Our Azerbaijan authorities continue to value the strong cooperation with the Fund and appreciate the staff’s support and policy advice. The comprehensive set of papers covering the Article IV Consultations, the fourth PRGF review, as well as the assessment of the financial system provide an in-depth analysis of the current macroeconomic and financial situation. Our authorities are very satisfied with the continued positive developments of the main macroeconomic indicators. Strong growth in both the oil and non-oil sectors, moderate inflation, growing international reserves, as well as a disciplined fiscal policy stance underscore Azerbaijan’s success in sustaining sound macroeconomic performance. All quantitative performance criteria for end-2003, and end-March, end-June, and end-September 2004 were met.

The authorities are fully aware of the important challenges that remain in the area of structural reforms to ensure that this performance can be maintained over the medium and long term and that it translates into a significant reduction of the existing poverty levels. Our authorities recognize that the implementation of structural measures has been slower than envisaged under the program. However, it was important to garner sufficiently broad support for these difficult measures. Our authorities are confident that the adoption of the long-term oil revenue management strategy, the adoption of the National Bank Law, and the implementation of the State Program for the Regional Development, which has already resulted in the creation of more than 80,000 new jobs during the last year, are crucial steps in moving forward the structural reform agenda.

Fiscal Policy

Fiscal policy was tight and broadly in line with the program’s objectives. The main objectives of the authorities were to reduce the overall tax burden, broaden the tax base, and stimulate investment activity in the economy. Notwithstanding reductions of social security contribution rates and other measures aimed at further optimizing the tax levels, revenues of the state budget increased significantly. In line with the recently adopted strategy for the management of oil revenues, and despite high oil prices and large capital inflows, Azerbaijan has demonstrated a solid track record of sound fiscal policy by maintaining a sustainable level of the overall and non-oil deficits. Furthermore, in line with prudent budgetary management rules, excess inflows of revenues resulting from higher than budgeted oil prices are accumulated in the special stabilization account at the treasury. While the authorities had intended to establish the rules for the operation of this account in the Presidential Decree of the 2005 Budget, it was deemed to be more appropriate to include them in a Cabinet of Ministers regulation.

The important and politically difficult recent increase in energy prices will help further reduce subsidies in this area and improve effectiveness in the management of the public utilities. The authorities remain committed to gradually move energy prices to cost recovery levels.

The implementation of the State Program for Poverty Reduction and Economic Growth (SPPRED) and other policy decisions aimed at strengthening economic growth while maintaining macroeconomic stability, are reflected in the spending priorities. With minimum wage increases and other measures in 2004, the budget has become more oriented toward the poverty reduction objectives. Capital expenditure from the budget also continues to rise significantly in 2005.

Fiscal transparency in hydrocarbon activity is a long-term commitment of the Azerbaijani authorities. The State Oil Fund of Azerbaijan continues to accumulate and manage the oil and gas related revenues in a prudent manner. As summarized in Box 1, Azerbaijan is a strong supporter of the Extractive Industries Transparency Initiative (EITI). Working in close cooperation with the industry and civil society representatives, it is one of the first countries to agree to the EITI reporting mechanisms. Furthermore, by adopting the Accounting Law, reporting standards of the state owned enterprises (SOEs) will also be improved substantially and brought in conformity with international standards.

Monetary Policy

Several factors have increased inflationary pressures, such as strong foreign currency inflows and general economic growth, increased minimum wages and targeted support, higher oil and import prices. The authorities see their primary task in ensuring that these factors do not lead to a breach of single digit inflation levels, which have been successfully maintained for the last years. This is reflected in the 5 percent inflation rate targeted in the monetary program for 2005.

Our authorities are glad to note that Azerbaijan has accepted the obligations under Article VIII Sections 2, 3, and 4. They are also intensively working with the Fund and other partners in developing, institutionalizing and operationalizing the AML/CFT framework. Recommendations of the FSAP are being taken on board in the conduct of the monetary and financial sector policies.

Financial Sector Policy

The development of the whole spectrum of the financial services has continued together with the improvement of key performance indicators in the sector. The annual growth rate of banking credit to the economy has increased from 32 percent in 2003 to about 50 percent this year and underscores the strengthening of financial intermediation. The growth of the banking sector assets by 45 percent (US$1.5bn in 2004) and a decline of NPLs points to further improvement in the quality of lending. Although interest rates on deposits continued to decline, the rising level of banking deposits by 50 percent in the last 11 months demonstrates on the one hand an increasing confidence of the population in the banking sector, and on the other hand indicates the rising income levels. Structural changes in the banking sector will continue through further consolidation and greater foreign participation.

The new Banking System and Central Bank Laws prepared in coordination with the Fund has significantly strengthened the banking sector legislation. The authorities are confident that this will provide the basis to improve the quality of the financial sector in Azerbaijan, in particular given the strengthening of the supervisory framework.

Structural Policy

Strengthening the operational effectiveness and financial management at the large SOEs has continued. As noted in the LOI, quarterly reporting on the annually approved budgets of these organizations will further be ensured with the aim to eventually moving all public utilities towards the full cost recovery.

Creation of favorable conditions and supporting development of the non-oil sector represents one of the highest priorities of the authorities. The implementation of a comprehensive regional development program, focusing on the development of both business and physical infrastructure in the regions and rural area, as well as easing the tax burden and improving the business climate resulted in the opening of hundreds of new enterprises throughout the country.

The adoption of the Law on Civil Services, the implementation of Anti-Corruption legislation, the preparation of the Competition Law, and the continuing privatization are part of the efforts to improve governance and the rule of law. The adoption of the Accounting Law and introduction of the international reporting standards starting January 2005, as well as the rise in the salaries of the civil workers and strengthening of internal controls will also contribute to the improved governance.