received general and special SDR allocations from the IMF in the amount of SDR 153.6 millions.

Sources: Central Bank of Azerbaijan; and IMF staff estimates and projections.

In 2009, Azerbaijan received general and special SDR allocations from the IMF in the amount of SDR 153.6 millions.

Table 6.Azerbaijan: Monetary Survey, 2009–15(in millions of manat, unless otherwise specified)
Prel.Proj.
2009201020112012201320142015
Net foreign assets3,4444,6367,8238,2629,90311,53211,923
Net international reserves of the CBA4,2575,4888,5499,41211,90713,44313,832
Net foreign assets of commercial banks−731−779−674−1,063−1,842−1,842−1,842
Other−83−73−52−86−162−65−63
Net domestic assets5,1895,8896,0538,4929,23210,50714,524
Net claims on consolidated central government−637−777−2,098−2,038−2,775−3,141−2,989
Credit to the economy8,9469,78611,81415,60316,93018,83021,086
Of which: private sector7,4297,9199,35211,29614,40915,89018,294
Other items, net−3,120−3,119−3,663−5,073−4,922−5,182−3,573
Broad money8,63310,52713,90316,77419,36022,04326,451
Manat broad money6,1578,29710,99713,80616,43518,85321,518
Cash outside banks4,2535,4567,1589,25710,45912,86415,952
Manat deposits1,9042,8423,8394,5505,9765,9895,566
Foreign currency deposits2,4762,2302,9062,9672,9253,1903,492
(Annual percentage change)
Net foreign assets−18.534.668.75.619.916.43.4
Net domestic assets63.413.52.840.38.713.838.2
Credit to the economy37.99.420.732.18.511.212.0
Of which: private sector25.66.618.120.827.610.315.1
Broad money (M3)16.621.932.120.615.413.920.0
Manat broad money (M2)9.934.832.525.519.014.714.1
Reserve money−1.132.930.225.610.612.69.5
Manat reserve money1.731.629.427.110.712.79.5
Memorandum items:
Gross official international reserves (US$ millions)5,3646,92710,89911,58713,98715,98716,487
Velocity of total broad money (M3) 1/3.02.82.62.32.32.32.3
Broad money in percent of non-oil GDP41.144.352.953.553.954.155.4
Credit to private sector in percent of non-oil GDP20.918.636.837.942.341.742.7
Currency to broad money ratio49.351.851.555.254.058.460.3
Share of foreign currency deposits in total deposits56.544.043.139.532.934.838.6
Foreign currency deposits to broad money ratio28.721.220.917.715.114.513.2
Sources: Central Bank of Azerbaijan; and IMF staff estimates and projections.

Velocity is defined as the ratio of gross domestic demand (excl. oil–related imports) and average broad money.

Sources: Central Bank of Azerbaijan; and IMF staff estimates and projections.

Velocity is defined as the ratio of gross domestic demand (excl. oil–related imports) and average broad money.

Table 7.Azerbaijan: Selected Economic and Financial Indicators, 2013–19
Proj.
2013201420152016201720182019
(Annual percentage change, unless otherwise
National income
GDP at constant prices5.85.04.63.53.24.04.2
Of which: Oil sector 1/0.5−0.1−0.10.00.02.12.7
Non-oil sector 2/9.98.37.55.55.05.05.0
Consumer price index (period average)2.43.54.04.35.04.95.0
External sector (in U.S. dollars)
Exports f.o.b.−1.0−1.9−5.8−4.7−3.00.71.9
Of which: Oil sector−1.0−1.9−6.7−5.8−3.9−0.11.3
Non-oil sector−1.8−2.57.710.78.08.08.0
Imports f.o.b.0.27.28.89.47.16.46.3
Of which: Oil sector6.831.032.118.610.35.12.4
Non-oil sector−0.54.35.27.76.46.67.2
Export volumes−0.1−1.90.00.10.12.73.6
Import volumes0.99.29.99.56.45.85.9
(In percent of GDP, unless otherwise specified)
Consolidated central government finance
Overall fiscal balance1.00.3−3.1−4.8−6.3−6.6−6.4
Non-oil primary balance, in percent of non-oil GDP 4/−45.0−43.2−41.8−40.4−38.3−36.9−34.2
External sector
Current account balance19.715.09.95.65.55.04.6
Non-oil current account balance (in percent of non-oil GDP)−19.8−18.8−18.0−18.8−14.7−13.3−12.8
Foreign direct investment (net)−0.90.522.32.12.11.2
Of which: Non-oil sector1.20.61.31.82.02.22.4
Public and publicly guaranteed external debt outstanding11.714.014.214.815.015.515.8
Memorandum items:
Gross official international reserves (in billions of U.S. dollars)14.016.016.517.017.518.018.5
Nominal GDP (in billions of manat)57.761.667.572.779.886.193.9
Nominal GDP (in billions of US. dollars)73.579.487.894.6103.8112.0122.1
Nominal non-oil GDP (in billions of manat) 2/34.138.142.847.052.357.163.4
Nominal non-oil GDP (in billions of US. dollars) 2/43.449.155.761.268.074.282.5
Oil Fund Assets (in billions of U.S. dollars) 5/35.437.738.537.634.730.428.8
Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes the production and processing of oil and gas.

Includes oil and gas transportation (except through the western route), and export tax paid by the state oil company.

Historical data includes statistical discrepancy.

Defined as non-oil revenue minus total expenditure (excluding interest payments) and statistical discrepancies.

Includes the central government foreign exchange deposits managed by the Oil Fund.

Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes the production and processing of oil and gas.

Includes oil and gas transportation (except through the western route), and export tax paid by the state oil company.

Historical data includes statistical discrepancy.

Defined as non-oil revenue minus total expenditure (excluding interest payments) and statistical discrepancies.

Includes the central government foreign exchange deposits managed by the Oil Fund.

Appendix I. Risk Assessment Matrix1
Nature/Source of Main ThreatsOverall Level of Concern
Likelihood of Severe Realization of Threat in the Next 1–3 years (high, medium, or low)Expected Impact if Threat Materializes (high, medium, or low)
Global Risks
Surges in global financial market volatility (related to UMP exit), leading to economic and fiscal stress, and constraints on country policy settings.HighMedium

Channels of transmission from international financial markets to Azerbaijan are not strong. The biggest impact would be through the value of assets held by the oil fund.
Protracted period of slower growth in advanced economies (negative surprises on potential growth) or emerging economies (incomplete structural reforms).High

(Advanced economies)

High

(Emerging markets)
High

A long period of slow growth in Europe could hurt oil export volumes in the short run and hurt plans to export gas directly to Europe. A slowing in emerging markets will have less impact.
Sustained decline in commodity prices triggered by deceleration of global demand and coming-on-stream of excess capacity (medium-term).MediumMedium/High Given Azerbaijan’s high oil dependence, the economy could go into recession. The oil fund savings could help cushion the shock. A prolonged price decline would necessitate a large fiscal adjustment.
Increasing geopolitical tensions surrounding Ukraine lead to disruptions in financial, trade and commodity marketsMediumMedium/High

Disruptions in gas supply could raise oil prices by 15 percent. Such event would strengthen growth prospects as well as fiscal and external positions.
Nature/Source of Main ThreatsOverall Level of Concern
Likelihood of Severe Realization of Threat in the Next 1–3 years (high, medium, or low)Expected Impact if Threat Materializes (high, medium, or low)
Country specific risks
Oil production risk Disruptions in oil production if recent efforts to stabilize oil output cannot be sustainedMediumHigh

Disruptions in oil production would undermine growth prospects and result in deteriorations of the overall fiscal and external positions.
Financial sector risks (The weak position and supervision of the systemic public bank (IBA) could compromise the stability and soundness of the system)MediumMedium

A further deterioration of this bank could create systemic problems in the banking system. Though the government is likely to step in with important fiscal costs.
Fiscal risks Slippages in the fiscal adjustment due to investment commitments for the 2015 Euro Olympic games in Baku.MediumMedium/Low

Delays in undertaking the fiscal adjustment could exacerbate fiscal vulnerabilities to a potential oil price decline.
Escalation of the conflict with Armenia over Nagorno-Karabakh (Tensions with Armenia could increase, following recent geopolitical events surrounding Ukraine)MediumHigh

Military conflict would entail severe

economic and social impacts and

damage FDI prospects, particularly

in the non-oil sector.
Policy responses: With potential downside risks, staff will recommend that the authorities rebuild policy buffers. This would entail strengthening the non-oil fiscal position beyond the levels envisaged in the 2014 approved budget. Sustaining efforts to enhance banking supervision combined with development of plans to bring the public bank under a sustainable financial position will also help contain risks in the financial sector.
Appendix II. Debt Sustainability Assessment

Azerbaijan: External Debt Sustainability: Bound Tests 1/2/

(External debt in percent of GDP)

Sources: Azerbaijan desk data, and IMF staff estimates.

1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.

2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.

3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.

4/ One-time real depreciation of 30 percent.

Azerbaijan: Public Sector Debt Sustainability Analysis (DSA)–Baseline Scenario

(In percent of GDP, unless otherwise indicated)

Source: IMF staff.

1/ Public sector is defined as general government.

2/ Based on available data.

3/ Long-term bond spread over U.S. bonds.

4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.

5/ Derived as [(r - π(1+g) - g + ae(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

6/ The real interest rate contribution is derived from the numerator in footnote 5 as r - π (1+g) and the real growth contribution as -g.

7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).

8/ Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.

9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

Currently, the shares of oil and gas in total exports are 87 percent and 7 percent, respectively. These shares could become 60 percent and 30 percent as Azerbaijan reaches the peak of gas production for delivery to Europe before 2020. The reserves to production ratio for oil and gas are 22 years and 57 years, respectively, according to the 2013 British Petroleum Statistical Review of World Energy. Major reasons behind the depletion of oil reserves are the age of the oil fields and limited investment in the oil sector.

For a discussion of the marked decrease in the poverty rate (including gains in employment, wages and productivity, and social transfers), see “The Inclusiveness of Azerbaijan’s Growth” in IMF Country Report 12/05 (Box 2) and 12/06 (Chapter 1).

In the remaining part of this report, oil refers to oil and gas, except when gas is discussed explicitly.

The Tariff Council increased the prices of petrol, diesel fuel and some other petroleum products by 30 percent on average. This is the first adjustment to these prices since December 2007. The International Energy Agency (IEA) ranked Azerbaijan as one of the oil exporting countries in the world with lowest energy consumption subsidies in 2012 (about 3 percent of GDP).

See IMF Country Reports 13/164 and 13/165 for an application of the FAD fiscal module of the Resource-rich Developing Countries Framework to Azerbaijan.

In particular, the CBA tightened consumer loan extension procedures and limited the loan-to-value of car loans.

For a discussion on IBA issues see IMF Country Report 12/05.

A 12 percent decline in the assumption for oil production in 2014 (about 100,000 barrels per day) could worsen the consolidated fiscal balance by 5 percentage points of GDP and, in the absence of spending adjustment, would result in a withdrawal of oil fund reserves by $4 billion. A similar impact on the budget would arise with US$20 decline in the oil price. The probability of such event this year is not small as pointed out by the analysis conducted by the IMF research department in the context of the 2014 Spring World Economic Outlook.

For detailed discussion on options to strengthen the non-oil tax revenue see IMF Country Report 12/06 (chapter 2).

The only non-contributory, means-tested safety net program is the Targeted Social Assistance (TSA) channeling about 10 percent of social transfer spending. According to the World Bank, the TSA is well targeted with about half the benefits flowing to the bottom decile of the population and less than one percent leaking to the top decile. Benefits, however, reach only about 4 percent of the population.

For detailed discussion on options for fiscal policy rules in Azerbaijan see IMF Country Report 13/165 (chapter 1).

For detailed discussion on exchange rate policy in Azerbaijan, see IMF Country Report 12/06 (chapter 3) and 13/165 (chapter 2).

See IMF Country Report 13/164 for recent amendments to the tax code aimed at providing some tax incentives to foster the non-oil sector development.

Prior to March 2014, bonds from the State Oil Company of the Azerbaijan Republic (SOCAR) were the country’s only benchmark-sized international bonds. SOCAR issued bonds in February 2012 and March 2013.

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities.

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