Journal Issue

Republic of Azerbaijan: 2016 Article IV Consultation—Press Release; Staff Report; and Informational Annex

International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
September 2016
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1. Oil and gas are central to Azerbaijan’s economy. During the oil price boom (2006-14) hydrocarbon (HC) activity accounted for three-quarters of GDP and government income, and 90 percent of exports. Oil production is expected to decline in 2016-19, with oil prices below historical averages. A pivot toward gas extraction and the building of a new pipeline network should raise gas output and exports (from 2018 onward). Oil reserves are estimated to be 7 billion barrels, while gas reserves are 35 trillion cubic feet. The authorities are negotiating a new production sharing agreement with the consortium of foreign oil companies (AIOC), who together with the state oil company (SOCAR) extract hydrocarbons in Azerbaijan.

2. President Aliyev’s New Azerbaijani Party (YAP) dominated 2015 parliamentary elections. The main opposition parties opted not to participate. Constitutional amendments have been proposed to lengthen presidential terms from 5 to 7 years. To improve policy discussion and coordination, a high-level committee on economic policy planning and reforms was established in late 2015.

Recent Developments

3. A series of negative shocks have dented economic performance. Plummeting oil prices, weak regional growth, currency movements and a contraction in HC production quickly erased a large current account surplus. To preserve reserves, the central bank (CBA) undertook a 25 percent devaluation in February 2015 and a second 32 percent devaluation in December 2015, with a shift to a managed floating ER regime. Growth fell to 1.1 percent in 2015 and contracted by 3.4 percent in first half of 2016, given cuts in public investment, stagnant credit activity and flat oil production. Inflation averaged 4.1 percent in 2015 and rose to about 11 percent by mid-2016, reflecting exchange rate pass-through effects (ERPT) (Annex I).

4. Buffers remain substantial given Oil Fund (SOFAZ) assets. Foreign exchange (FX) sales have lowered CBA reserves from $13.8 billion at end-2014 to $4.3 billion by end-June (3.5 months of projected 2016 imports of goods and services). Based on the IMF’s composite reserve adequacy metric, Azerbaijan should hold about 8.4 months of current imports. SOFAZ assets, which can be used to support the ER, amounted to some $34 billion (close to 100 percent of 2016 projected GDP; about 28 months of current imports). Based on the Fund’s EBA-lite methodology, the real effective exchange rate (REER) remained modestly overvalued as of end-2015 (Annex II).

5. A counter-cyclical stimulus tailored to promote growth and protect vulnerable populations is being implemented. Public sector wages, overall pensions, and social protection expenditures have been increased by 10 percent (3 percent of non-oil GDP) in 2016. With the issuance of an external Southern Gas Corridor (SGC) bond in March for $1 billion, space was freed up in the state budget for an additional 3½ percent of non-oil GDP in capital spending to complete ongoing projects. To ease social tensions, state-owned enterprises and local authorities have hired 35,000 minimum wage workers on temporary contracts.1 Moreover, new non-oil tax measures are expected to reduce revenues by ¼ percent of GDP (Box 1). Overall, current and capital expenditures rise by about 2 percent of GDP, while the consolidated government non-oil primary deficit as a percent of non-oil GDP rises by about 3 percentage points (pps), to 38 percent.2

Box 1.Azerbaijan: Non-Oil Tax Revenue

The authorities aim to raise non-oil tax revenues without adding new taxes or raising rates. The plan is focused on fostering non-oil activity (broadening the base), simplifying the tax system and encouraging compliance via accessible e-services. However, it is not clear the extent to which these measures will improve the tax intake in the long-run or Azerbaijan’s low tax yield efficiency.

Revenue from different tax categories, 2015

(millions of AZN manat)

The current tax structure relies on value-added (VAT), and corporate (CIT) and personal (PIT) income taxes. The PIT rate is 14 percent for income up to AzN 2,500 per month and 25 percent thereafter. The CIT rate is 20 percent, but certain firms can opt to pay a simplified tax (ST) rate (4 percent in Baku, 2 percent elsewhere). ST payers do not pay property tax or VAT. The VAT rate is 18 percent, but firms participating in production sharing agreements and joint ventures in the hydrocarbon sector are exempt.

New tax policy changes focus on adjusting registration limits. For 2016 the qualifying income threshold have been raised (from AzN 200 to 2,500) while the standard deduction was held constant at AzN 136. The VAT registration and ST eligibility has been increased (from AzN 120,000 to 200,000). Traders or catering firms with turnover exceeding AzN 200,000 can now opt out of VAT and pay at the ST rate (albeit at 6 and 8 percent, respectively). Construction firms can now choose to pay a VAT or an average of AzN 45 per square meter.

VAT Rates and Productivity, 2014

(in percent)

Sources: IMF, VAT Database (Fiscal Affairs Department), Government Finance Statistics Yearbook (Statistics Department)

Exemptions have been recently introduced to boost private investment. From March 2016, new investment projects within certain regions and sectors, and a minimum investment amount can qualify for an “investment certificate.” Required investment amounts range from AzN 200,000 (rural regions) to 10 million (more urbanized). Among the priorities are industrial parks, manufacturing plants, and research activities. Valid for seven years, the certificate provides for a 50 percent reduction of income taxes, VAT-free import of technological equipment, and no property or land tax. A number of SMEs have applied, signaling a positive effect on investment.

Taxpayer services have been modernized. All formal labor contracts are registered in a database that is shared between the Ministry of Taxes and the Ministry of Labor and Social Protection. Business and individuals can now pay taxes and custom duties via e-services reducing compliance time. These efforts, together with a reduction in the number of required taxes, have resulted in a marked improvement (from 103rd in 2011 to 34th in 2016) in Azerbaijan’s Ease of Paying Taxes indicator (from the World Bank’s Doing Business survey).

6. Fiscal space has declined. More than 70 percent of Azerbaijan’s public debt is denominated in foreign currencies. Given the devaluations and borrowing plans, the debt sustainability analysis (DSA) indicates that the debt to GDP ratio will move from 11 percent in 2014 to about 38 percent in 2016 (Annex III).

7. The CBA tightened the monetary policy stance in 2016 to limit inflationary pressures. In three separate moves (in February, March and August), the CBA increased its refinancing rate by 650 basis points (bps) (to 9.5 percent) and adjusted the interest rate corridor.3 Since mid-2016, the CBA has held manat deposit auctions to withdraw liquidity. With the move to a managed float and periodic FX auctions, exchange rate volatility has increased.4 Credit growth has turned negative in 2016 given weak economic activity, mismatches in banks’ currency positions and expectations of additional devaluations.

8. The authorities have taken steps to repair the banking system (Annex IV). The devaluations led to an increase in dollarization, weakened bank balance sheets and deteriorated financial soundness indicators—raising significant financial stability concerns. In mid-2015, the government created a bad bank-SPV to manage and collect nonperforming loans (NPLs) from the largest state bank (IBA), while the CBA closed or merged a number of smaller banks. In March 2016, banking and insurance supervision was transferred from the CBA and Ministry of Finance (MOF), respectively, to a new supervisory and regulatory authority, the Financial Market Services Agency (FMSA). To support confidence, household bank deposits were afforded a blanket guarantee backstopped through the CBA.5 To address dollarization, new macro-prudential limits were placed on dollar lending and foreign currency reserve requirements were increased. The FMSA has put together a supervisory action plan and has started to address ailing institutions. A Financial Stability Board has also been created.6

Azerbaijan: Banking Sector Financial Soundness Indicators 2011–15(In percent)
20112012201320142015 1/
Regulatory Capital to Risk-Weighted Assets14.716.818.119.25.5
Liquid Assets to Total Assets14.612.29.811.423.4
Nonperforming Loans (NPLs) to Total Loans 2/3/
NPLs Net of Provisions to Total Loans 2/3/
Bank Return on Assets−−1.0
Bank Return on Equity−−9.8
Sources: Central Bank of Azerbaijan and staff estimates.

2015 data reflects prudential FSIs.

Excludes restructured loans. Impaired loan ratios are higher under IFRS.

Disclosed NPLs are underestimated for 2011-14; only overdue portion of principal and interest is counted.

Sources: Central Bank of Azerbaijan and staff estimates.

2015 data reflects prudential FSIs.

Excludes restructured loans. Impaired loan ratios are higher under IFRS.

Disclosed NPLs are underestimated for 2011-14; only overdue portion of principal and interest is counted.

Outlook and Risks

9. Near-term economic prospects are poor—with a recession projected in 2016. Under current policies, real GDP is expected to contract by -2.4 percent in 2016, and hover around 1-2 percent in the next few years, while inflation is expected to gradually fall under 8 percent. Large fiscal surpluses during the oil boom years are projected to turn into deficits in 2015-18. The current account balance should improve as the devaluations work to limit imports and support non-traditional exports. The authorities plan to utilize about $500 million in SOFAZ assets in 2016 to help finance balance of payments gaps.

10. Macro-financial risks to the outlook are substantial (Appendix I).

  • Given the economy’s HC export structure and public investment framework, oil price shocks have a strong impact on the real economy, with spillover effects on the ER, bank profitability, and credit delivery systems (Box 2). Macro-financial linkages have increased significantly over time, through rapid growth in bank credit during the oil boom years—notably to the household and construction sectors. (Box 3). Dollarization—which increases vulnerabilities to liquidity and solvency shocks—has expanded. Weak bank capital and liquidity positions are also weighing on credit activity.

  • While the authorities are making progress in cleaning up the banking system at a difficult juncture, the bank restructuring strategy entails important risks—notably the decision to inject substantial new resources into IBA—a large systemic public bank with a weak track record and a continued lending focus on oil-related industrial projects.

  • Staff projections seek to incorporate these financial sector risks. So far, bank closures have been handled effectively and have occurred without provoking destabilizing deposit runs. Deposit growth, which declined during the devaluations, has rebounded (due in part to the blanket guarantee), helping to support bank funding. Downgrades by international rating agencies have had little impact given limited dependence on external credit lines. Negative financial accelerator effects and increases in dollarization rates experienced in 2015-16, are assumed to reverse gradually as oil prices are expected to improve over the forecast period and as banking sector reform progresses. Staff’s growth and private credit forecasts for 2016-2020 average 1.3 and 6.0 percent, respectively, well below historical averages and imply a relatively slow recovery.

Box 2.Azerbaijan: Linkages and Spillovers

Negative Oil Price Shock
Lower Export Revenue, CA Balance

Impacts Hydrocarbon Sector
FX Reserves Fall

Lower AIOC and SOCAR profits

Negative Confidence Effects
Exchange Rate Pressure

Lower SOFAZ Revenues

Depreciation/Dollarization Pressures

Lower Transfers to State Budget

Negative Wealth Effects
Bank/Private Balance Sheets Weakened

Less Public Investment
Effects Non-Oil Economy Real Economic Growth FallsLess Credit / Finanical Intermediation

The oil price is the main channel linking Azerbaijan to the global economy. Oil profits are a key part of factor income, a share of which get reinvested in FDI by the consortium of foreign oil companies which is developing Azerbaijan’s oil fields. Given the ad hoc fiscal rule, a portion of these profits were used to build up sovereign wealth fund (SOFAZ) buffers and recycled throughout the economy via budgetary transfers for public investments. Oil price shocks also put pressure on exchange rates and reserves and creating income/wealth and confidence effects, and affect financial intermediation.

Azerbaijan: Forecast Error Variance Decomposition of Non-Oil Growth

Source: IMF Staff estimates

Public investment is the main transmitting mechanism between the oil and non-oil sectors in Azerbaijan. An estimated vector auto regression (VAR) model using annual data from 1997 to 2015 shows that, net of public investment, the impact of trading partner growth on non-oil sector is negligible. Public investment and oil prices, however, explain the majority of variance in the non-oil growth rates, especially over the medium term.

While direct external linkages to the financial sector are small, indirect linkages have been substantial. Azerbaijan’s financing needs have been low by international standards, given external and fiscal surpluses. Lending by global banks to Azerbaijan’s financial sector has been minimal and corporations have relied mainly on their own resources. FDI, focused on the energy sector, remained strong due to new gas developments. However, the oil price-led devaluations have weakened the domestic banking system and raised the risk premium for Azerbaijan when borrowing in international markets. As a consequence, financing the new gas pipeline project faced higher costs as reflected in the yield of the 10-year bond issued in mid-March 2016.

Azerbaijan: Euro Bond Yield

Source: Bloomberg

Box 3.Azerbaijan: Macro-Financial Linkages7

Oil and ER shocks have led to a rise in dollarization levels. Dollarization in Azerbaijan had fallen from 2002 to 2014, with a minor setback at the start of the financial crisis in 2008. It appears to move in line with oil prices, a key propagator of the business cycle (BC) in Azerbaijan.

Starting from a very low base, bank credit has expanded rapidly over the last decade. Two separate growth phases—first from 2005-10, and a second dramatic acceleration in credit activity in 2011-15—appear to have occurred. The main growth sectors were in trade, construction, households and industry—with trade credit expanding at a slower rate in the second period and construction, industry and household credit surging.

Azerbaijan: Dollarization of Deposits

Sources: CBA and IMF staff estimates.

Azerbaijan: Credit Growth By Sector


Sources: CBA and Staff estimates.

Total credit as a percent of non-oil GDP has almost tripled, going from 23 percent in 2005 to 63 percent by 2015. Over the same period, credit to households has increased from 6½ to 24½ percent of non-oil GDP, while credit to the construction sector has increased from 1½ to 9 percent of non-oil GDP. Mortgages have been a key component of the growth in household credit (now 4½ of non-oil GDP), with the remaining 20 percent stemming from consumer oriented lending (e.g., credit cards, auto loans and home appliances).

Azerbaijan: Credit by Sector

(in percent of Non-Oil GDP)

Sources: CBA and IMF staff estimates.

Sectoral credit gaps and BCs do not fully co-move together. The “credit gap”, defined as the difference between a credit-to-GDP ratio and its long-term trend, reflects a financial cycle (FC). The last 3 BCs (trough-to-trough) were in 2001-05, 2005-09 and 2009-2016. In comparison, sectoral credit gaps appear to be more diverse with little movement during the first BC. Corporate and trade FCs appear to co-move and lag a bit the second BC. In the last BC, household, trade and construction FC respond sharply during the boom.

Box 3.Azerbaijan: Macro-Financial Linkages8 (concluded)

Azerbaijan: Business Cycles

(in percent)

Sources: Haver and IMF Staff estimates.

Azerbaijan: Financial Cycles

(in percent)

Sources: Haver and IMF staff estimates.

Two sets of regressions are estimated to find evidence of a macro-financial linkage. One set focuses on credit regressions, looking to see how BCs affect the credit market. The other focus is on growth regressions, using individual sectoral credit growth or FCs to ascertain the impact of credit developments on real activity. A loan to deposit leverage ratio and oil price growth are used as financial and real sector conditioning variables. The data is quarterly (2006q1-2016q2). Regression results which found significant macro-financial linkages are reported below. They indicate that construction and industry credit growth are affected by non-oil growth, while growth in trade, construction, and household credit impact non-oil growth. For example, a one percentage point increase in overall credit growth is found to increase growth by 0.15 percent. At the same time, a one percentage point change in non-oil growth is related to an expansion in construction and industry credit growth by about 3½ and 2¾ percent, respectively.

Azerbaijan: Credit and Non-Oil Growth Regressions 1/
Construction and real estateIndustryNon-oil growthNon-oil growthNon-oil growthNon-oil growth
Fitted values for non-oil growth3.49**


Loan to deposit ratio0.77






Oil price growth−0.03






L1.Real credit growth0.15**

L1.Trade & services credit0.13**

Construction and real estate0.041*









Quarterly observations424243434343
Adjusted R-squared0.180.290.710.710.660.72
Sources: Haver and Staff estimates.

Using quarterly data, 2005q1-2016q2. Quarterly dummies included. Three quarter lags of both dependent and independent variables included. Heteroskedastic-robust standard errors in brackets. * p>0.1, ** p>0.05, *** p>0.001.

Sources: Haver and Staff estimates.

Using quarterly data, 2005q1-2016q2. Quarterly dummies included. Three quarter lags of both dependent and independent variables included. Heteroskedastic-robust standard errors in brackets. * p>0.1, ** p>0.05, *** p>0.001.

11. Overall, risks to the outlook are tilted to the downside. Additional oil price declines associated with a deteriorating global outlook would worsen external balances, increase ER pressures, expose fiscal vulnerabilities and further dent consumer and business confidence. Budgetary transfers from SOFAZ would diminish resulting in further spending cuts or larger fiscal deficits, which may require drawdowns from SOFAZ’s stock of assets. Direct exposure to international financial markets is concentrated mostly on Oil Fund assets held abroad. As demonstrated above, complications in the bank restructuring process could also impact growth. Better than expected oil price developments constitute the main upside risk. The authorities broadly agreed with staff’s macroeconomic projections and hold similar views on the risk outlook.

Policy Discussions

A. Implementing a Sustainable Fiscal Consolidation

12. Staff argued that the composition of the stimulus was less than ideal but agreed an accommodative fiscal stance in 2016 was appropriate. The authorities acknowledged that fiscal space had shrunk and the stimulus could put added pressure on the ER. However, buffers were available to soften the impact of the recession on vulnerable populations and the stimulus only partially offset the effect of the devaluations. Moreover, the 2016 budget was based on a conservative $25 a barrel oil price.

13. Staff recommended targeting an additional 12 pps of adjustment in the non-oil primary deficit over 2017-20. This would be in line with the permanent income hypothesis (PIH) fiscal rule for Azerbaijan and bring the non-oil deficit in line with the estimated sustainable level (Box 4).9

Box 4.Azerbaijan: Recommended Fiscal Rule Targets

Azerbaijan currently uses an ad-hoc fiscal policy framework. The framework contains three main elements: (i) an ad-hoc rule to save ½ of oil revenue abroad in a well-managed oil fund (SOFAZ); (ii) using ¾ of transferred oil-fund revenue to finance investment; and (iii) broad coverage of fiscal accounts, underpinned by rolling non-binding three-year budget plans. The system is pro-cyclical (tightly linked to oil prices), lacks focus on long-term non-oil sustainability and is biased toward excessive public investment.

Azerbaijan: Non-Resource Primary Balance

(Percent non-resource GDP)

Sources: IMF staff calculations.

Staff has recommended a rule-based framework to promote fiscal discipline and anchor expectations. A modified permanent income (PIH) model, which relies on a non-resource primary balance (NRPB) target (as a percentage of non-resource GDP), can be used to guide optimal consumption-savings decisions.10 Under the model, the initial years of scaled-up investment have to be fully reversed by fiscal adjustments. Between 2008 and 2016, Azerbaijan public investment has averaged about 15 percent of GDP. Based on expected oil prices, fiscal revenues, and the depletion of natural resource wealth by 2035, the modified PIH model computes a NRPB target of 26 percent in the long term. The projected 2016 NRPB was 38 percent.

To supplement the analysis, a “golden rule” investment rate has also been estimated. The model of Cherif and Hasanov (2013) provides an estimated optimal investment rate under different assumptions for productivity, planning horizons and initial buffers.1 With an assumed 10 percent return on public investment, 45-year horizon, and initial wealth-to-revenue ratio of 2, the optimal investment rate is within the range of 15-18 percent of total government revenues. Recent estimates indicate that public investment as a percent of total government revenue could go from 52 percent in 2016 to 23 percent by 2020.

Azerbaijan: Optimal vs. Projected Investment Spending Paths, 2013–21

(In billions of AzN)

Source: IMF staff calculations.

  • The authorities stressed that fiscal policy would return to a consolidation path and outlined a number of measures. In particular, they agreed that some parts of past capital expenditures have been inefficient, and that capital spending levels are high and needed to decrease. They also indicated that there was room to lower expenditures on goods and services. Going forward, the 2016 pension, wage and social spending increases would not be repeated, capital spending reductions would resume, and new pension legislation will lower pension deficits. Notably, the devaluation effects which automatically raised certain expenditures would be absent. Moreover, efforts are underway to raise non-oil revenues—not by increasing tax rates—but by expanding the non-oil tax base over time with investment incentives. In addition, overall fiscal balances would also improve based on WEO oil price projections and as gas production commences.

  • Staff and the authorities reached agreement on the fiscal adjustment path and the projections which incorporate policy measures. While large and subject to implementation risks, the adjustment was broadly seen to be feasible given proposed policy measures which tilted toward spending cuts and new pension reforms. Staff stated that the authorities’ non-oil tax measures reduce revenues in 2016—and it is premature to gauge their long run effect. Importantly, the temporary increase in public employments should not be made permanent, and if these recruits cannot find positions, they should be directed to targeted social assistance programs. Cash transfer programs to fight poverty could be made more effective by making them conditional (e.g., education/training).

14. The government’s plan to implement pension system reform is welcomed. The plan— expected to be enacted by end-2016—will increase the focus on social-insurance principles, linking benefits almost entirely to individual retirement accounts. Retirement ages and contribution periods will increase. The base pension—a flat benefit that accounts for more than half of pension spending—will be eliminated and replaced by an increase of the current defined-contribution benefit. A minimum pension will soften the impact on the low wage workers. Annual pension fund deficits (some 3 percent of GDP) should gradually be eliminated. Staff recommended the full implementation of the plan without delay.

15. There was consensus that a rule-based fiscal framework and strong institutional arrangements would preserve fiscal sustainability over the medium term. The authorities are aware of the underlying fiscal risks: (i) oil revenue volatility; (ii) an unsustainable level of public investment; (iii) uncertain recovery of IBA bad assets; (iv) Social Protection Fund (SPF) deficits; and (v) a growing debt stock. Staff stressed that a rule-based fiscal framework supplemented by a strong public financial management system, detailed multi-annual budgets, and a public debt strategy would entrench fiscal discipline and mitigate the volatility of oil revenue while promoting intergenerational equity. In this context, the authorities plan to request FAD TA on fiscal rules.

B. Modernizing Monetary and ER Policy Frameworks2

16. The CBA is informally targeting base money growth in 2016, with a desired move to IT in the long-run. A tighter monetary stance has helped to limit inflationary ERPT effects and pressure on the currency. However, the CBA is concerned that: (i) requests for financial stability loans linked to the bank restructuring process could disrupt monetary programming; (ii) liquidity injections could affect the ER; (iii) credit growth may not easily resume; and (iv) latent deflationary signals linked to slower growth were hidden by ERPT effects.

17. Staff indicated that the banking system still holds excess liquidity (concentrated in a few banks) and doubts about banking system soundness were stifling normal interbank intermediation. The problems in the interbank market highlight the need to restructure quickly the banking system and to develop financial markets. CBA interest rates remain negative in real terms and are below interbank, T-bill and retail deposit rates. This suggests that CBA interest rates may need to rise further (and informal interest rate caps eliminated) given market expectations. Consistent with its monetary policy stance, the CBA should stand ready to adjust monetary conditions to reflect unexpected changes in the fiscal impulse or bank restructuring process that put the money base and inflation objectives at risk.

18. Staff emphasized the importance of modernizing monetary policy and ER frameworks. In particular, with the move to a new ER regime, markets are now seeking guidance on the future direction of monetary policy. In this regard, emphasizing the primacy of the inflation objective would help to anchor expectations. Given shallow money markets and ineffective monetary transmission, a formal move to monetary targeting would be an appropriate intermediate step. However, to meet its monetary targets, the CBA will need to improve liquidity forecasting and management, and enhance its instrument and analytical toolkit. Importantly, a true policy rate should be established, around which the CBA would carry out its main liquidity management operations.3

Azerbaijan: Key Monetary and ER Policy Recommendations
Formally introduce monetary targeting; identify intermediate and operational targets.
Implement liquidity forecasting and management.
Set policy rate around which it would carry out liquidity management operations.
Policy rate set as reference rate for CBA’s OMOs.
Futher expand debt securities market.
Make CBA sole seller of FX through program of regular auctions.
Avoid pressure on the ER by eliminating market distortions.
Clearly communicate CBA’s monetary and ER policy framework and toolkit.

19. The authorities are comfortable with the degree of exchange rate volatility experienced under the new FX regime. ER markets are thin and dominated by SOFAZ oil flows. While the AzN/US$ rate had been able to move within a wide range, too much variability could still negatively impact fragile bank and private sector balance sheets. At the same time, the CBA has been able to make some ad hoc purchase of reserves—without a clear reserve management strategy. Staff noted that greater ER flexibility would help to preserve buffers, while more clarity on CBA ER policy objectives and intervention strategy would improve the functioning of the FX market and guard against policy errors. Once the ER became fully market determined, the CBA should adopt the policy rate as a nominal anchor.

C. Reducing Financial Sector Vulnerabilities

20. Financial sector discussions focused on the best way to restructure the banking system.

  • The authorities stressed that IBA’s management has been replaced, staffing and operating costs cut, new lending standards implemented, and the balance sheet gradually cleaned. Privatization, however, would take time and would require returning the bank to full health through renewed lending. Staff noted that the SPV exchange of bad assets was at full face value, and a substantial amount of new financial assistance has been provided to IBA in the form of fresh SOFAZ dollar deposits, IBA deposits placed at the CBA at preferential rates, and new capital injections. Downsizing and privatizing IBA would reduce bank concentration, increase competition and improve efficiency in the system. Losses should be recognized quickly and existing owners made to bear their fair share of the burden. Any residual shortfalls should be addressed by a transparent budget transfer-with no impact on the CBA balance sheet.

  • The FMSA indicated it was ready to remove regulatory forebearance and address problems in the rest of the system. FMSA staffing and training had geared up, while basic on-site inspections and asset quality reviews have been completed. Banks have been classified into three categories (solvent, need capital/liquidity assistance or insolvent) and notifications for additional capital injections have been made. Staff argued that the process should proceed quickly and follow guiding principles, which would consist of (i) making sure bank resolution follows least-cost considerations—i.e., wiping out existing shareholders and bailing in related party deposits, before government support is contemplated; (ii) providing liquidity assistance only to economically viable banks on the basis of high quality collateral; and (iii) standing ready to pay out guaranteed deposits in closed banks.

21. Progress in implementing recommendations from the 2015 FSAP and a recent TA mission on banking supervision should accelerate with the establishment of the new regulator. There was agreement that the real-time switch in financial sector regulators as the banking system was being restructured had slowed momentum on supervisory reforms. However, the authorities pointed out that unlike the CBA, the FMSA’s ability to conduct on-site inspections was not restricted and political support for an overhaul of financial sector regulation had strengthen. Staff has provided comments on drafts of new financial legislation.

Azerbaijan: Key FSAP Findings
Legal restrictions and limited capacity.
Lack of an explicit mandate for systemic financial stability.
Gaps in crisis management hampered bank resolution.
Poor information exchange between deposit insurance fund and banking supervision.
Rules on emergency lending assistance (ELA) unclear.
Specific resolution plans for systemic banks lacking.

D. Implementing Reforms to Raise Potential Growth

22. The government highlighted progress in implementing their “2020 development strategy”. This included opening new e-government service centers; improving public construction tenders; simplifying customs clearance; increasing electronic payments; creating regional industrial zones; moving toward WTO accession and trade diversification; and extending agriculture and environmental reforms. Efforts have been made to diversify the economy away from oil toward non-traditional sectors such as agriculture and tourism, create a more business-friendly environment, and integrate Azerbaijan to the economies of the region through the establishment of agro and industrial parks. Further progress in these areas would promote sustainable and inclusive growth (Annex V).

23. Staff noted that the reversal of positive tail winds—buoyant oil prices and investment—will slow the economy’s growth potential unless reforms are implemented (Annex VI). Creating a private sector-led non-oil economy requires reforms to improve governance, reduce the costs of doing business, and remove barriers to competition. Azerbaijan’s low rank on World Bank governance-related indicators (lower half globally) suggests that further efforts are needed to improve government effectiveness, broaden anti-corruption efforts, and strengthen the rule of law as well as the independence of the judiciary. Efforts to diversify economy toward low productivity sectors (e.g. agriculture) are unlikely to boost growth unless productivity challenges are addressed (e.g., through better technology).

Staff Appraisal

24. The lower oil price environment provides an impetus for moving to a new economic growth model, based on a diversified non-oil private sector. This requires implementing structural reforms—the most pressing being a rapid and efficient cleanup of the banking system. Financial sector vulnerabilities currently constitute a major risk to the growth outlook. Once banking system health is restored, other reforms can take root, strengthening confidence. Improved communication among economic policymakers and the public would help to reduce uncertainty. Importantly, pressures to fall back to the old economic model of fixed exchange rates and unsustainable public investment linked to oil transfers should be resisted.

25. The 2016 counter-cyclical stimulus is appropriate, but there is a need to return to fiscal consolidation next year. Fiscal space is contracting and public investment spending remains high. Reducing the non-oil primary deficit over the medium-term in line with the PIH fiscal rule is key. The weight of the adjustment should tilt toward spending cuts, with some increase in non-oil tax revenues. The authorities should stand ready to lower current spending if the cuts in capital spending do not materialize. New public employments should not be made permanent. Cash transfer programs could also be made more effective by linking them to behavioral conditionality (e.g., training and education).

26. A rule-based fiscal framework would help to preserve fiscal sustainability. The framework should contain a strong PFM system, detailed multi-annual budgets, and a public debt strategy to entrench fiscal discipline and mitigate the volatility of oil revenue. Accelerated implementation of PEFA recommendations would also prove beneficial. In this context, the new pension reform reduces risks and improves overall fiscal sustainability.

27. The CBA would benefit from formally introducing monetary targeting and communicating the primacy of its inflation objective. The monetary stance was appropriately tightened in early 2016 to limit inflationary pressures and support the ER. However, markets now seek guidance on the future direction of policy. Policy uncertainty, coupled with slower economic activity, dollarization, and internal bank weaknesses, has negatively impacted credit activity. This has resulted in concentration of excess liquidity within a few banks. Given these difficulties, the CBA will need to modernize its policy substantially to be able to influence money supply and inflation via interest rates.

28. Monetary policy should be recalibrated as the CBA gradually moves to an interest rate-based operational framework. Consistent with its monetary policy stance, the CBA should stand ready to adjust monetary conditions to reflect changes in the fiscal impulse or bank restructuring process, which could put the money base and inflation objectives at risk. Greater ER flexibility will help to preserve buffers and pave the way for modernizing monetary and ER policy frameworks. Once the ER becomes market determined, the CBA should adopt the policy rate as a nominal anchor.

29. Following international best practices would help to ensure the success of the government’s bank restructuring plans. Consideration should be given to downsizing and privatizing IBA. The amount of government support remains substantial—as evidenced by the ongoing bank bailout. While some actions have been taken to reform the bank, it is unclear when it will be able to return to profitability. Inflating IBA’s loan portfolio—creating an overly large public bank which dominates the corporate loan market, and which faces the same long-standing political economy incentives—should be avoided. A detailed plan and preparations are needed to address the problems in the rest of the banking system. In particular, a sound communication strategy would help to mitigate the risk that a confidence shock jeopardizes financial stability. Finally, it is important to ensure the legal framework does provide the bank resolution authority with proper tools and power to deal with any problematic bank.

30. Financial vulnerabilities need to be addressed along the lines of FSAP recommendations. It is important to bolster on-site banking supervision, the macro-prudential framework, and bank ownership rules. Financial safety nets, including emergency lending assistance and deposit insurance, should be strengthened to ensure continued and timely provision of liquidity to viable banks and expeditious payment of deposits. A resolution authority should be established with wide powers to take corrective measures quickly without seeking shareholder permission or the need to resort to the court system.

31. Implementation of the structural reform agenda has become even more critical given the end of the oil price boom. To expand the economy’s potential, efforts are needed to improve governance, reduce corruption and the costs of doing business, and remove barriers to competition. The priority structural reforms contained in the government’s “2020 development strategy” are appropriate although the issuance of investment certificates needs to be monitored closely to avoid abuse.

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

Figure 1.CCA Macroeconomic Outcomes

Sources: International Monetary Fund, World Economic Outlook.

Figure 2.Azerbaijan: Real Sector Indicators

Sources: Haver Analytics and IMF staff estimates.

Figure 3.Azerbaijan: External Sector

Sources: Haver Analytics and IMF Staff Estimates.

Figure 4.Azerbaijan: Real Exchange Rate

Sources: Haver Analytics, National authorities, and IMF Staff Estimates.

Figure 5.Azerbaijan: Fiscal Sector

Sources: Haver Analytics and IMF staff estimates.

Figure 6.Azerbaijan: Monetary Sector

Sources: National authorities, Haver analytics, and IMF staff estimates.

1/ Reduction of credits in September and October 2015 due to one bank restructuring.

2/ According to the 2015 FSAP report, for statistical purposes only overdue payments are classified as non-performing loans (NPLs). The reported time series of NPLs does not fully reflect actual NPLs.

Figure 7.Azerbaijan: Deposits and Interest Rates

Sources: Haver analytics and IMF Staff estimates.

Figure 8.Azerbaijan: Business Environment and Governance

Sources: World Bank, Worldwide Governance Indicators, World Economic Forum, and The World Bank Enterprise Surveys.

1/ LIC: Low-income countries.

Table 1.Azerbaijan: Selected Economic and Financial Indicators, 2013–20
(Annual percentage change, unless otherwise specified)
National income
GDP at constant prices5.82.81.1−
Of which: Oil sector 1/0.5−2.40.3−0.4−
Non-oil sector9.96.91.1−
Consumer price index (period average)
Money and credit
Domestic credit, net4.320.410.
Of which: Credit to private sector27.626.714.0−
Manat base money10.7−0.9−
Manat broad money19.06.1−50.62.813.216.819.124.3
Total broad money15.411.4−
External sector
Exports f.o.b.−1.9−11.1−44.8−
Of which: Oil sector−2.1−11.3−47.1−13.614.
Imports f.o.b.−0.8−16.34.7−13.710.910.72.36.3
Of which: Oil sector9.323.367.1−16.68.922.2−1.55.7
Real effective exchange rate0.34.4−7.3
(In percent of GDP, unless otherwise specified)
Gross investment25.723.126.529.825.624.422.321.4
Consolidated government20.315.316.318.414.914.011.610.7
Private sector5.47.810.111.410.710.410.710.7
Of which: Oil sector2.
Gross national savings42.136.726.130.528.733.432.031.8
Consolidated government21.318.59.68.511.013.618.018.7
Private sector 2/20.818.216.522.017.819.814.013.1
Consolidated central government finances
Total revenue and grants39.538.933.835.037.640.344.445.3
Total expenditure38.535.740.544.941.540.738.137.3
Overall fiscal balance1.03.2−6.8−9.9−3.9−
Non-oil primary balance, in percent of non-oil GDP−46.5−35.8−34.4−37.7−32.6−31.8−28.3−27.4
General government gross debt12.711.228.337.537.436.032.630.0
External sector
Current account (- deficit)16.413.9−
Foreign direct investment (net)
Memorandum items:
Gross official international reserves (in millions of U.S. dollars)14,15213,7585,0174,1174,6175,1175,6176,117
Nominal GDP (in millions of manat)57,70858,97854,35255,31459,73962,12865,23567,844
Nominal non-oil GDP (in millions of manat)34,05137,70139,54239,90643,09944,82347,06448,946
Nominal GDP (in millions of U.S. dollars)73,53775,25454,04835,68638,54140,08342,08743,770
Oil Fund Assets (in millions of U.S. dollars)35,87837,10433,57433,12034,40737,25441,28946,066
Exchange rate (manat/dollar, end of period)0.7850.7841.550
Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes the production and processing of oil and gas.

Historical data includes statistical discrepancy.

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

Includes the production and processing of oil and gas.

Historical data includes statistical discrepancy.

Table 2.Azerbaijan: Balance of Payments, 2013-20(In millions of U.S. dollars, unless otherwise specified)
Exports, f.o.b.31,77628,26015,58613,53415,37016,70818,13318,970
Oil and oil products30,00326,62714,08812,17513,87515,03416,23216,785
Imports, f.o.b.−11,156−9,332−9,774−8,431−9,352−10,351−10,587−11,253
Oil sector−1,167−1,438−2,403−2,005−2,183−2,668−2,627−2,776
Trade balance20,62118,9285,8125,1036,0186,3577,5467,717
Services, net−4,189−6,090−4,227−2,820−3,212−1,370−2,115−1,697
Oil sector−2,565−4,058−2,869−3,259−2,960−2,786−2,593−2,593
Investment income, net−4,126−2,294−1,827−2,191−1,832−1,602−1,546−1,620
Of which: profit of oil consortium−4,742−2,599−1,827−3,395−3,581−3,933−4,085−4,304
Compensation of employees, net−229−286−201−147−175−205−239−277
Transfers, net−30174221316393410404413
Of which: Private−52−34221289365369378385
Current account balance12,04710,432−2222601,1923,5894,0504,537
Non-oil currenct account balance−9,482−8,101−7,210−3,254−3,954−2,046−2,861−2,557
Capital account, net15−7752443
Direct investment, net1,1272,206855865708655601906
Of which: In reporting economy, net1,9164,4143,5633,5733,4162,6682,6503,012
Oil sector, net1,8763,1332,2823,1922,6761,8681,7501,762
Others, net401,2811,2813817408009001,250
Portfolio investment, net7281,3219222,5211,863813563163
Other investment, net−8,478−6,963−11,151−5,005−1,978−1,714−683−331
Financial account, net−6,623−3,436−9,374−1,619593−246481737
Capital and financial account balance−6,608−3,442−9,367−1,614595−241485740
Errors and omissions−1,975−2,810−2,307
Overall balance3,4644,180−11,896−1,3541,7873,3474,5345,277
Change in net foreign assets of CBA (increase -)−2,4109969,000900−500−500−500−500
Change in Oil Fund assets (increase -)−1,654−1,3202,896454−1,287−2,847−4,034−4,777
Change in other government FX assets (increase -)600−3,856
Memorandum items:
Current account balance (in percent of GDP)16.413.9−
Non–oil Current account balance (in percent of Non–oil GDP)−21.9−16.8−18.3−12.6−14.2−7.1−9.4−8.1
Gross official international reserves14,15213,7585,0174,1174,6175,1175,6176,117
in months of next year’s non-oil imports f.o.b.11.913.
Oil Fund assets35,87837,10433,57433,12034,40737,25441,28946,066
Oil price (US$ per barrel)110.0100.050.843.350.453.355.557.4
Nominal GDP73,53775,25454,04835,68638,54140,08342,08743,770
Sources: Azerbaijani authorities; and IMF staff estimates and projections.
Sources: Azerbaijani authorities; and IMF staff estimates and projections.
Table 3.Azerbaijan: Balance of Payments, 2013-20(In percent of GDP, unless otherwise specified)
Exports, f.o.b.43.237.628.837.939.941.743.143.3
Oil and oil products40.835.426.
Imports, f.o.b.−15.2−12.4−18.1−23.6−24.3−25.8−25.2−25.7
Oil sector−1.6−1.9−4.4−5.6−5.7−6.7−6.2−6.3
Trade balance28.025.210.814.315.615.917.917.6
Services, net−5.7−8.1−7.8−7.9−8.3−3.4−5.0−3.9
Oil sector−3.5−5.4−5.3−9.1−7.7−7.0−6.2−5.9
Investment income, net−5.6−3.0−3.4−6.1−4.8−4.0−3.7−3.7
Of which: profit of oil consortium−6.4−3.5−3.4−9.5−9.3−9.8−9.7−9.8
Compensation of employees, net−0.3−0.4−0.4−0.4−0.5−0.5−0.6−0.6
Transfers, net0.
Of which: Private−
Current account balance16.413.9−
Non-oil currenct account balance−12.9−10.8−13.3−9.1−10.3−5.1−6.8−5.8
Capital account, net
Direct investment, net1.
Of which: In reporting economy, net2.65.96.610.
Oil sector, net2.
Others, net0.
Portfolio investment, net1.
Other investment−11.5−9.3−20.6−14.0−5.1−4.3−1.6−0.8
Financial account, net−9.0−4.6−17.3−4.51.5−
Capital and financial account balance−9.0−4.6−17.3−4.51.5−
Errors and omissions−2.7−3.7−4.3
Overall balance4.75.6−22.0−
Change in net foreign assets of CBA (increase -)−3.31.316.72.5−1.3−1.2−1.2−1.1
Change in Oil Fund assets (increase -)−2.2−−3.3−7.1−9.6−10.9
Change in other government FX assets (increase -)0.8−5.1
Memorandum items:
Current account balance (in percent of GDP)16.413.9−
Non-oil Current account balance (in percent of Non-oil GDP)−21.9−16.8−18.3−12.6−14.2−7.1−9.4−8.1
Gross official international reserves (Millions of US$)14,15213,7585,0174,1174,6175,1175,6176,117
in months of next year’s non-oil imports f.o.b.11.913.
Oil Fund assets (Millions of US$)35,87837,10433,57433,12034,40737,25441,28946,066
Oil price (US$ per barrel)110.0100.050.843.350.453.355.557.4
Nominal GDP (in Millions of US$)73,53775,25454,04835,68638,54140,08342,08743,770
Sources: Azerbaijani authorities; and IMF staff estimates and projections.
Sources: Azerbaijani authorities; and IMF staff estimates and projections.
Table 4.Azerbaijan: Statement of Consolidated Government Operations, 2013–20(In millions of manat)
Tax revenue7,9088,8518,97610,05511,13511,59712,25812,534
Income taxes3,2353,2833,1943,5233,9594,2174,5234,513
Individual income tax8609809831,2771,3791,3901,4121,420
Enterprise profits tax2,3752,3032,2112,2462,5802,8283,1113,093
Value added tax (VAT)2,7103,1203,4553,8114,1884,2854,5294,706
Excise taxes593797648679740765807841
Taxes on international trade6708287598199259771,0011,045
Other taxes320369445604652678712741
Social security contributions380454477620670675685689
Nontax revenue 1/14,87514,1009,1649,07811,11613,24916,55618,041
Of which: Oil Fund revenues 2/14,12813,1338,1307,9269,88111,97015,21916,655
Tax credits for SOCAR energy subsidies00204231196186179174
Compensation of employees2,1053,1673,3243,8334,1594,3314,5074,687
Use of goods and services4,5965,3696,0576,2176,6646,9317,2857,581
Social benefits1,9072,2002,3392,9333,2813,4983,5743,741
Of which: Social protection fund1,0771,1421,1001,2461,3741,4901,5521,615
Other expense479380183181228273318
Net Acquisition of Nonfinancial Assets11,7139,0158,88010,1768,8908,6737,5817,277
Overall balance5641,883−3,675−5,453−2,341−2474,1425,414
Statistical discrepancy00000000
Non-oil primary balance 3/−15,818−13,478−13,616−15,049−14,038−14,232−13,305−13,404
Net financial transactions5641,883−3,675−5,452−2,341−2464,1425,414
Net acquisition of financial assets2711,806740−1,5072744,4066,7617,919
Oil Fund−1,4461,477−1,467−7012,0024,4326,2807,432
Privatizations and other sale of assets−400−29−100−100200204208
Banking system 4/8781651,118−353−814−113138140
Net incurrence of liabilities−293−774,4153,9452,6154,6532,6192,505
Debt securities−19−36−691,1751,2101,2471,2841,322
Of which: Domestic banking sector−14−31−69119250300325200
Loans (all external)−274−414,4842,7701,4053,4061,3351,183
Memorandum items:
Oil revenue16,50515,44910,1399,97112,10114,35917,79919,139
Non-oil revenue 5/6,2777,5028,2059,39310,34610,67311,19511,610
Non-oil tax revenue 6/6,3547,6328,1419,19810,05510,32910,78511,144
Non-oil GDP (in million of manats)34,05137,70139,54239,90643,09944,82347,06448,946
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.

Comprises government deposits in CBA and commercial banks.

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, energy subsidies.

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.

Comprises government deposits in CBA and commercial banks.

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, energy subsidies.

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

Table 5.Azerbaijan: Statement of Consolidated Government Operations, 2013–20(In percent of non-oil GDP)
Tax revenue23.223.522.725.225.825.926.025.6
Income taxes9.
Individual income tax2.
Enterprise profits tax7.
Value added tax (VAT)
Excise taxes1.
Taxes on international trade2.
Other taxes0.
Social security contributions1.
Nontax revenue 1/43.737.423.222.725.829.635.236.9
Of which: Oil Fund revenues 2/41.534.820.619.922.926.732.334.0
Tax credits for SOCAR energy subsidies0.
Compensation of employees6.
Use of goods and services13.514.215.315.615.515.515.515.5
Social benefits5.
Of which: Social protection fund3.
Other expense0.
Net Acquisition of Nonfinancial Assets34.423.922.525.520.619.416.114.9
Overall balance1.75.0−9.3−13.7−5.4−0.68.811.1
Statistical discrepancy0.
Non-oil primary balance 3/−46.5−35.8−34.4−37.7−32.6−31.8−28.3−27.4
Net financial transactions1.75.0−9.3−13.7−5.4−0.58.811.1
Net acquisition of financial assets0.84.81.9−
Oil Fund−4.23.9−3.7−
Privatizations and other sale of assets−0.10.0−0.1−0.3−
Banking system 4/−0.9−1.9−
Net incurrence of liabilities−0.9−
Debt securities−0.1−0.1−
Of which: Domestic banking sector0.0−0.1−
Loans (all external)−0.8−
Memorandum items:
Non-oil revenue 5/18.419.920.823.524.023.823.823.7
Non-oil tax revenue 6/18.720.220.623.023.323.022.922.8
Non-oil GDP (in billion of manats)34.137.739.539.943.144.847.148.9
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.

Comprises government deposits in CBA and commercial banks.

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, energy subsidies.

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.

Comprises government deposits in CBA and commercial banks.

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, energy subsidies.

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

Table 6.Azerbaijan: Summary Accounts of the Central Bank, 2013–20(In millions of manat, unless otherwise specified)
Net foreign assets11,90712,45811,39510,00010,77511,55012,32513,100
Net international reserves of the CBA11,90712,45911,28310,00110,77611,55112,32613,101
Gross international reserves11,91312,46111,28410,00610,78011,55412,32813,102
Foreign liabilities−5−2−1−5−4−3−2−1
Other items, net0−1112−1−1−1−1−1
Net domestic assets−114−591−3,834−1,152−107221,2281,764
Domestic credit238−5653,5235,7724,4994,6134,9975,404
Net claims on consolidated central government−3,290−4,193−5,651−6,090−6,990−7,190−7,140−7,090
Net claims on banks 1/1,4591,5095,4108,0607,7638,1518,5598,987
Credit to the economy2,0892,1453,7643,8023,7263,6523,5783,507
CBA notes−20−27000000
Other items, net−353−26−7,358−6,924−4,509−3,890−3,769−3,640
Reserve money11,79311,8677,5618,84810,76612,27213,55314,864
Manat reserve money11,64211,5426,9028,0769,83011,42112,82614,423
Currency outside CBA11,03310,8465,4177,2769,06910,79812,04013,366
Bank reserves and other deposits5556881,4787967576197811,053
Other deposits538744444
Reserves in foreign currency151325659772936852727440
Sources: Central Bank of Azerbaijan; and IMF staff estimates and projections.

Includes CBA holdings of Aqrarcredit’s bonds as a part of the SPV, and IBA deposits.

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

Includes CBA holdings of Aqrarcredit’s bonds as a part of the SPV, and IBA deposits.

Table 7.Azerbaijan: Monetary Survey, 2013-20(In millions of manat, unless otherwise specified)
Net foreign assets9,90310,49211,0569,67810,45411,23012,00612,782
Net international reserves of the CBA11,90712,45911,28310,00110,77611,55112,32613,101
Net foreign assets of commercial banks−1,842−1,833−554−254−254−254−254−254
Net domestic assets9,45711,07510,26311,91012,84313,67114,28714,716
Domestic credit, net14,15517,03718,75719,65920,26921,85924,24326,850
Net claims on consolidated central government−2,775−3,366−5,823−4,522−5,173−5,074−4,700−4,450
Credit to the economy16,93020,40224,58124,18025,44226,93328,94331,300
Of which: private sector14,40918,25720,81620,37821,71623,28125,36427,793
Other items, net−4,698−5,962−8,495−7,749−7,427−8,188−9,956−12,134
Broad money19,36021,56621,31921,58823,29724,90226,29327,498
Manat broad money16,43517,4368,6138,85110,01811,70413,93517,324
Cash outside banks10,45910,1524,7764,8714,9695,5156,1226,796
Manat deposits5,9767,2843,8373,9805,0496,1887,81310,528
Foreign currency deposits2,9254,13012,70512,73713,27913,19812,35810,174
(Annual percentage change)
Net foreign assets19.95.95.4−
Net domestic assets11.417.1−7.316.
Credit to the economy8.520.520.5−
Of which: private sector27.626.714.0−
Broad money (M3)15.411.4−
Manat broad money (M2)19.06.1−50.62.813.216.819.124.3
Reserve money10.60.6−36.317.021.714.010.49.7
Manat reserve money10.7−0.9−
Memorandum items:
Gross official international reserves (US$ millions)14,15213,7585,0174,1174,6175,1175,6176,117
Velocity of total broad money (M3) 1/
Broad money in percent of non-oil GDP56.957.253.954.154.155.655.956.2
Credit to private sector in percent of non-oil GDP42.348.452.651.150.451.953.956.8
Share of foreign currency credits in total credit portfolio 2/
Currency to broad money ratio54.047.122.422.621.322.123.324.7
Share of foreign currency deposits in total deposits 3/32.936.276.876.272.568.161.349.1
Foreign currency deposits to broad money ratio15.119.259.659.
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.

Based on total credit portfolio of the banking system.

Based on monetary survey data which only includes resident balances.

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.

Based on total credit portfolio of the banking system.

Based on monetary survey data which only includes resident balances.

Annex I. Azerbaijan: Exchange Rate Pass-Through (ERPT) Effects

At first sight, ERPT effects in Azerbaijan appear to have been relatively muted. The AzN/US$ rate depreciated by some 50 percent in 2015, however, the headline inflation rate (y/y) as of June 2016 was only about 10 percent. After the first devaluation in January, non-tradable inflation (services) remained low but a component of tradable inflation (food inflation) jumped to above 5 percent. With the larger second devaluation in December, tradable goods (food and non-food) inflation rates jumped sharply (to about 17 percent) in early 2016—pushing up headline rates. Inflation has started to decline since January.

Azerbaijan: CPI Inflation

(Headline, Food, Non-Food, Services)

Sources: Haver Analytics

The composition and weights of the CPI basket play a role in ERPT dynamics. The import content of the CPI basket is estimated to be 34 percent. Tradable good weights in the CPI basket are high—with food good weights at 58 percent and the non-food goods weight at 22 percent. These two factors (high import and tradable good weights) would imply a strong ERPT. However, a large part of food stuffs is produced locally and priced to market in local currency with limited import content. These are also subject to high local distribution costs which do not move on ER changes. Moreover, during 2015 world food prices fell by some 3 percent, helping to reduce the pressure on food inflation in Azerbaijan. While non-tradable services only make up some 20 percent of the basket, a sizeable percentage (13 percent) is administratively controlled. After the devaluations, the authorities did not allow administrative prices to increase—keeping service inflation in check.

A vector auto-regression (VAR) model indicates that nominal exchange rate shocks impact inflation, but dissipate quickly. The VAR model included the log first differences of oil prices, nominal effective exchange rates (NEER), government expenditures, base money, and the CPI and used monthly data from January 2006 to April 2016. The results indicate that a one standard deviation Cholesky shock to the NEER raised headline inflation rates by 0.45 percent on impact and dissipated by the third month. The impulse response functions and variance decompositions demonstrate that shocks to other variables did not significantly impact headline inflation rates. These results were robust to changes in the order of variables in the VAR. With the NEER depreciated by some 40 percent in 2015, the VAR model implies an 18 percent increase in inflation. These estimates are broadly in line with inflation outcomes in early 2016, particularly when one considers the factors mentioned above, the low inflationary environment prior to the devaluations, tighter CBA monetary policy to reduce second round effects, and weaker price pressures emanating from sluggish domestic demand in a highly dollarized economy.

Azerbaijan: Impluse Response Function

(Response of CPI to a One Standard Deviation Shock to NEER)

Source: Staff estimates

Annex II. Azerbaijan: Assessment of Azerbaijan’s External Position

Azerbaijan’s external position has deteriorated. The current account (CA) and real effective exchange rate (REER) in Azerbaijan tend to move in line with oil prices.1 With the oil prices falling, the CA position has worsened—shifting from a surplus of 14 percent of GDP in 2014, to a small deficit in 2015. However, the non-oil CA and the share of non-oil exports to total world exports have remained relatively flat. As of April 2016, the REER has depreciated by some 45 percent since January 2015 given the 2 step devaluations against the US$.

Azerbaijan: Real Effective Exch ange Rate and Oil Price

Sources: WEO and IMF staff estimates.

International reserves at the CBA have fallen sharply. CBA reserves have declined by $9.5 billion since end-2014, and stood at $4.3 billion (3.5 months of imports) as of end-June, 2016. The sovereign wealth fund had $34 billion as of end-2015 (close to 100 percent of projected 2016 GDP), and plans to fill balance of payments financing gaps may reduce the stock by some $500 million in 2016.

Based on the EBA-lite methodology, the REER is viewed as slightly overvalued. The EBA-lite analysis reflects values for cyclically-adjusted balances consistent with medium-term sustainability, and other policy variables (cyclically-adjusted fiscal balances, FX intervention, private credit and capital controls). Given the need to restrict the substantial use of expansionary fiscal policy and CBA intervention in the FX market, the desired targets for the change in international reserves and fiscal balance were set to zero. Private credit as a percent of GDP and the capital control index were not adjusted from current values. The results in the table indicate that the CA norm would be 0.81 percent of GDP based on economic fundamentals, relative to the actual -0.41 percent of GDP deficit. The estimated residual is substantial, with policy gaps large relative to the CA gap. Overall, this results in a small real exchange rate (RER) gap of 1.14 percent of GDP. Given an estimated RER elasticity of -0.21, the required change in the RER would be a depreciation of some 6 percent. The authorities plan to use SOFAZ assets to finance fiscal and CA gaps, which would also imply an external unsustainable position.

Azerbaijan: REER and Non-Oil Exports, 2000-15

Sources: Azerbaijan Authorities, and IMF staff estimates.

Azerbaijan: EBA-Lite Assessment
CurrentDesired Value
Current account (CA) 1/2/−0.410.81
Cyclically adjusted fiscal balance 1/−7.700.00
Change in reserves 1/−10.480.00
Private credit 1/30.730.7
Capital control index0.530.53
Real exchange rate gap5.89

In percent of GDP

Desired value reflects staff estimate of the CA norm.

In percent of GDP

Desired value reflects staff estimate of the CA norm.

Annex III. Public Sector Debt Sustainability Analysis

Shock to oil prices and consequently the budget deficit and two sharp devaluations of the manat have all contributed to an increase in Azerbaijan’s public debt and a recent downgrade of its sovereign bonds. Between 2014 and early 2016, nominal gross public debt, largely denominated in foreign currencies or held by non-residents, doubled as a share of GDP. However, the majority of Azerbaijan’s debt has long maturities, which can mitigate financing pressure. While the government could cover its budget deficit with transfers from the State Oil Fund (SOFAZ) in the medium term, such increase makes debt to GDP ratio more susceptible to various macro and financial shocks.

Baseline Scenarios

Azerbaijan’s debt sustainability indicators worsened during 2015 and remained at similar levels throughout 2021. As a share of GDP, nominal gross debt for general government increased from about 11 percent in 2014 to 28 and 38 percent during the next two years. Downward projection for this ratio starts in 2018 with the return of fiscal surplus. Net debt to GDP ratio fluctuates depending on the assumed rate of financial asset acquisition by the government. Financing needs largely depend on projected hydrocarbon revenue and planned fiscal consolidation. To achieve debt stabilization, primary balance should anchor around 1.9 percent of GDP by 2021.

Exchange rate depreciation and an increase in primary deficit were main causes for the debt increase. As more than 80 percent of Azerbaijan’s public debt is denominated in foreign currencies in 2014, the currency depreciation of 60 percent against the US dollar has significantly worsened its debt outlook. Still slightly over-valued, the exchange rate could depreciate further in 2016 and 2017, resulting in even higher debt ratios. In the medium term, primary deficit could improve due to an increase in gas production, the recovery of oil prices, and accelerating fiscal consolidation.

Unrecognized contingent liabilities by the government remain an important debt issue. Historical debt figures include risk-weighted guarantees by the central government. Explicitly guaranteed bonds issued by Aqrarkredit to recapitalize IBA (see Annex IV) are also included in the baseline for 2016. Additional guarantees to the banking sector and other state-owned enterprises could further complicate the debt sustainability analysis.

Realism of Projections

The realism of staff’s baseline assumptions has improved over time. The median forecast error for growth over 2007–15 was around -3 percent. Staff tended to be overly optimistic about growth during the early years of this period. More recent growth forecasts have been closer to the final outturns. Inflation forecasts have been subject to larger errors, often on the pessimistic side while forecasts for primary balance have been overly optimistic. Adjustment in Azerbaijan’s cyclically-adjusted primary balance (CAPB) appears larger than the cross-country median. The fiscal consolidation plan is mainly through a reduction in public investment. Boom-bust analysis applies to countries with three consecutive years of positive output gap or high credit growth. In the case of Azerbaijan, 2016 could be the trough of the business cycle with quick recovery.

Risk Assessment

The heat map indicates high risk to the debt profile. Shocks to real GDP growth and to contingent liabilities could impact the gross financing needs of the government and subsequently the debt level. The ratios of external debt and debt denominated in foreign currencies are above the upper threshold of early warning benchmark.

Market perception is another potential risk to the debt profile. Currently, the baseline scenario assumes the government’s ability to roll over its short term debt every year while slowly amortizing its long-term debt. The recent downgrades of not only the sovereign bonds but also the guaranteed notes by state-owned corporations could challenge this assumption.

Stress Tests

The DSA stress tests indicate potentially high ratios of debt to GDP and to revenue, especially from shocks to real GDP growth and real exchange rate.

Seven scenarios were considered:

  • Growth shock. Real GDP growth is subjected to a one standard deviation negative shock. Inflation is assumed to decline in line with lower growth, dropping ¼ percentage point for every 1 percentage point decrease in growth. Reflecting higher risk premiums, nominal interest rates rise by 25 basis points for every 1 percent of GDP worsening of the primary balance. Under this scenario, the debt to GDP ratio increases to over 70 percent of GDP in 2018 and remains high throughout 2021. Gross financing needs peak in 2018 at 20 percent of GDP.

  • Interest rate shock. Based on the maximum historical level, a 1200 basis point increase in spreads is applied throughout the projection period. The debt to GDP ratio, however, is minimally affected.

  • Real exchange rate shock. A 25 percent real exchange rate devaluation is applied to 2017 coupled with a 25 basis point increase in interest rates for each 1 percent of GDP reduction in the primary balance. With high level of external debt, the impact is significant with debt to GDP ratio peaking at above 56 percent in 2017.

  • Primary balance shock. A 2 percent of GDP decline in revenues is applied over two years, coupled with a rise in nominal interest rates over the same period. The ratios of debt to GDP and to revenue both deteriorate moderately.

  • Combined macro fiscal shock. This scenario combines the shocks to real growth, the interest rate, the real exchange rate, and the primary balance while eliminating double counting of the effects of the individual shocks. The debt ratio is on an unsustainable trajectory path throughout 2021.

  • Contingent liabilities shock. For a standard non-interest expenditure shock of 10 percent of the size of the banking sector, with interest rates assumed to increase by 25 basis points for every 1 percent of GDP worsening in the primary balance, the primary balance will deteriorate in 2016 and 2017. The debt level is expected to peak in 2018 at 70 percent of GDP.

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 and includes public guarantees, defined as explicit as well as ownership-weighted implicit guarantees.

2/ Based on available data.

3/ Long-term bond spread over German 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 changes in the stock of guarantees, 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.

Azerbaijan Public DSA – Composition of Public Debt and Alternative Scenarios

Source: IMF staff.

Azerbaijan Public DSA – Realism of Baseline Assumptions

Source: IMF Staff.

1/ Plotted distribution includes surveillance countries, percentile rank refers to all countries.

2/ Projections made in the spring WEO vintage of the preceding year.

3/Azerbaijan has had a positive output gap for 3 consecutive years, 2013–2015 and a cumulative increase in private sector credit of 17 percent of GDP, 2012-2015. For Azerbaijan, t corresponds to 2016; for the distribution, t corresponds to the first year of the crisis.

4/ Data cover annual obervations from 1990 to 2011 for advanced and emerging economies with debt greater than 60 percent of GDP. Percent of sample on vertical axis.

Azerbaijan Public DSA – Stress Tests

Source: IMF staff.

Azerbaijan Public DSA Risk Assessment

Source: IMF staff.

1/ The cell is highlighted in green if debt burden benchmark of 70% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.

2/ The cell is highlighted in green if gross financing needs benchmark of 15% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.

3/ The cell is highlighted in green if country value is less than the lower risk-assessment benchmark, red if country value exceeds the upper risk-assessment benchmark, yellow if country value is between the lower and upper risk-assessment benchmarks. If data are unavailable or indicator is not relevant, cell is white.

Lower and upper risk-assessment benchmarks are:

200 and 600 basis points for bond spreads; 5 and 15 percent of GDP for external financing requirement; 0.5 and 1 percent for change in the share of short-term debt; 15 and 45 percent for the public debt held by non-residents; and 20 and 60 percent for the share of foreign-currency denominated debt.

4/ Long-term bond spread over German bonds, an average over the last 3 months, 22-Feb-16 through 22-May-16.

5/ External financing requirement is defined as the sum of current account deficit, amortization of medium and long-term total external debt, and short-term total external debt at the end of previous period.

Annex IV. Azerbaijan: Bank Restructuring, Financial Sector Reforms and FSAP Recommendations

The banking system in Azerbaijan is relatively underdeveloped and heavily concentrated. At end-2015, the system consisted of 43 banks, with the International Bank of Azerbaijan (IBA), a majority state-owned bank, holding some 40 percent of system wide assets, mostly in industrial loans. There are eight majority foreign-owned banks and two majority state-owned banks. IBA profitability has been a persistent problem given a tendency to provide subsidized loans to government projects.

The reform process has proceeded along 4 integrated tracks. This includes (i) restructuring IBA; (ii) creating new supervisory institutions; (iii) cleaning up the rest of the banking system; and (iv) implementing new insurance fund and macro-prudential policies. An FSAP was completed in July 2015. The status of FSAP recommendations is presented in Table 1.


The authorities are restructuring the IBA mainly through the creation of a bad bank-SPV, new financial support, and implementation of management reforms.

  • Bad bank creation: A joint CBA-MoF preliminary audit of IBA’s loan portfolio found approximately AzN 7 billion in bad assets (70 percent of total assets). In mid-2015, Aqrarkredit (a small state-owned credit agency) was tasked with receiving and managing part of IBA’s bad assets, and issuing state guaranteed bonds at a 0.15 percent interest rate, 30-year maturity, 5-year grace period, to the CBA. These funds—routed through the SPV—have been paid to the IBA in exchange for the bad assets, which have been placed in the SPV for debt collection. The first tranche of IBA’s bad assets (AzN 2.5 billion) was transferred to the SPV in late 2015, and an additional AzN 4.6 billion has been moved in 2016.

  • Burden of losses: The NPLs were bought at the full book value. Existing owners who had borrowed from the IBA to fund previous IBA bank equity purchases were forced to reverse those transactions and settle other liabilities. The remaining depositors were all protected. As the bonds sold to the CBA mature and the distressed assets recovery process unfolds, the government will inject financial resources into Aqrarkredit to service its debt on a timely manner.

  • Continued financial support: SOFAZ has committed to deposit $2 billion in IBA. SOFAZ deposits have been used to repay some of IBA’s most expensive foreign currency liabilities (about $1 billion), with the remaining foreign debt ($3 billion) on a more sustainable path. The IBA also expects the government to inject AzN 500 million in new capital. In addition, the CBA has provided 1 billion manat in subordinated loans to IBA. Finally, in order to provide IBA with an income stream, 3 billion manat was deposited in the CBA at 5 percent interest rate.

  • Greater government control: At end-2014, the MOF and non-state entities owned 51 and 10 percent of IBA shares respectively, while undisclosed individuals account for 39 percent. The government’s share increased to 85 percent by end-2015. Once an additional capital injection is finalized in late-2016, the government will own about 95 percent of IBA’s shares. Nevertheless, the ultimate goal is to completely privatize the bank within five years.

  • New management: The government has replaced the IBA’s management and board, and is starting the process of reforming bank operations, investigating allegations of fraud and malfeasance and examining changes in governance, funding, and bank loan strategy. The new management is cutting costs with staff reductions of some 20 percent, foreign branch closures and paying off expensive foreign debt. Bank operations in 2016 indicate that IBA still remains heavily focused on larger industrial based activities. Current IBA management indicated that sustained substantial interest income is needed to ensure IBA profitability.

B. Supervision

A new integrated financial supervision agency, the FMSA, was created in March 2016. Its mandate covers the licensing, supervision and regulation of securities markets, investment funds, insurance companies, lotteries, banks and non-bank credit institutions (including the postal operator) and payment systems, including AML/CFT activities. Its main objectives are to (i) ensure effective operation and stability of financial markets; and (ii) protect creditors’ rights, insured persons, investors and other consumers of financial markets. The management structure includes a five-person Board of Directors, and a CEO, all appointed by the president with five-year terms. Banking and financial supervision responsibilities have been removed from the CBA Law. The CBA, however, will still be directed to provide direct short-term (under 6 months) loan support to banks on the advice of the FMSA. Supervised institutions will pay a membership fee to the FMSA to fund its operations.

In line with FSAP recommendations, the authorities created a Financial Stability Board in mid-2016. The Board will include representatives of ADIF, CBA, MOF, FMSA, and SOFAZ, and will be chaired by the Prime Minister. The group has been meeting regularly on an informal basis.

C. The Rest of the Banking System

  • Closing and merging problem banks. The CBA revoked licenses for 2 insolvent banks in 2015, and moved quickly to close a further 6 banks in January-February 2016, while merging an additional 2 banks. The closed banks comprised about 6 percent of the total size of the banking system. The FMSA put provisional administrators in 4 more banks in July 2016—allowing 1 to become a non-bank finance company. The number of banks now stands at 31 as of end-July 2016, though three of the closed banks are challenging in court CBA’s decision The new regulator has also intervened in a systemically important bank, imposing a deposit moratorium which was recently lifted.1 Authorities are still considering a number of resolution alternatives.

  • Restructuring the banking sector. The FMSA has concluded an asset and credit quality assessment of the banking sector loan portfolio. The diagnostics included a top-down stress test exercise as well as on-site inspections. The FMSA report groups the banks in three categories: (i) systemically important banks; (ii) medium-sized banks, some of which have capital and/or liquidity deficiencies that will need to be addressed by the banks following supervisory actions; and (iii) small and non-viable banks, which FMSA intends to close by the end of this year.2 The chart below presents a quick snapshot of the status of problem loans within the system as of end 2015.3

Azerbaijan: Commercial Bank’s Problem Loans Net of Provisions (Scaled by Capital) by Share of Deposits

Sources: FMSA and IMF Staff estimates. Data does not include the largest bank in the system. Red dots are banks with total assets that exceed AzN 1 billion.

D. Insurance Fund and Macro-Prudential Policies

The deposit insurance fund (ADIF) issued a blanket guarantee. Following a sharp drop in deposits (about 15 percent of total deposits), the ADIF removed the AzN 30,000 insured deposit limit in early February 2016, and provided a blanket guarantee on all individual deposits with an interest rate cap of 12 percent for manat deposits and 3 percent for U.S. dollar deposits. Total individual deposits amounted some 14 percent of GDP in mid-2016. The blanket guarantee is to be in place for 3 years from March 2016, after which it will be reviewed. ADIF has signed a Memorandum of Understanding (MOU) that allows it to borrow from CBA and the government, if the liquid assets of the ADIF fall below 1 percent of insured deposits.4 The ADIF is working on a draft law that will provide it with powers to inspect banks on deposit-related matters, in coordination with the new regulator. The draft law also foresees a move to a risk-based fee system.

The FMSA passed a decision on Responsible Lending, effective May 6 2016, which sets out the conditions for granting foreign and local currency loans. Foreign currency mortgage loans are now prohibited and foreign currency consumer loans are only allowed to individual or entities who receive foreign currency revenues and who a have a bank account. Existing foreign currency loans can only be restructured in line with established prudential lending conditions, and new foreign currency consumer loans are limited by new debt load limits on borrowers. The FMSA is also working with banks to create a private credit bureau.

E. Epilogue: FSAP issues

Some of the financial reforms are in line with FSAP recommendations, while others are clearly not. For example, the FSAP had stressed the importance of moving quickly to close weak banks and to establish a SPV mechanism to handle IBA’s bad loans. However, issuing a blanket deposit insurance guarantee, creating a new financial system regulator (FMSA) or undertaking full debt/equity swaps in the IBA were not part of FSAP recommendations.

Recommendations made in the 2015 FSAP still remains relevant. Key recommendations to enhance the financial safety net included (i) strengthening supervisor resolution powers to allow swift intervention, if needed, before a bank becomes insolvent and reducing the dependence on the court system; (ii) MOUs among agencies potentially involved in resolution, to permit efficient information sharing; (iii) formalize borrowing agreements between the deposit insurance fund and the CBA and the MOF, allowing resources from the ADIF to be applied for all resolutions and on a least-cost basis; (iv) set out ELA preconditions and require banks to be prepared for providing high quality collateral, if ELA is needed; and (v) develop bank-specific contingent plans for banks considered systemic.

Table 1.Azerbaijan: Status of 2015 FSAP Recommendations
Authority 1/Time 2/Status
Recommendations for Addressing the Current Situation
Clearly communicate with the public the reasons behind the recent large devaluation and measures taken to support the banking systemCBAI
Minimize forbearance and require banks to prepare strict time-bound plans to address capital and liquidity gapsCBAINot done.
Perform a comprehensive review of the quality of bank loan portfolios with third party participation and require banks to share plans for ensuring capital adequacyCBA, MoF, GovernmentINot done.
Set higher risk weights for foreign currency lendingCBAINot done
Introduce differential reserve requirements and deposit insurance premia to encourage manat depositsCBA, DIFIPartially done. Differential insurance premia introduce, but not differential reserve requirement.
Banking Oversight
Facilitate on-site supervision by exempting regulated financial institutions from the Law of the Republic of Azerbaijan on Regulation of Business Inspections and Protection of Interests of BusinessesParliamentINot done. There is a new supervisor and a draft law is being prepared and shared with the IMF for comments.
Introduce consolidated supervision as an overarching supervisory approachParliamentNTNot done. There is a new supervisor and a draft law is being prepared and shared with the IMF for comments.
Remove ability of CBA to provide subordinated loans and gradually disinvest from IBA capitalParliament, CBANTNot done.
Enhance transparency on ultimate beneficiaries by revising the Commercial Secrets LawParliamentNTNot done.
Enforce corrective measures, particularly in compliance with prudential normsCBAINot done.
Establish supervisory regimes for market, operational, interest rate and country riskCBANTNot done. There is a new supervisor and a draft law is being prepared and shared with the IMF for comments.
Raise quality of corporate governance, particularly by requiring independent and qualified non-executive directorsCBA, MoJ, ParliamentMTNot done. Now there is a new supervisor and a draft law is being prepared and shared with the IMF for comments
Strengthen the governance structure of the CBA by appointing non-executives to the two vacant positions and establishing an Audit CommitteeParliament, CBANTNot done. There is a new supervisor and a draft law is being prepared and shared with the IMF for comments.
Provide CBA power to raise prudential standards for individual banks and banking groupsParliament, CBANTNot done. There is a new supervisor and a draft law is being prepared and shared with the IMF for comments.
Strengthen identification and assessment of the suitability of shareholders, including ultimate beneficial ownersParliament, CBANTNot done. Now there is a new supervisor and a draft law is being prepared and shared with the IMF for comments
Systemic Financial Risk
Establish interagency body for crisis preparedness and management, and sharing supervisory information on a regular basisCBA, SCS, MoF, DIFINot done
Provide CBA explicit mandate for financial stability, financial stability unit within CBACBANTNot done. There is a new supervisor and a draft law is being prepared and shared with the IMF for comments.
Financial Safety Net, Resolution of NPLs, and Systemic Liquidity Management
Give the CBA full powers for bank resolution without resorting to the court system and the full range of tools necessary for resolutionParliamentINot done. There is a new supervisor and a draft law is being prepared and shared with the IMF for comments.
Formalize borrowing arrangements with the CBA, enabling DIF funds to be applied for all resolution procedures on a least-cost basisCBA, DIF, MoFNTNot done. There is a new supervisor and a draft law is being prepared and shared with the IMF for comments. A new law for DIF also being prepared.
Sign an MOU between DIF and CBA to ensure automatic exchange of information with a view toward eventually introducing risk-differentiated deposit insurance premiaDIF, CBANTNot done. There is a new supervisor and a draft law is being prepared and shared with the IMF for comments. A new law for DIF also being prepared.
Set out ELA preconditions, indicative term sheet for lending, and requiring banks to be pre-positioned for sale and repurchase arrangements with high quality assetsCBAIPartially done. There is some criteria and preconditions for ELA, but it does not fully address FSAP recommendations (e.g. banks not required to be pre-positioned for sale.
For systemic banks develop bank-specific resolution plans based on comprehensive resolvability assessments that seek to minimize fiscal risk and moral hazardCBANTNot done. There is a new supervisor, which should take care of this.
Anti-Money Laundering and Counter Financing of Terrorism
Continue to address AML/CFT deficiencies on adequate criminalization of money laundering, transparency of beneficial ownership, and preventive measures, including sanctions.Parliament, MoJ, MoFNTNot done

The new financial market regulator (FMSA) has taken over banking supervision as of April, 2016.

I – “Immediate”: within one year. NT – “Near-term”: one to three years. MT – “Medium-term”: three to five years.

The new financial market regulator (FMSA) has taken over banking supervision as of April, 2016.

I – “Immediate”: within one year. NT – “Near-term”: one to three years. MT – “Medium-term”: three to five years.

Annex V. Azerbaijan: Inclusive Growth

A 2012 SIP reported on the inclusiveness of Azerbaijan’s growth.1 It noted that the oil boom and associated rapid non-oil growth contributed to a substantial reduction in poverty and inequality. However, economic diversification, youth employment, governance reforms, and greater SME access to financing were seen as essential to keep growth inclusive.

While inclusive growth indicators show gains in poverty reduction, gaps in gender parity, health, education, and youth employment remain. The percent of the population in poverty in Azerbaijan in 2014 was 6 percent relative to the CCA average of 26 percent, and the Human Development Index was also above average. However, youth employment was only 23 percent relative to the regional average of 42 percent, and average years of schooling are below regional norms. Moreover, female representation in parliament and in education enrollment remains low. Cell phone subscriptions per 100 people are also below average—implying that access as well as availability may limit integration into the economy.

Azerbaijan: Inclusive Growth Indicators, 2014
Under national poverty line 1/Using Improved Health Facility 1/Youth Employment RatioHDI 2/Expected years of schoolingFemale Members of Parliament 1/Parity in Education 3/Cell Phone Subscriptions 4/
CCA average25.595.241.60.7012.519.41.11116.1
Source: ADB 2014 Inclusive Growth Indicators,

In percent

HDI: Human Development Index

Parity in education is the ratio of gross female to gross male school enrollment.

Per 100 people.

Source: ADB 2014 Inclusive Growth Indicators,

In percent

HDI: Human Development Index

Parity in education is the ratio of gross female to gross male school enrollment.

Per 100 people.

Azerbaijan’s economic structure hinders the absorption of young job seekers—limiting inclusive growth. In 2015, under 25 (35) year olds constituted 40 (60) percent of the population, with 70 percent within the range of 15 to 64 years of age. The low-productivity, low-growth agricultural sector remains Azerbaijan’s largest employer, absorbing 37 percent of the workforce, but contributing only about 5 percent of GDP. The capital-intensive mining sector contributes 40 percent of GDP, but employs only about 1 percent of the entire workforce.

Annex VI. Azerbaijan: Potential Output in the New Normal

As in other emerging markets, Azerbaijan’s potential growth slowed in the aftermath of the global financial crisis.1 At first, the boom in oil prices led to a marked increase in (i) foreign direct investment (particularly in the oil sector); and (ii) public investment and infrastructure spending given rapidly rising budgetary transfers from the Oil Fund. At the same time, the authorities started to make headway in implementing structural reforms—which together with improved infrastructure—helped to raise productivity. As a result, estimates of potential growth from a simple production function rose to over 15 percent during 2003-08, while estimates of potential non-oil sector growth from statistical filter methods reached near 10 percent.2 However, the economy’s growth potential has receded sharply of late given lower investment rates (capital contributions), and more recently from reductions in total factor productivity (TFP). As of 2012-15, the economy’s potential was seen to be around 3 percent while non-oil potential growth was around 5 percent.

Azerbaijan: Total Economy Potential Growth Contributions

(in percent)

Sources: Staff estimates.

Changes in the external environment call for a further reassessment of potential growth. Going forward, lower oil prices (and perhaps higher interest rates) should translate into lower investment rates. To ascertain how potential growth may be affected, staff projected factors of production (capital and labor) and estimated a TFP regression model based on WEO changes in oil prices and an index of structural reforms (SRI) to forecast future TFP movements. Specifically, for 2016-21 it is assumed that capital accumulates at the now lower WEO projected investment growth rates and labor grows at recent historical rates (about 1 percent). Based on the TFP regressions, if structural reforms proceeded at the same pace as the oil boom years, potential growth could reach about 6 percent. No change in reform trends suggest growth of some 3½ percent, while a reversal of reforms indicate potential growth would fall to about 1 percent. This analysis suggests that in an environment of low oil prices and reduced investment, the driver of growth will need to come from stepped up structural reforms.

Azerbaijan: Productivity and Structural Reforms (in percent)

Source: Staff estimates. The structural refom index is a weighted average of the World Bank’s Governance indicators, which range from 0 to 100.

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, leading to economic and fiscal stress, and constraints on country policy settings.MediumMedium

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)


(Emerging markets)

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.HighMedium/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 Iran, Russia, Turkey and 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.
Country specific risks
Oil production risk

Disruptions in oil production if recent efforts to stabilize oil output cannot be sustained

Disruptions in oil production would undermine growth prospects and result in deteriorations of the overall fiscal and external positions.
Financial sector risks

(A further deterioration in banking sector profitability and capitalization (particularly in IBA) could compromise the stability and soundness of the system).

A further deterioration in systemic banks would result in destabilizing deposit runs and bank closures. The government is likely to step in with important fiscal costs.
Escalation of the regional conflicts (Tensions with countries in the region could increase, following recent geopolitical events).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 2016 approved budget and allow further depreciation of the manat in line with ER fundamentals. Sustaining efforts to enhance banking sector performance and banking supervision combined with actions to restructure and privatize the public bank under a sustainable financial position will also help contain risks in the financial sector.

Less than 10 percent of these employments are part of the consolidated government accounts.

Foreign currency expenditures (e.g., service on external debt) of about 1½ percent of GDP rose automatically following the devaluations.

In May 2016, the corridor was narrowed, with the floor raised (from 2 to 4 percent) and the ceiling reduced (from 17 to 15 percent).

However, tight bid-ask spreads (+/- 1 percent) at the CBA auctions constrain ER movements. The amount of FX offered is determined jointly by the CBA and SOFAZ.

In mid-2016, household deposits amounted to some 14 percent of projected 2016 GDP.

The Board will include representatives of deposit insurance fund (ADIF), CBA, MOF, FMSA, and SOFAZ, and will be chaired by the Prime Minister.

See Morley (2015), “Macro-Financial Linkages”, Journal of Economic Surveys, April.

See Morley (2015), “Macro-Financial Linkages”, Journal of Economic Surveys, April.

The non-oil primary balance as a percent of GDP is projected to be about –38 percent of non-oil GDP in 2016, while the target based on the PIH fiscal rule (Box 4) is estimated to be -26 percent.

IMF Country Report No. 13/165, “Revamping the fiscal policy framework in Azerbaijan,” June 2013.

Cherif, R. & Hasanov, F., 2013. "Oil Exporters’ Dilemma: How Much to Save and How Much to Invest," World Development.

See IMF (2015), “Evolving Monetary Policy Frameworks in Low-Income and Other Developing Countries” Staff Report, and IMF (2016), “Exchange Rate Developments and Policies in the Caucasus and Central Asia”, MCD Department Paper Series.

The CBA refinancing rate has been more associated with CBA liquidity lending—including for financial stability purposes—and less linked to price stability objectives.

The CA balance averaged -12 percent of GDP in 2000-05, but shifted to a 23 percent of GDP surplus on average during 2006-15 as oil prices boomed and the REER appreciated sharply.

Retail depositors still face some constraints as they can only withdraw up to 1,000 manat per day. Companies can only withdraw deposits if it relates to payment of salaries and other operational expenses.

Banks in the third group (including the 4 placed in administration in July 2016) represent 22 percent of the system’s deposits.

The problem loans presented in the chart are FMSA “prudential” data, and differ from the “statistical” data reported in financial soundness indicators (FSI) which only present overdue payments.

Total covered deposits of banks closed in 2015 and 2016 have amounted to AzN 300 million. This has depleted existing ADIF reserves. ADIF has already borrowed AzN 22 million from CBA, which will be enough to pay deposits in the 3 litigating banks. If any additional bank is closed, ADIF will need further financial support.

See IMF Country Report No. 12/6, “The Inclusiveness of Azerbaijan’s Growth”.

See IMF (2015), “Where are we headed? Perspectives on potential output”, WEO April.

Production function estimates are based upon Burns, (2014), “Estimating potential output in developing countries”, Journal of Policy Modeling. The filtered estimates of non-oil sector potential growth are an average of Hoderick-Prescott and Baxter-King statistical filters.

This amount does not include project finance of $500 million provided for the construction of Baku-Tbilisi-Ceyhan Pipeline, which in addition to Azerbaijan, also covered Georgia and Turkey.

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