Azerbaijan Republic: staff Report for the 2004 Article IV Consultation, Fourth Review Under the Poverty Reduction and Growth Facility, Requests for Waiver of Performance Criteria, Extension of Arrangement, Reduced Access and Rephasing of Disbursements

This paper examines Azerbaijan Republic’s 2004 Article IV Consultation and Fourth Review Under the Poverty Reduction and Growth Facility. A long-term oil revenue management strategy has been adopted by the authorities, targeting a path of non-oil deficits over the medium term that seeks to preserve macroeconomic stability and also avoid overstretching implementation capacity. To ensure coherent fiscal policy, annual budgets will need to start from the poverty reduction strategy and incorporate public investment and regional development programs.

Abstract

This paper examines Azerbaijan Republic’s 2004 Article IV Consultation and Fourth Review Under the Poverty Reduction and Growth Facility. A long-term oil revenue management strategy has been adopted by the authorities, targeting a path of non-oil deficits over the medium term that seeks to preserve macroeconomic stability and also avoid overstretching implementation capacity. To ensure coherent fiscal policy, annual budgets will need to start from the poverty reduction strategy and incorporate public investment and regional development programs.

I. Introduction

1. The Executive Board completed the 2003 Article IV consultation with Azerbaijan on May 14, 2003, and approved the request to complete the third review under the PRGF on December 19, 2003. On both occasions, Directors commended the authorities for implementing prudent financial policies, and urged them to develop a long-term strategy for the use of oil revenues and to continue aggressive implementation of structural reforms. Directors also stressed the importance of completing bank privatization and accelerating energy sector restructuring.

2. In the attached Supplementary Letter of Intent (SLOI), the authorities describe their performance under the PRGF arrangement and their planned economic program for 2005, and propose performance criteria and indicative targets for end-December 2004, end-March 2005, and end-April 2005. The authorities also request several waivers, an extension of the PRGF arrangement through July 4, 2005, and cancellation of the previously planned sixth review and correspondingly reduced access under the arrangement.

3. Azerbaijan accepted the obligations of Article VIII, Sections 2, 3, and 4 effective November 30, 2004, and is committed to maintain an exchange system free of restrictions in making payments and transfers for current international transactions. Summaries of Azerbaijan’s relations with the Fund and World Bank are provided in Appendices I and II, respectively, and statistical issues are reviewed in Appendix III.

II. Overview

4. Azerbaijan’s economy has been, and will continue to be, dominated by oil. Oil and oil products comprised 86 percent of total 2003 exports; 2004 is expected to be similar. In addition, massive oil and gas projects—in 2004, foreign direct investment (FDI) in these projects will be equivalent to almost 40 percent of GDP—have played a major role in Azerbaijan’s economy in recent years. Starting in 2005, as the first of these projects is completed, oil exports will increase dramatically—from around 175,000 barrels per day now to 1.25 million barrels per day by 2010. However, this surge will be temporary; by around 2024 exports will return to current levels. The management of this oil wealth presents the key medium- and long-term challenge for the government of Azerbaijan.

5. Azerbaijan’s macroeconomic performance in recent years has been impressive, with strong growth, low inflation, and a stable exchange rate (Figure 1). Real GDP grew by an annual average of over 10 percent during 2000–03, driven by oil-sector FDI and related spillover effects in the construction and transportations sectors, substantial gains in agriculture following land reform in the mid-1990s, and robust growth in non-oil exports (primarily agriculture and chemical products). Except for the acceptance of the obligations of Article VIII, Sections 2, 3, and 4, there have been no major developments in Azerbaijan’s exchange system since the conclusion of the 2003 Article IV consultations.

Figure 1.
Figure 1.

Azerbaijan: Recent Economic Developments, 2000–05

Citation: IMF Staff Country Reports 2005, 019; 10.5089/9781451802689.002.A001

Sources: Azerbaijan authorities; and Fund staff estimates.1/ 12-month growth rates.2/ Includes only public and publicly-guaranteed external debt.3/ Excludes capital repatriation from foreign investors.4/ Decrease means depreciation.

6. The National Bank of Azerbaijan (ANB) has continued its policy of informally targeting the manat/U.S. dollar exchange rate to anchor the price level, allowing for movements in this rate within a narrow band. Until recently, it targeted a gradual depreciation in the nominal manat/U.S. dollar rate (2-4 percent a year), a policy that was consistent with low, single-digit inflation. Starting in late 2003, however, foreign exchange inflows increased considerably, due to higher FDI and exports, and the ANB has allowed for modest nominal appreciation to counter increasing inflationary pressures (see below).

7. Fiscal policy has been prudent since the start of the stabilization program in 1996, and the composition of expenditures has improved. The non-oil consolidated deficit increased from more than 10 percent of non-oil GDP in 2001 to an average of about 15 percent during 2002-04—still well below the long-run sustainable level, as estimated in the IMF Country Report No. 03/130. The authorities are paying increasing attention to infrastructure investment, with domestically financed investment spending as a share of total government spending (net of foreign financed spending and energy subsidies) increasing from less than 5 percent in 1998 to over 17 percent in 2004. Fiscal and quasi-fiscal energy subsidies have also been reduced sharply, from about 22 percent of GDP in 2000 to an estimated 10 percent in 2003. The share of wages in total spending is relatively high and rising, reflecting excessive government employment, but the level of public sector wages is still low.

8. Progress in structural reforms has been mixed, with periods of fast progress followed by gridlock. In early 2001 the authorities embarked on a comprehensive structural reform program, which was supported by a PRGF arrangement starting in July 2001. During most of that year, the authorities aggressively pursued reforms designed to (i) improve transparency of government spending, including by establishing clear rules for the operation of the Oil Fund, creating a supreme audit institution, and including in the budget previously quasi-fiscal energy-related subsidies (QFS); (ii) reform the Ministry of Tax (MOT) and State Customs Committee (SCC); and (iii) start financial sector restructuring (IMF Country Report No. 02/40). During 2002, key structural reforms in the energy and banking sectors were delayed, and a number of ad-hoc decisions on spending Oil Fund assets were made. Following an acceleration of reforms for most of 2003—enhancing financial discipline in the energy sector, strengthening the budget preparation and implementation process, and improving the business environment (IMF Country Report No. 04/9)—reforms stalled again in late 2003. The authorities have recently resolved internal disputes on outstanding issues, and the pace of structural reforms has picked up.

9. The authorities face the challenge of managing the coming oil boom, with government revenues from oil exports projected to grow about 65 percent in 2005, and by an average of over 128 percent per year during 2006–09. Despite the recently adopted oil revenue management strategy, designed to ensure the revenue windfall is managed effectively, policy coordination remains weak and progress on energy and banking sector reforms has been slow.

10. Over the last few years, the Fund has supported Azerbaijan’s economic reforms through the PRGF and Article IV consultations, and has provided technical assistance on a wide range of issues. The authorities have continued their track record of effective use of this assistance, although at times they have implemented the advice more slowly than recommended. In recent years, this assistance has contributed to further development of the Treasury system, a more modern and comprehensive Budget Systems Law, improved tax and customs administration, strengthened banking supervision, improvements in national accounts statistics, and most recently substantially improved banking sector legislation.

III. Recent Developments and Performance Under the Program

11. Macroeconomic developments remain broadly in line with program objectives (Tables 16). Real GDP grew 9.9 percent during January–September relative to the same period of 2003, driven by oil-related FDI and strong growth in non-oil exports. The real effective exchange rate has remained broadly stable, following a depreciation of about 8 percent in 2002 and 11 percent in 2003.

Table 1.

Azerbaijan: Selected Economic and Financial Indicators, 2001-05

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

Excludes the increased revenues and expenditures from including SOCAR’s quasi-fiscal activities in the budget.

In percent of beginning of the year broad money (M3) stock, unless otherwise specified.

In terms of nonoil GDP.

For 2002 and 2003 includes investments of US$50 million and US$121.5 million, respectively, for the government’s share in BTC, equivalent to 0.8 percent and 1.7 percent of GDP, respectively.

Calculated by deducting Oil Fund, AIOC and SOCAR revenue from the consolidated government budget balance.

In percent of exports of goods and services.

Excluding Oil Fund assets.

Table 2.

Azerbaijan: Monetary Survey, 2001-05 1/

(In billions of manats)

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Sources: Azerbaijan National Bank; and Fund staff estimates.

Accounts are valued at program exchange rates of 4,606 manat per U.S. dollar and 1.26 U.S. dollar per SDR.

Takes into account the following temporary transactions by the ANB in which one side of the transaction took place in late Dec. 2003 and the other side on Jan. 2, 2004: (i) sales of US$10.8 mln. to a commercial bank; (ii) repurchase of 40 bln. manat REPOs; and (iii) repurchase of 60 bln. manat treasury bills.

Quarterly figures are cumulative changes year to date.

Velocity is defined as nominal non-oil GDP divided by average broad money.

Table 3.

Azerbaijan: Summary Accounts of the Azerbaijan National Bank, 2001-05 1/

(In billions of manats)

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

Accounts are valued at program exchange rates of 4,606 manat per U.S. dollar and 1.26 U.S. dollar per SDR.

Takes into account the following temporary transactions by the ANB in which one side of the transaction took place in late Dec. 2003 and the other side on Jan. 2, 2004: (i) sales of US$10.8 mln. to a commercial bank; (ii) repurchase of 40 bln. manat REPOs; and (iii) repurchase of 60 bln. manat treasury bills.

Table 4.

Azerbaijan: Consolidated Government Operations, 2003-05

(In billions of manats)

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Sources: Azeri authorities; and staff estimates and projections.

Includes profit oil, acreage fees, and income earned on Oil Fund assets. Oil bonuses also enter in the Oil Fund, but these are treated as a financing item.

The budget column reflects the draft 2005 budget submited to the Cabinet of Ministers (based on a US$25 per barrel oil price); the projection column reflects the staff estimates of the submited budget on the basis of (i) latest WEO oil price projections (US$42.75 per barrel), and (ii) staffs revenue estimates of the proposed policies in this budget.

Table 5.

Azerbaijan: Selected Fiscal Indicators, 2001-05

(In percent of non-oil GDP, unless otherwise indicated)

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Sources: Azeri authorities and Fund staff estimates and projections.

Starting from 2002 includes SOCAR tax credits for energy subsidies.

Investment expenditure increases by 1.2 percent of non-oil GDP (0.8 percent of GDP) in 2002 and by 2.4 percent of non-oil GDP (1.7 percent of GDP) in 2003 due to an equity investment by the government in BTC Azerbaijan.

Calculated by deducting Oil Fund, AIOC and SOCAR revenue from the consolidated government budget balance.

In 2005, part of the increase in the non-oil deficit (0.8 percent of non-oil GDP) is due to the increase in domestic petroleum products. This is because our program definition for oil revenue include both domestic and export revenue. Taxation of domestic petroleum products is, however, a sustainable source of revenue.

The budget column reflects the draft 2005 budget submited to the Cabinet of Ministers (based on a US$25 per barrel oil price); the projection column reflects the staff estimates of the submited budget on the basis of (i) latest WEO oil price projections (US$42.75 per barrel), and (ii) staffs revenue estimates of the proposed policies in this budget.