Azerbaijan Republic: Selected Issues and Statistical Appendix

This Selected Issues paper and Statistical Appendix for Azerbaijan aims to provide a guide to the management of Azerbaijan’s expected natural resource-generated windfall. The paper provides information on Azerbaijan’s endowment of oil and gas deposits and the projected revenue stream, and highlights the common characteristics of policies leading to the mismanagement of natural resource wealth in natural resource-abundant countries. It also outlines a medium- and long-term policy strategy for oil wealth management in Azerbaijan.


This Selected Issues paper and Statistical Appendix for Azerbaijan aims to provide a guide to the management of Azerbaijan’s expected natural resource-generated windfall. The paper provides information on Azerbaijan’s endowment of oil and gas deposits and the projected revenue stream, and highlights the common characteristics of policies leading to the mismanagement of natural resource wealth in natural resource-abundant countries. It also outlines a medium- and long-term policy strategy for oil wealth management in Azerbaijan.

III. Azerbaijan—Monetization And Dollarization Trends

A. Introduction

59. Since the government of Azerbaijan embarked on a comprehensive stabilization and structural reform program in 1996, macroeconomic developments have been favorable. Real GDP growth has averaged over 10 percent per year during the last few years. In addition, the exchange rate has been fairly stable, and inflation has declined to low single digits, with Azerbaijan having the lowest cumulative inflation in the BRO (Baltics, Russia and other countries of the Former Soviet Union) since 1996.

60. Despite these impressive achievements, there has been only a very modest recovery in money demand in Azerbaijan, following a precipitous fall in the first half of the 1990s. There has actually been a decline in demand for manat money balances relative to GDP since the start of the stabilization program in 1996. However, there has been a moderate increase in total money demand (manat money plus foreign currency deposits) relative to GDP during this period, as dollarization has been on the rise. At end-2002 foreign currency deposits were nearly 50 percent of broad money balances, double their level in the mid-1990’s and the highest level of dollarization in the BRO.

61. This chapter seeks to explain this modest recovery in money demand. It reviews trends in monetization and financial deepening in Azerbaijan, and compares those trends with the rest of the BRO. Evidence provided in this chapter indicates a strong positive correlation between the demand for real money balances in the BRO and progress in structural reforms—particularly in enterprise, financial sector and judicial reforms—and that the limited extent of these reforms in Azerbaijan goes a long way toward explaining the slow pace of recovery of money demand.

62. The chapter is organized as follows. Section III-B provides a summary of economic theory and empirical evidence on money demand, to put in perspective the developments in money demand in the BRO during the transition period. Section III-C summarizes Azerbaijan’s trends in monetization. Section III-D compares monetization trends in Azerbaijan with those in other BRO countries. Section III-E reviews the impact of structural reforms on the pace of remonetization in the BRO in general and in Azerbaijan in particular. Section III-F summarizes the benefits and costs of the remonetization process. Section III-G concludes.

B. Economic Theory on Money Demand and Empirical Evidence

63. The demand for money arises primarily from its usefulness in making transactions, and because it provides a hedge against the risk inherent in holding other assets. Theories on the demand for money are classified into two different but compatible groups. The first group—the transaction theories of money demand—stresses the role of money as a medium of exchange, noting that real money balances held by the public involve a trade-off between the convenience provided by money in conducting transactions and the interest income foregone as a cost of this convenience. The second group of theories—the portfolio theories of money demand—stresses the role of money as a store of value, claiming that the demand for money depends on the difference in risk and return between money and the other assets that people can hold instead of money to store their wealth.

64. Combined, these economic theories predict that real money balances are an increasing function of income, and a decreasing function of interest rates and the expected rate of inflation. Empirical studies have found broad support for these predictions. An increase in GDP, for example, is associated ceteris paribus with an increase in real money balances, whereas an increase in the interest rate on substitutes for money or in the expected rate of inflation is associated with a decline in real money balances.

65. Despite the broad agreement on the direction of the short run relationship between money and the endogenous macroeconomic variables, most empirical studies have failed to find a stable long-run relationship between money and these variables. Over time, there are often abrupt and unpredictable shifts in the demand for money. It is argued that institutional change—including regulatory changes in the banking sector and the emergence of new instruments that are close substitutes for money—is the main factor contributing to these shifts in money demand (see Box III-1 for a summary of historical money demand trends).

66. In transition economies, these shifts in money demand tend to be more frequent and larger than in other countries of similar economic and institutional development. This is due to several factors, including the rapid institutional change ongoing in these economies, the adjustment to the end of the high inflation that was experienced early in the transition process and, in some cases, banking sector crises. In many transition economies the remonetization has taken place largely through an increase in foreign currency deposits with banks, contributing to an increase in dollarization. As suggested by Havrylyshyn and Beddies (2003), asset substitution appears to be a key factor driving continued dollarization. By opening the way to holding foreign currency-denominated assets, dollarization allows investors to diversity their portfolios (see Appendix III-1 for a more detailed discussion on causes of dollarization and its policy implications).

Historical Trends of Money Velocity 1/

The long-run behavior of the income velocity of money, defined as the ratio of GDP over money (the sum of currency in circulation, demand and time deposits), has exhibited a U-shaped pattern since the late-19th century in most industrial countries. Velocity fell, for example, in Canada and the United States through the early-1940s, and it has displayed an upward trend since then in both countries. Similarly, in the United Kingdom velocity fell from around 1910 onward, with a turnaround occurring in the mid-1940s.

The declining trend in velocity prior to the 1940s reflected a growing use of money for settling transactions, rather than barter and payments in kind. The reversal in money velocity starting from the mid-1940s was largely due to the increased sophistication of the financial systems in the industrial countries. The upward trend in money velocity reflected the emergence of a large number of close substitutes for money—such as bonds, common stocks, and other financial assets, that reduced the demand for money as an asset—and also the development of various methods of economizing on money balances, such as the use of credit cards, die transfer of funds electronically, and modem cash management techniques that reduced the transactions demand for money. While both these sets of institutional variables operate at the same time, the monetization effects typically dominate first, causing velocity to decline. Later, the financial sophistication effects dominate, causing velocity to increase.

1/ This text box summarizes the discussions on the historical trends in money velocity in “The Long-Run Behavior of the Velocity of Circulation: The International Evidence”, Bordo, M.E. and Jonung, Lars, 1987.

67. Another important empirical finding on money demand is that demonetization and remonetization appear to be asymmetric processes: higher inflation leads almost immediately to lower money demand, but lower inflation does not automatically raise money demand. Gosh (1996), for example, finds that the inflation elasticity of real demand for money is high during periods of demonetization, but barely above zero (and not statistically significant) during periods of remonetization. When faced with high inflation, households and enterprises find ways to conserve on money holdings. In doing so, they discover new “technologies” for operating with lower money holdings and, having invested the fixed costs involved in developing these technologies, are reluctant to give them up.

C. Monetization Trends in Azerbaijan

68. Monetary developments in Azerbaijan have gone through two distinct phases since independence in 1991. During the first phase, lasting through late 1995/early 1996, and which involved excessive money printing to cover large fiscal deficits, there was a precipitous fall in real money balances. During the second period, the sharp demonetization that took place in the first half of the 1990s was halted. However, although there has been some modest decline in M34 velocity since end-1996, interrupted by a brief reversal in the aftermath of the Russian crisis of mid-1998, the recovery in money demand that has been seen in other BRO countries in recent years has not yet materialized in Azerbaijan.

First phase: Demonetization

69. During the first half of the 1990s, faced with revenue shortfalls and a costly war in Nagorno-Karabakh, the authorities resorted to printing money to finance the burgeoning fiscal deficit. Reserve money grew sharply during this period, resulting in inflation rates of over 1,000 percent from early 1993 through mid-1995. Seignorage revenue5 and the inflation tax6 peaked in 1993. at about 25 percent and 27 percent of GDP, respectively (Table III-1). Seignorage declined to about 15 of GDP in 1994, and to about 4 percent of GDP in 1995, as the authorities gradually reduced the rate of reserve money growth. The inflation tax continued to exceed seignorage in 1994, amounting to about 22 percent of GDP, as demand for real money balances continued to decline in the face of continued high inflation, before falling to less than 3 percent of GDP in 1995, following a sharp reduction in the rate of increase of money supply during the second half of that year.

Table III-1.

Azerbaijan: Indicators of Monetization and Financial Deepening

(in units as indicated)

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Source: Azeri authorities and IMF staff calculations.

Second phase: Slow Remonetization

70. In early 1996 the authorities embarked on a comprehensive stabilization and structural reform program. By that time M3 had declined to less than 10 percent of GDP (about 12 percent of non-oil GDP), compared to over 20 percent of GDP at end-1994. To anchor inflationary expectations, given the very strong link between depreciation and inflation at the start of the stabilization program, the central bank targeted a strong manat, allowing for an appreciation of the nominal exchange rate of manat vis-à-vis the US dollar, with the rate of appreciation gradually declining as inflation fell. The turnaround in macroeconomic developments following the 1996 program was swift. Real GDP rebounded strongly, growing by about 10 percent per year since 1998, and 12-month CP1 inflation quickly fell to low single digits. The restoration of political and macroeconomic stability, together with initial progress in banking sector and other structural reforms, soon halted the demonetization process that had prevailed during the first half of the 1990s. The decline in real money balances bottomed out around mid-1997, with both M2 and M3 velocity declining moderately through end-1998 (Figure III-1.).

Figure III-1.
Figure III-1.

Azerbaijan: Money, Inflation and Velocity trends

Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A003

Source: Azeri authorities, and IMF staff estimates.1/ Ratio. M2 velocity defined as the ratio of non-oil annualized GDP over annual average manat broad money. M3 velocity defined as the ratio of non-oil annualized GDP over annual average broad money (manat broad money plus foreign currency deposits)2/ 12-month growth rates.

71. This initial progress in remonetization was short-lived, however, as demand for money was adversely affected by the Russian crisis of mid-1998. Faced with a sharp loss of confidence in the domestic currency and in domestic-currency-denominated assets, the authorities reversed their previous policy of nominal appreciation. To maintain macroeconomic stability, however, they allowed for only a modest depreciation of the exchange rate. Except for the Baltics, which have continued to operate formal fixed exchange regimes since the mid-1990s, Azerbaijan mounted one of the strongest defenses of the exchange rate in the BRO in the face of the Russian crisis. Between June 1998 and July 1999 there was a 30 percent decline in reserve money, and only a moderate depreciation of the manat/US$ exchange rate.7 There was a sharp decline in banking sector deposits as well, in both domestic and foreign currencies.

72. With improved economic conditions across the region, as well as a one-time 7 percent depreciation of the manat in July 1999, the adverse effects stemming from the Russian crisis had waned by mid-1999. Against a background of low inflation and a stable exchange rate, demand for money in Azerbaijan started to recover in early 2000. By June 2000 nominal reserve money had increased to the pre-Russian crisis level, and continued to increase through end-2002. The decline in foreign currency deposits also bottomed out in mid-1999, and at end-2002 foreign currency deposits were triple their level of June 1999. The recovery in domestic currency deposits, however, has been very slow, reaching the pre-Russian crisis level of June 1998 only in June 2002.

73. In summary, while there has been a modest increase in the ratio of M3 to GDP during the period 1996-2002 (about 30 percent), M2 balances declined relative to GDP during this period, despite a relatively stable exchange rate and low inflation throughout this time. The modest financial deepening took place almost exclusively through an increase in foreign currency deposits (FCD). While high and persistent dollarization is a distinctive feature of the remonetization process of transition economies, only a few BRO countries have experienced similar increases in dollarization following sustained disinflation (Armenia, Georgia, Kazakhstan, and Tajikistan). As discussed in Appendix I, the observed persistence of dollarization in the BRO may be due to a combination of factors, including: (i) inertial or hysteresis effects, i.e., many people have learned to transact in foreign currency, and choose to continue to do so in view of the costs involved in changing their behavior; (ii) a low level of development of domestic financial markets in the region, and (iii) it is possible that part of the measured increase in dollarization reflects a switch of cash dollar holdings for dollar deposits, as confidence in banks improves.

D. Monetization Trends in Azerbaijan Compared with Others in the BRO

74. Macroeconomic developments in the BRO following the dissolution of the former Soviet Union were similar to those in Azerbaijan. High fiscal deficits in the early transition stage were largely financed by printing money, contributing to high inflation, sharply declining real money balances, and increasing dollarization in virtually all BRO countries. As can be seen from Tables III-2 and III-3, the inflation tax remained significant in most BRO countries through 1995, due to excessive money financing of fiscal deficits. This led to a rapid demonetization process across the region, similar in magnitude to the developments in Azerbaijan described in Section III-C, with broad money balances relative to GDP dropping by the mid-1990s to only a small fraction of the levels prevailing in these countries at the start of the transition process. During the second half of the 1990s the stabilization programs introduced in most BRO countries started to take hold. With the notable exception of Belarus and Uzbekistan, inflation was gradually brought under control, and by end-2002 single digit annual inflation rates prevailed throughout most of the region.8

Table III-2.

BRO Countries: Seignorage Revenue

(in percent of GDP)

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Source: IFS and Fund staff estimates.
Table III-3.

BRO Countries: Inflation Tax

(in percent of GDP)

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Source: IFS and Fund staff estimates.

75. These improvements in macroeconomic conditions contributed to increased confidence in the individual countries’ domestic currencies and banking systems. As can be seen from Figures III-2 and III-3, there has been a trend decline in M2 velocity and M3 velocity in most BRO countries since 1996, although in some cases there was a temporary reversal in the aftermath of the Russian crisis.

Figure III-2.
Figure III-2.

BRO Countries: M2 Velocity Trends, 1995-2002

Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A003

Source: EU2 Database.1/ M2 velocity is defined as the ratio of nominal GDP over the average stock of manat broad money (excluding foreign currency deposits).2/ For Azerbaijan, M2 velocity is the ratio of non-oil GDP over the average stock of manat broad money.
Figure III-3.
Figure III-3.

BRO Countries: The M3 Velocity Trends, 1995-2002 1/

Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A003

Source: EU2 Database.1/ M3 velocity is defined as the ratio of nominal GDP over the average stock of broad money (including foreign currency deposits).2/ For Azebaijan, M3 velocity is the ratio of non-oil GDP over the average stock of broad money.

76. The pace of remonetization, however, has varied greatly across the BRO. As noted earlier, Azerbaijan’s progress in remonetization has been relatively modest, with the ratio of M3 to GDP improving by about 30 percent since 1996, following a sharp decline in the first half of the 1990s. During this period, the pace of remonetization in most BRO countries was significantly faster, with only Uzbekistan, Tajikistan, and the Kyrgyz Republic having lower monetization growth rates (Uzbekistan has actually had an increase in M3 velocity during this period). Excluding Azerbaijan, monetization growth rates ranged from about 150 percent in Ukraine to about 40 percent in Latvia and Moldova.

77. The trends in the M2/GDP ratio in the BRO are broadly similar to the M3/GDP trends, with the notable exception of Azerbaijan and Kazakhstan. In Azerbaijan, as noted earlier, there has been a decline in the M2/GDP ratio since 1996, compared to a modest increase in the M3/GDP ratio. In Kazakhstan, the M2/GDP increased by much less than the M3/GDP ratio during the period 1996-2002 (30 percent increase in the former compared to 100 percent increase in the latter), indicating a sharp increase in dollarization.

78. Two observations are in order. First, despite the rapid remonetization observed in most BRO countries over the last few years, the level of monetization remains, except for the Baltics, far below the level prevailing in the transition economies of Eastern Europe. It thus seems that the velocity of money should continue to decline for some time in the BRO, provided that macroeconomic stability is maintained and structural reforms continue, before it reverses direction and starts to increase, echoing the path observed in the industrial countries.

79. Second, the monetization trends in Azerbaijan compared to the other BRO countries are puzzling. Why has there been virtually no remonetization in Azerbaijan, despite it having the lowest cumulative inflation since 1996, as well as one of the fastest real GDP growth rates in the region? After all, as indicated in Section III-B above, empirical evidence suggests that there is an inverse relationship between inflation and the demand for real money balances. The answer seems to be related to Azerbaijan’s relatively slow progress in structural reforms.

E. Structural Reforms and their Impact on Monetization Trends

80. Azerbaijan has made significant progress in structural reforms since 1996, particularly in the areas of price liberalization, small-scale privatization, banking sector restructuring, and foreign exchange and trade reforms, closing the gap with the front-runners in the BRO. A review of transition indicators compiled by the EBRD shows that Azerbaijan had the highest improvement in the average index of reforms between 1996 and 2001 (Figure III-4). At the same time, however, Azerbaijan’s EBRD transition indicators for “second generation” reforms remain among the lowest in the BRO, particularly in the area of large-scale privatization, non-bank financial sector restructuring, and enterprise and judicial reforms (Table III-4).

Figure III-4.
Figure III-4.

BRO Countries: Progress in Structural Reforms, 1996-2001

Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A003

Source: EBRD, Transition Report, 2001.
Table III-4.

A Comparative Perspective on the State of Structural Reforms in Azerbaijan in 2001 Relative to Other BRO Countries

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Source: EBRD, Transition Report 2002.

For the Kyrgyz Republic, the EBRD index for 2001 is not available, and the 2000 index is shown in the table.

81. Anecdotal evidence from firms and banks operating in Azerbaijan confirms that there has indeed been slow progress in these reforms. While there has been a recent acceleration in banking sector reforms, progress in enterprise and judicial system reforms remains slow, hampering the process of remonetization. Banks complain, for example, that the protection provided by the courts remains weak, significantly increasing their cost of doing business. In addition, assets that can be pledged as collateral are effectively limited to cars, flats, and securities, as there is no functioning registry for other assets (such as fixed assets of enterprises). Moreover, competition in the banking sector is hindered by the dominance of the system by the two state-owned banks (International Bank of Azerbaijan and BUS Bank), which have an effective monopoly on government banking services. Large-scale privatization is also moving slowly, and the reform of state enterprises is lagging, as evidenced by high inter-enterprise arrears.

82. Figures III-5 and III-6 plot the relationship between monetization trends in the BRO and the EBRD transition indicators on, respectively, banking sector restructuring and enterprise reform. There appears to be a relatively strong positive relationship between progress in structural reforms captured by these indicators and the pace of remonetization in the region. The direction and strength of the relationships summarized in Figure III-5 and Figure III-6 are only suggestive, however, as no control is made for the potential impact on monetization of other factors, such as the ones mentioned in Section III-B above.

Figure III-5.
Figure III-5.

BRO Countries: Relationship between Banking Sector Reform and Remonetization

Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A003

Note: EBRD index on banking reform and interest rate liberalization indicates -- 1 Little progress beyond establishment of a two-tire system; 2 - Significant liberalization of interest rate and credit allocation; limited use of directed credit or interest rate ceilings; 3 - Substantial progress in establishment of bank solvency and of a framework for prudential supervision and regulation; full interest rate liberalization with little preferential access to cheap refinancing significant lending to private enterprises and significant presence of private banks; 4 - significant improvement of banking laws and regulations toward BIS standards; well-functioning banking competition and effective prudential supervision significant learn lending to private enterprises; substantial financing deepening.
Figure III-6.
Figure III-6.

BRO Countries: Relationship between Enterprise Reform and Remonetization

Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A003

Note: EBRD Index of Enterprise reform indicates – 1 - Soft budget constraints (lax credit and subsidy policies weakening financial discipline at the enterprise level) few other reforms to promote corporate governance; 2 - Moderately tight credit and subsidy policy but weak enforcement of bankruptey legislation and little action taken to strengthen competition and corporate governance; 3 - Significant and sustained actions to hard budget constraints and to promote corporate governance effectively (e.g. privatization combined with tight credit and subsidy policies and/or enforcement of bankruptcy legislation); 4 - Substantial improvement in corporate governance, for example, an account of an active corporate control market; significant new investment at the enterprise level.

83. For this reason, a panel regression with country-specific effects was estimated, pooling together data for 13 BRO countries for the period 1996-2001, using the following specification:



- Δ: indicates annual percentage change;

- Mit: are nominal broad money balances at year end (M2t for manat money balances and M3t for total broad money balances, i.e. manat money plus foreign currency deposits);

- CPIt: is the consumer price index at year end;

- GDPt: is nominal annual GDP; and

- RUS: is a dummy variable, which is equal to 1 in 1998 and 0 in all other years for all countries included in the panel, designed to capture the effect of the Russian crisis;

- State: is a dummy variable, which is equal to 1 for Azerbaijan and Uzbekistan and 0 for all other countries included in the panel, as discussed below;

- Structural: is an index of structural reforms as compiled by EBRD and reported in the EBRD Annual Transition Reports (the index of banking sector reforms and the average index of structural reforms were tested in this panel data analysis).9

84. The results of the regressions are summarized in Table III-5.10 Consistent with the empirical literature, income appears to be positively correlated, and inflation negatively correlated, with the demand for both real M2 and M3. Both relationships are statistically significant at the 5 percent level. In addition, the dummy variable on the Russian crisis is significant at the 5 percent level in all tests.

Table III-5.

Results of Panel Regression in BRO 1/2/

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Source: EBRD Transition Report 2002, and IMF FSU database.

Two and three asterisks indicate statistical significance at, respectively, 5 percent level 10 percent level.

Data in paranthesis indicate t-statistics.

85. The strength of the relationships between real demand for money and structural reforms is mixed. The coefficients of both the EBRD index of banking reform and the average EBRD index of structural reforms in the M3 real money demand equations have the expected sign and are significant at the 5 percent level. In the M2 equations, however, while these coefficients do have the expected sign, they are not statistically significant.

86. State ownership in the banking sector appears to be negatively correlated with the demand for real money balances. In the absence of reliable time series of state ownership in the domestic banking sectors of all countries included in this panel analysis, a dummy variable was included in the regression analysis, taking values of one for Azerbaijan and Uzbekistan, and zero for all other countries. In these two countries, the asset share of state-owned banks is currently over 60 percent, and has been even higher during the 1996-2001 period. In the rest of the countries, the asset share of state owned banks ranges from less than 10 percent in most of them to nearly 40 percent in Russia.11 The coefficient of this dummy variable has a negative sign in all four tests reported in Table III-5, is large in magnitude, and is significant at the 10 percent level in 3 out of 4 regressions, suggesting that the control of the banking sector by state-owned banks has a strong negative effect on remonetization and financial deepening.

87. Taken together, the evidence provided by Figure III-5. and III-6, as well as the results of the panel regressions summarized in Table III-5, suggest that Azerbaijan’s slow progress in structural reforms, and in banking sector restructuring in particular, is a key factor behind the slow growth in real money demand in Azerbaijan.

F. Is Fast Remonetization Necessarily a Good Thing?

88. Increasing monetization is, among other things, an indicator of improving confidence in macroeconomic policies and management, as well as in the banking sector. In addition, by providing banks with more resources for lending, remonetization translates into increased financial deepening, an important ingredient for sustainable economic growth.

89. Except for Estonia and Latvia, the stock of banking sector credit to the economy in the BRO, as a ratio to GDP, is significantly below that in other Eastern European countries. As of end-2002, the credit/GDP ratio varied from as low as 4.2 percent in the Kyrgyz Republic to as high as 30 percent in Estonia and Latvia (Table III-6). The comparable ratios at end-2002 were about 30 percent in Poland and over 40 percent in Hungary. The bank credit to GDP ratios are much higher in the industrial countries, amounting to, for example, about 60 percent in the United States and 150 percent in the United Kingdom.

Table III-6.

BRO Countries: Credit to Economy as a Share of GDP, 1995-2002

(in percent)

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Source: IMF FSU database, and Fund staff calculations.

90. Given the relatively low stock of credit to the economy in virtually all BRO countries, it would seem that rapid remonetization would be desirable. However, the low credit/GDP ratios across the BRO are, in part, an indicator of fragile and relatively unsophisticated banking systems, and of judicial systems that provide little protection to banks against delinquent borrowers. In addition, existing accounting systems in most BRO countries are incompatible with international standards, undermining the ability of banks to properly assess credit risks. A rapid expansion of credit under these circumstances could overwhelm such weak banking systems, and over time could lead to a deterioration in the quality of the banking system’s loan portfolio.

91. Consistent with its modest remonetization, credit growth in Azerbaijan has also been moderate, against a background of low inflation and a relatively stable exchange rate. During 2001-02, credit growth averaged about 14 per year, or slightly higher than nominal GDP growth. Except for Armenia and the Kyrgyz Republic, real credit growth in the BRO over the last few years has been higher than in Azerbaijan. The fastest real credit growth rates have been registered in Latvia, Kazakhstan and Ukraine, in all of which the credit to GDP ratio effectively doubled during the period 2000-02.

G. Conclusions

92. There has been only a modest financial deepening in Azerbaijan since the start of the stabilization and structural reform program of early-1996, despite a stable macroeconomic environment and strong economic growth. The demand for manat money balances relative to GDP has actually declined since 1996. In addition, the level of dollarization remains the highest among BRO countries.

93. The evidence presented in this chapter suggests that structural reforms in general, and bank restructuring in particular, have had a strong positive influence on the pace of remonetization in the BRO. Large state ownership in the banking sector is associated with lower growth rates in real money balances, as is slow progress in bank restructuring and in other key structural reforms. To accelerate the remonetization process, the Azerbaijan authorities should accelerate structural reforms, particularly in large-scale privatization and the judicial systems; complete the privatization of IB A and BUS Bank; introduce measures to foster increased competition in the banking sector, including by tendering for government banking services; and establish an efficient registry system for fixed assets of firms so as to broaden the scope of assets that can be pledged as collateral for bank loans.

94. In light of international experience with money demand, there is ample scope for continued remonetization in Azerbaijan. However, while rapid remonetization is an indicator of improved confidence in economic policies and the banking sector, should a sharp acceleration of financial intermediation take place in Azerbaijan, the authorities should ensure that credit policies are not relaxed and that banking and other structural reforms continue. This will help avoid future banking crisis, which could undermine confidence in the authorities’ economic reforms. In addition, the authorities should improve the treasury bill market and accelerate other reforms that would contribute to an increase in demand for manat-denominated assets, while maintaining the impressive gains in macroeconomic stabilization.

Table III-7.

BRO Countries: Growth of Credit to the Economy, 1995-2002

(in percent)

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Source: IMF FSU database, and IMF staff calculations.

APPENDIX III-1: Dollarization: Causes and Policy Implications

As noted in Section III-C, a distinctive characteristic of remonetization in Azerbaijan is that it has taken place largely through an increase in foreign currency deposits (FCD), contributing to a sharp increase in measured dollarization.12 The literature highlights two main reasons for the observed persistence of dollarization in transition and emerging economies.

The first reason—hysteresis—has to do with the fact that during periods of hyperinflation, as well as extended high inflation, economic agents reduce their holding of money balances denominated in domestic currency, to avoid erosion of their asset holdings. This change of behavior is a slow process that involves institutional changes, and is not reversed quickly when inflation is brought under control. This is similar to the explanation of the asymmetric response of money demand to changes in inflation.

The second reason—asset substitution—is related to the relatively low level of development of domestic financial markets. To the extent that there are few attractive assets available in local currency, investors will have little choice but to invest in assets denominated in foreign currency. Dollarization therefore, as argued by Havrylyshyn and Beddies (2003), opens the way to diversifying portfolios and reducing risks.

There is another possible explanation, especially for countries that have experienced sharp increases in the FCD/M3 ratio against a background of a stable macroeconomic environment, such as Azerbaijan and Kazakhstan. In these cases, an increase in the FCD/M3 ratio could reflect improved confidence in the banking sector, and a conversion of cash dollar holdings into FCD in the banking sector, with no change in dollarization.

As can be seen from Figures III-7, progress in financial market development in the BRO, as measured by the EBRD transition indicator on securities markets and non-bank financial institutions reforms, is negatively correlated with the level of dollarization, seeming to provide support for the asset substitution argument mentioned above. In the case of Azerbaijan, for example, there are limited opportunities to invest in domestic currency-denominated instruments. The stock market is virtually inexistent. and the supply of treasury bills is highly volatile and limited to short-term maturities (3- and 6-months only).

Figure III-7.
Figure III-7.

BRO Countries: Dollarization and Development of Domestic Financial Markets

Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A003

Note: The EBRD Index indicates -- 1 - little progress; 2 - formation of securities exchanges, market-makers and brokers; some trading in government paper and/or securities; rodimentary legal and regulatory framework for the issuance and trading of securities; 3 - substantial issuance of securities by private enterprises; establishment of independent share registries; secure clearance and settlement procedures and some protection of minority shareholders; emergence of non-bank financial institutions (e.g. investment funds, private insurance and pension funds, leasing companies) and associated regulatory framework; and 4- securities laws and regulations approaching IOSCO standards; substantial market liquidity and capitalization; well-functioning non-bank financial institutions and effective regulation.

While dollarization is measured as the ratio of FCD/M3, the extent of currency substitution appears to also be very high in Azerbaijan. Transactions of relatively high value, such as, for example, sales of cars and apartments, reportedly continue to be settled primarily in foreign currency. The fact that the banknote with the highest denomination in Azerbaijan is the manat 50,000 note, equivalent to about US$10, is an important factor in reducing the attractiveness of manat notes, thereby contributing to the reportedly high level of currency substitution.

Although dollarization allows domestic economic agents to better diversify their portfolio, there are potential costs from dollarization. A high dollarization ratio complicates, for example, the choice of an appropriate intermediate target for monetary policy. More importantly, it makes the economy vulnerable to exchange rate volatility, undermining the authorities’ ability to effectively respond to financial crises. With foreign currency-denominated loans in Azerbaijan amounting to about 75 percent of total banking sector loans at end-2002, a sharp exchange rate depreciation is likely to have a significant adverse impact on banks’ financial position, as most of these foreign currency-denominated loans are to borrowers whose income is denominated in domestic currency.13 A sharp depreciation therefore, unless accompanied by an immediate and complete pass-through into domestic prices, will cause difficulties for firms trying to service these loans, and lead eventually to increased loan defaults.

Given that there are potential costs to high dollarization, the question is whether the authorities should introduce direct measures aimed at reducing dollarization. The two most common direct measures are higher required reserve rates for foreign currency deposits, and forced conversions of foreign currency deposits into domestic currency deposits. International experience indicates that these measures are ineffective, and have been counterproductive in many cases. Bolivia, Peru, Uruguay and Turkey, for example, have used higher reserve requirements for foreign currency deposits than for domestic deposits, but none of these countries has experienced a reduction in dollarization. Mexico in 1982, Peru in 1985, and Argentina in 2002 introduced forced conversions of foreign currency deposits to domestic currency deposits. These conversions actually entailed a significant loss of government credibility. Mexico has also at times restricted domestic firms’ holdings of foreign currency deposits, without much success.

While dollarization complicates the conduct of monetary policy, and may also exacerbate the situation in the case of a financial crisis, direct measures aimed at curbing dollarization should be avoided. Despite its costs, an increase in foreign currency deposits has a positive impact on financial deepening, providing the domestic banking system with resources available for lending, which is an important ingredient for sustainable economic growth. In addition, experience indicates that the effectiveness of direct measures is likely to be transitory at best, as domestic residents eventually find ways to circumvent them. The most effective “de-dollarization” measure therefore, is for the authorities to focus on the development of domestic financial markets, while maintaining strong macroeconomic policies.


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In this chapter, M2 refers to currency in circulation plus all manat-denominated deposits in commercial banks. M3 refers to M2 plus foregin currency deposits in commercial banks.


Defined as the increase in nominal reserve money balances during the period, i.e., RMt - RMt-1, where RM stands for nominal reserve money.


Defined as the loss in value of the public’s cash holdings due to inflation, calculated as follows: ITt = (πt/(1 + πt))* RMt-1, where ITt is the nominal inflation tax at period t; πt is the inflation rate during period t; and RMt-1 is reserve money stock in the previous period.


There was a depreciation of about 3 percent in the manat/US$ exchange rate from June 1998 through July 1999, compared to an appreciation of about 8 percent and 5 percent, respectively, in 1996 and 1997. Prices fell between October 1998 and July 1999, with the 12-month CPI inflation at -9.5 percent in July 1999.


While the 12-month inflation at end-2002 amounted to about 15 percent in both Russia and Tajikistan, there has been a trend decline in inflation in both countries, following the sharp spike in inflation in the wake of the Russian crisis of mid-1998.


The level of the EBRD indices, rather than their change, was used in this analysis. The reason is that countries which have experienced the highest improvement in these indices since 1996 are those that have been catching up with the front-runners, starting from a very low base. Thus there is a negative correlation between the level of reforms and the change in the reform index, and this would have distorted the coefficient on the change in reforms.


A fixed effects specification was chosen after the Wald test on the appropriateness of linear restrictions suggested that it is superior to a simple OLS pooled test.


In Russia this corresponds to 1999, as information for later years is not in the 2002 EBRD Transition Report. In Lithuania, state-owned banks also accounted for nearly 40 percent of total banking sector assets in 2000, but this ratio had declined to about 5 percent at end-2001.


With Azerbaijan’s oil sector being financed almost exclusively from abroad, its non-oil exports in 2002 amounted to about USS 250 million, compared to an outstanding stock of bank loans denominated in foreign currency equivalent to US$320 million.


Examples are the establishment of a large tax payer unit, reorganizations and consolidation of tax offices, adoption of new work processes, introduction of bonded warehouses and customs brokers, and partial automation of customs procedures.

Azerbaijan Republic: Selected Issues and Statistical Appendix
Author: International Monetary Fund