Republic of Azerbaijan
2007 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Azerbaijan
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This 2007 Article IV Consultation highlights that Azerbaijan’s real GDP growth accelerated to 31 percent in 2006, driven by rapidly increasing oil production and transportation. Non-oil real GDP, excluding oil and gas transportation, grew by about 8 percent, as nontradable sectors benefited from ramped up government spending and rapidly growing banking credit. Inflation rose into the double digits by August 2006. Progress in other structural reforms has been mixed. The short-term growth and external outlooks remain exceptionally favorable, but keeping inflation from increasing further represents a major challenge.

Abstract

This 2007 Article IV Consultation highlights that Azerbaijan’s real GDP growth accelerated to 31 percent in 2006, driven by rapidly increasing oil production and transportation. Non-oil real GDP, excluding oil and gas transportation, grew by about 8 percent, as nontradable sectors benefited from ramped up government spending and rapidly growing banking credit. Inflation rose into the double digits by August 2006. Progress in other structural reforms has been mixed. The short-term growth and external outlooks remain exceptionally favorable, but keeping inflation from increasing further represents a major challenge.

I. Introduction

1. Azerbaijan is at the beginning of a large but temporary oil production boom that will peak in 2009–10 if no new oil deposits are discovered. The key challenge facing the country is to use the financial opportunity presented by the oil boom to ensure sustainable non-oil output growth and poverty reduction, in particular after the oil boom has peaked, in an environment of macroeconomic stability. Against the background of exceptionally rapid expenditure increases and rising inflation, the consultation discussions focused on the following issues:

  • What is the appropriate pace of spending out of oil revenue?

  • How to reduce inflation to single digits?

  • What are the key productivity-enhancing structural reforms?

2. In recent consultations, the Fund’s advice has focused on the need to adopt a sustainable medium-term fiscal strategy, increase exchange rate flexibility, and implement macro critical structural measures. After a long period of closely following the Fund’s fiscal policy advice, the authorities did not moderate the pace of fiscal expansion in 2006, as recommended by the Fund, because they felt that infrastructure and other development needs should be addressed urgently despite rising inflation. Regarding exchange rate policy, in line with the Fund’s advice, the authorities exited the fixed peg in early 2006, but they did not allow the exchange rate to appreciate sufficiently to contain inflation due to concerns regarding financial system stability and competitiveness. The Fund’s structural policy advice has been only partially implemented in recent years.

II. Recent Developments

3. The oil production boom resulted in remarkably high growth and a strengthening of the external position in 2006. Real GDP grew by 31 percent, and the current account surplus reached 16 percent of GDP, improving Azerbaijan’s public sector net external asset position (Tables 12). Non-oil real GDP, excluding oil and gas transportation, grew by about 8 percent, as nontradable sectors benefited from buoyant budgetary expenditure and banking credit (Figure 1). According to official data, rapid growth contributed to a significant poverty reduction during 2003–06 (Text Table 1 and Table 3).

Table 1.

Azerbaijan: Selected Economic and Financial Indicators, 2003–07

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

For 2007, the scenario assumes the continuation of current policies in Tables 1-2, Tables 4-7, and Tables 9-10.

Oil and gas transportation includes all pipelines except the western route. The Baku-Tbilisi-Ceyhan (BTC) pipeline started operation in May 2006.

Excludes administered prices for fuel, energy, transportation, water, and communications as well as prices for selected fruits and vegetables.

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

The historical data include the statistical discrepancy.

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

Table 2.

Azerbaijan: Balance of Payments, 2003–07

(In millions of U.S. dollars, unless otherwise specified)

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

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

Figure 1.
Figure 1.

Azerbaijan: Recent Developments, 2003-07

Citation: IMF Staff Country Reports 2007, 191; 10.5089/9781451802702.002.A001

Sources: Azerbaijan authorities; and Fund staff estimates.1/ The tradable non-oil sector includes agriculture, non-oil extraction, and non-oil industry.
Text Table 1.

Azerbaijan: Selected Economic Indicators, 2003-07

(Annual percentage change, unless otherwise specified)

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Sources: Azerbaijan authorities; World Bank; and Fund staff estimates and projections.

This scenario assumes the continuation of current policies.

Oil and gas transportation includes all pipelines except the western route. The Baku-Tbilisi-Ceyhan pipeline started operation in May 2006.

Excludes administered prices for fuel, energy, transportation, water, and communications as well as prices for selected fruits and vegetables.

Based on Household Budget Survey and World Bank staff estimates.

Table 3.

Azerbaijan: Millennium Development Goals, 1990-2004 1/

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Source: World Development Indicators database, September 2006.

Figures in italics refer to periods other than those specified.

4. The officially reported 12-month CPI rate rose to double digits by August 2006 and reached 16.4 percent in March 2007 1 (Figure 1). This rise in the inflation rate was fueled by a significant relaxation of macroeconomic policies and substantial wage increases against the background of capacity constraints, as well as by the one-off effect of a large adjustment to utilities and energy prices (4 percentage points).

5. Continued real effective exchange rate (REER) appreciation and rising labor costs have intensified competitiveness pressures. There are initial signs of Dutch disease, as the tradable non-oil sector only grew by 4.0 percent in 2006 compared with 10.4 percent in 2005. While non-oil exports grew by more than 30 percent per year in U.S. dollar terms in both 2005 and 2006, this rapid growth is in part explained by rising international agricultural and metal prices, as well as significant subsidies on energy inputs from which non-oil exporters benefited. Despite their recent rapid growth, non-oil exports still represented only about 10 percent of non-oil GDP in 2006 (Figure 2).

Figure 2.
Figure 2.

Azerbaijan and Selected CIS Countries: Competitiveness Indicators, 1995-2006

Citation: IMF Staff Country Reports 2007, 191; 10.5089/9781451802702.002.A001

Sources: Azerbaijan authorities; and Fund staff estimates.

6. Following a decade of cautious fiscal policy, there was an exceptionally large fiscal relaxation in 2006. A 118 percent increase in oil revenue made it possible to ratchet up the non-oil primary deficit to 33 percent of non-oil GDP in 2006 compared with only 13 percent in 2005 (Tables 45). Non-oil revenue increased by 4 percent of non-oil GDP in 2006 compared with 2005 owing to booming consumption and incomes. Capital expenditure more than tripled, and wages, pensions, and other current expenditure increased by about 50 percent.

Table 4.

Azerbaijan: Consolidated Central Government Operations, 2003–07

(In millions of manats)

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

Starting in 2004 includes contingent revenues accrued on the “deposit account” of budgetary organizations.

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.

Tax credits for SOCAR energy subsidies for 2006 have been calculated pending final approval.

Includes changes of Oil Fund deposits abroad.

Includes SOCAR tax credits for energy subsidies.

Includes grants, VAT and excise taxes on oil and gas, and tax withholding on the Azerbaijan International Operating Company’s subcontractors.

Table 5.

Azerbaijan: Consolidated Central Government Operations, 2003–07

(In percent of non-oil GDP)

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

Starting in 2004 includes contingent revenues accrued on the “deposit account” of budgetary organizations.

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.

Tax credits for SOCAR energy subsidies for 2006 have been calculated pending final approval.

Includes changes of Oil Fund deposits abroad.

Includes SOCAR tax credits for energy subsidies.

Includes grants, VAT and excise taxes on oil and gas, and tax withholding on the Azerbaijan International Operating Company’s subcontractors.

7. There has been mixed progress in fiscal structural reforms. The authorities put in place a new system of targeted social assistance in mid-2006, and increased energy and utilities prices as of January 8, 2007, which will contribute to a reduction in implicit energy subsidies from 21 percent of non-oil GDP in 2006 to an estimated 11 percent in 2007. However, some key state-owned enterprises (SOEs) operated without approved budgets in 2006, and there has been limited progress in improving budgetary expenditure management or strengthening the auditing capacity of the chamber of accounts (the government’s supreme audit institution), raising concerns about the quality of the rapidly increasing expenditure.

8. At the time of the massive fiscal expansion, the ANB pursued an accommodating monetary policy in the context of the de facto crawling peg to the U.S. dollar initiated in early 2006. With very limited instrument independence, the ANB undertook large unsterilized purchases of foreign exchange mainly from the government, in order to limit the annual exchange rate appreciation to the targeted 5 percent (Figure 3). Key policy interest rates have remained negative in real terms since mid-2006. These policies led to a 133 percent increase in manat base money in 2006. This rapid base money increase reflected, in part, a reversal of the negative shock to money demand that occurred in late 2005 and some dedollarization, but it also fueled inflation in 2006 and created large inflationary pressures spilling over into 2007. Broad money and credit increased by 86 and 64 percent, respectively, in 2006 (Tables 67).

Figure 3.
Figure 3.

Azerbaijan: Monetary Indicators, 2003-07

Citation: IMF Staff Country Reports 2007, 191; 10.5089/9781451802702.002.A001

Sources: Azerbaijan authorities; and Fund staff estimates.
Table 6.

Azerbaijan: Summary Accounts of the National Bank, 2003–07

(In millions of manats)

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Sources: Azerbaijan National Bank; and Fund staff estimates and projections.
Table 7.

Azerbaijan: Monetary Survey, 2003–07

(In millions of manats, unless otherwise specified)

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Sources: Azerbaijan National Bank; and Fund staff estimates and projections.

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

9. Despite recent progress, the financial system remains small and highly concentrated. The banking system’s assets, the main pillar of the Azerbaijan financial system, represented only 21 percent of GDP in 2006, significantly below the ratios for Russia (53 percent) and Kazakhstan (91 percent). The two state-owned banks controlled more than 50 percent of the banking system’s assets in 2006.

10. While the authorities continue to improve prudential regulations, significant vulnerabilities in the banking system remain. In response to rising credit and foreign exchange risks, the ANB has tightened the prudential rules pertaining to loan collateral and open positions in foreign currencies, as well as increased the minimum capital requirement. However, as of January 1, 2007, many banks, including the two state-owned banks, failed to comply with one or more prudential regulations (Text Table 2). The two state-owned banks registered an increase in nonperforming loan ratios during 2006, reportedly due to previous under-reporting (Table 8).

Text Table 2:

Azerbaijan: Problem Banks, January 1, 2007 1/

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Source: Azerbaijan National Bank.

There were 43 banks in Azerbaijan at the beginning of 2007.

Number of state-owned banks in parenthesis.

Table 8.

Azerbaijan: Financial Soundness Indicators, 2003–06

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Source: Azerbaijan National Bank.