Republic of Azerbaijan
2008 Article IV Consultation: Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Republic of Azerbaijan
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This Article IV Consultation reports on policies of the Republic of Azerbaijan. These policies contain inflation and measures to strengthen the resilience of the banking system to promote the development of the financial sector. Non-oil GDP continued to expand rapidly, pushed by large increases in public expenditure, including wages and pensions. The authorities intend to continue with their expansionary fiscal plans in 2008, in line with their strategy to pursue fast improvements in living standards and infrastructure to set the basis for long-term non-oil growth.

Abstract

This Article IV Consultation reports on policies of the Republic of Azerbaijan. These policies contain inflation and measures to strengthen the resilience of the banking system to promote the development of the financial sector. Non-oil GDP continued to expand rapidly, pushed by large increases in public expenditure, including wages and pensions. The authorities intend to continue with their expansionary fiscal plans in 2008, in line with their strategy to pursue fast improvements in living standards and infrastructure to set the basis for long-term non-oil growth.

I. Introduction

1. Major expansions in oil and gas production and large increases in public expenditure resulted in spectacular growth in Azerbaijan during 2005–07. Annual real growth has been above 20 percent since 2005, resulting in higher living standards, lower unemployment, and rapidly declining poverty. While the oil boom has created unprecedented opportunities for economic and social development, its temporary nature and the expansionary policies being pursued pose significant macroeconomic challenges going forward.

2. The short and medium-term challenges have not changed much from those identified in the 2007 Article IV consultation, but they have intensified. Booming oil revenues will continue to provide abundant financing for large increases in government spending in the pursuit of a fast-track development strategy. Real appreciation pressures from the recent terms-of-trade gains, amplified by the large fiscal expansion, will continue to occur mostly through high inflation, particularly if monetary and exchange rate policy remains subdued. Growing government spending is likely to deepen problems with expenditure quality and efficiency, in the absence of more effective public expenditure management. Unless structural reforms are deepened, governance problems and an uncompetitive business environment are likely to hinder a stronger supply response. Finally, rapid credit expansion and limited risk assessment capacity by banks pose new challenges for regulation and supervision, while an underdeveloped financial system limits long-term funding and saving options.

3. The discussions focused on:

  • The appropriate macroeconomic policy mix to reduce inflation through a more restrained fiscal policy and a more determined use of exchange rate policy;

  • The need to improve the quality and efficiency of public expenditures, particularly for public investment; and,

  • Measures to strengthen the resilience of the banking system to shocks and to promote the development of the financial sector.

II. Recent Developments

Azerbaijan: Selected Economic Indicators, 2003–07

(Annual percentage change, unless otherwise specified)

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

Includes oil and gas transportation.

World Bank estimates for 2003-05, State Statistical Committee for 2006-07

4. The dominance of oil has increased, driving Azerbaijans’s strong economic growth performance (Table 1).1 In 2007, oil GDP grew by 37 percent and accounted for 59 percent of total GDP. Non-oil growth remained strong at about 12 percent, driven mostly by strong non-tradable sectors activity, particularly construction, commerce, and communications. The spectacular growth coupled with very high oil prices pushed per capita GDP to an estimated $3,663, and the official rates of poverty and unemployment declined significantly.

Table 1.

Azerbaijan: Selected Economic and Financial Indicators, 2004–08

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

Includes oil and gas transportation.

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 governments’s foreign exchange deposits managed by the Oil Fund.

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Real GDP: Annual Growth Rate

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

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Real GDP: Annual Growth Rate

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

1/ The tradable non-oil sector includes agriculture, non-oil extraction, and non-oil industry.

5. Booming oil exports strengthened the balance of payments further (Table 2). The current account surplus rose to 29 percent of GDP in 2007. However, non-oil exports—mostly agro-industry and metal products—remained relatively small at about 10 percent of non-oil GDP, as exporters faced rising labor costs and an appreciating real exchange rate. Despite very large investment repatriation from foreign oil companies, the governments’s oil fund assets together with the international reserves at the Azerbaijan National Bank (ANB) reached about $7.3 billion—triple the amount of external public sector debt in 2007.

Table 2.

Azerbaijan: Balance of Payments, 2004–08

(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 governments’s foreign exchange deposits managed by the Oil Fund.

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External Sector Developments

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

6. Inflation accelerated, reflecting fiscal-induced demand pressures, rising international food and commodity prices, increases in administered energy prices, and an accommodative monetary policy. Twelve-month inflation reached 19.5 percent in December, and remained high at 18.2 percent in March 2008, despite the fact that the January 2007 large energy price increase had already been absorbed in the base. The real effective exchange rate appreciation continued, because of widening inflation differentials with Azerbaijans’s trading partners.

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Inflation

(12-month percentage change)

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

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Real and Nominal Exchange Rate Developments

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

7. The consolidated fiscal balance returned to surplus in 2007, but the non-oil primary deficit to non-oil GDP ratio increased (Tables 3 and 4). Oil revenue grew by about 60 percent, and rising incomes and consumption—together with improved tax administration—boosted non-oil revenue (Box 1). Budgetary expenditure rose to 66 percent of non-oil GDP. Wages and transfers together increased by 46 percent. Following a two-fold jump in 2006, investment spending rose by 63 percent, and progress to strengthen expenditure planning, execution, and monitoring, particularly of large projects, was limited. Tax credits to the state oil and energy companies were reduced, reflecting increased energy prices and better collection rates. Yet, the government was unable to make a comprehensive assessment of the quasi-fiscal activities of the large state-owned enterprises (SOEs), since their economic and financial operations in 2007 were not adequately monitored. Staff estimates the implicit energy subsidies at about 15 percent of non-oil GDP, because of an increasing gap between domestic energy prices and world prices since the January 2007 adjustment.

Table 3.

Azerbaijan: Consolidated Central Government Operations, 2004–08

(In millions of manats)

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Sources: Azerbaijan authorities; and Fund 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. Oil bonuses also enter in the Oil Fund, but these are treated as a financing item.

Includes changes in Oil Fund assets.

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 Companys’s subcontractors.

Fund staff estimates.

Table 4.

Azerbaijan: Consolidated Central Government Operations, 2004–08

(In percent of non-oil GDP)

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Sources: Azerbaijan authorities; and Fund 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. Oil bonuses also enter in the Oil Fund, but these are treated as a financing item.

Includes changes in Oil Fund assets.

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 Companys’s subcontractors.

Fund staff estimates.

Non-Oil Revenues: Recent Developments and Policy Issues

The rapid increase in non-oil revenues from 22 percent of non-oil GDP in 2003 to 33 1/4 percent in 2007 reflects booming consumption and growing incomes and corporate profits, which constitute the base of the VAT and income taxes, respectively. In addition, significant improvements in tax administration, particularly during 2006-07, have also generated very positive results.

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Azerbaijan: Non-oil Revenues to Non-oil GDP

(In Percent, 2003–07)

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

Source: Azerbaijan authorities.
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Azerbaijan: Composition of Non-oil Taxes

(In Percent of Total, 2003–07)

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

Source: Azerbaijan authorities.

The following measures are at the core of the recent improvements:

  • A major cleanup of the VAT registration system cut almost by a half the number of registered taxpayers over 2005-07, and reduced fraud by eliminating unjustified refunds;

  • Improved taxpayers’ services strengthened voluntary compliance; and

  • The introduction of an automated system covering all non-oil taxes eased significantly tax processing.

Nevertheless, non-oil tax revenues remain below potential. This is explained by a costly system of exemptions regarding the VAT; customs administration problems that continue to undermine the revenues from non-oil customs duties; and a large, but difficult-to-quantify informal economy that mostly escapes the tax system.

Azerbaijan: Estimates of VAT Revenue Losses, 2006–07 1/

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Source: Azerbaijan authorities data; and Fund staff estimates.

Fund staff estimates based on the authoritiess’ data.

The estimated exemption rate of 29.4 percent was provided by the Ministry of Taxes.

In the short term, the authorities expect to broaden the non-oil tax base by: (i) implementing a modern system of risk-management for audits; (ii) strengthening voluntary compliance and establishing basic conditions for effective self-assessment; and (iii) reducing non-oil VAT exemptions. Progress on customs administration is expected once new regulations consistent with WTO rules are approved and implemented.

Azerbaijan: Estimates of Customs Duties Losses, 2006–07 1/

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Source: Azerbaijan authorities; data and Fund staff estimates.

Fund staff estimates based on the authoritiess’ data.

The exemption rate (18.2 percent) and the average statutory rate (5.7 percent) were provided by the customs officials.

The authorities are also considering a comprehensive review of non-oil tax policy to support the development of medium-sized companies and the diversification of the economy. In particular, they are interested in a simpler tax system with flat and lower personal and corporate income taxes, and a lower VAT rate, once the non-oil tax base has been further expanded.

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Overall Fiscal Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

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Public Expenditure and Non-Oil Primary Deficit

(Percent of non-oil GDP)

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

8. Policy coordination problems and limited operational independence at the ANB constrained the monetary policy response to the fiscal-induced overheating. In the context of a de facto slowly appreciating crawling peg to the dollar, the pace of manat appreciation was lower than originally envisaged by the authorities. The ANB established a new interest rate corridor to provide a better signaling mechanism, but policy interest rates remained negative in real terms. The ANB bought from the government about US $2billion in 2007—of which one third in December—and sterilized only a fraction of the currency issued in exchange, leading to about 100 percent increase in manat base money. There is little evidence that the July 2007 removal of restrictions on capital outflows to OECD countries had the intended effect of mitigating the monetary expansion. Abundant liquidity and increasing foreign borrowing by banks, boosted an accelerating credit expansion (Tables 5 and 6).

Table 5.

Azerbaijan: Summary Accounts of the National Bank, 2004–08

(In millions of manats)

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Sources: Azerbaijan National Bank; and Fund staff estimates and projections.
Table 6.

Azerbaijan: Monetary Survey, 2004–08

(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.

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ANB Monthly Net Purchases

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

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Policy Interest Rates

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

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Monetary Development

(Percentage change)

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

9. In March 2008, the ANB announced the introduction of a new exchange rate arrangement aimed at stabilizing the manat nominal effective exchange rate. The manat is now pegged to a dollar/euro currency basket, in which the weight of the euro will gradually increase. The basket peg and the envisaged weight adjustments are aimed at mitigating imported inflation.

10. Banks’ prudential indicators improved and supervision strengthened in 2007, but credit risks intensified and some structural weaknesses of the banking system persisted (Table 7 and Box 2). Deposits and assets concentration at the largest bank-state-owned International Bank of Azerbaijan (IBA)—declined, but is still high. The new deposit insurance scheme covers 37 out of 46 banks and is strengthening depositorss’ confidence. At end-2007, all banks met the 12 percent regulatory risk-weighted capital adequacy requirement. However, credit to the economy almost doubled in 2007, creating new risks.

Table 7.

Azerbaijan: Banking System Soundness Indicators, 2004–07

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Source: Azerbaijan National Bank.

11. The financial system is underdeveloped, providing few long-term instruments for savers and investors. The limited stock exchange activity is concentrated in treasury bills and ANB notes. Government bonds are issued with a maximum one-year maturity. In the absence of a yield curve, the corporate bond market is very thin, limiting funding choices for companies. With no domestic mutual or private pension funds and minimal life insurance, the government and corporate bonds market is illiquid. For individuals, there are virtually no domestic savings products beyond bank accounts—currently providing negative real returns—and real estate.

12. Structural reforms to promote a competitive non-oil sector remain slow, but WTO accession plans are driving new efforts. The one-stop facility for business registration is now operational, facilitating the establishment of new companies. Licensing requirements, though, remain heavy and unregulated, and governance issues—particularly in customs—are quoted by business as major impediments. Parliamentary approval of important bills to strengthen governance and the business environment (e.g. anti-monopoly, investment, and AML/CFT laws) has been pending for more than a year. Nonetheless, ongoing work to upgrade legislation in line with WTO rules in areas such as customs and technical standards and specifications is expected to improve the business environment.

Banking Sector Developments

Azerbaijans’s banking sector has registered stunning growth in recent years. The degree of monetization, measured as the ratio of broad money to non-oil GDP, has doubled in the past two years. Banking sector credit to the economy has expanded by more than 50 percent per year since 2004; it grew by 96 percent in 2007. Private banks have grown faster than state-owned banks, and accounted for 58 percent of total assets at end-2007, from 45 percent two years ago.

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Azerbaijan: Distribution of Banking System Assets

(2003-2007)

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

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Eevolution of the Ratio of Non-performing Loans to Total Loans, 2003-07

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

The officially reported soundness indicators and compliance with prudential regulations generally improved in 2007. All banks met the capital adequacy requirement at end-2007, including the two state-owned banks.1 Nonperforming loan (NPL) ratios declined significantly, largely reflecting a doubling of credit outstanding during the year. There was no bank violating the limit on net open foreign exchange position at end-2007. In addition, the authoritiess’ stress test shows that the banking system is resilient to interest rate and exchange rate shocks of moderate magnitude.

However, the current credit boom poses risks to the banking sector. Rapid credit expansion coupled with limited risk management capacity may lead to a lagged deterioration in the quality of banks’ portfolios. The risks could intensify in a couple of years when the economic activity is projected to slow down. Discussions with the ANB and commercial banks also revealed that the banking sector is highly exposed to the property sector through lending to the construction sector and using property as collateral for other loans. Furthermore, a few banks may face liquidity risks as they funded new credit in 2007 partially through external borrowing that needs to be refinanced in 2008, although the scale of foreign borrowing was constrained by the tightening global liquidity conditions in the latter part of the year.

The ANB has moved to take prudential and other measures to address increasing risks. Measures in the pipeline include: (i) introducing reserve requirements on foreign borrowing; (ii) tightening asset classification standards and raising provisioning requirements for NPLs; (iii) restricting the use of subordinate debt in meeting the capital adequacy requirements; iv) increasing the risk weight for mortgage loans and toughening the criteria for collateralized loans. Moreover, the ANB reviewed banks’ risk management systems, carried out more targeted inspections, and pushed banks to reduce credit growth targets.

1IBA increased its capital base partly by issuing subordinated debt in international capital market. Kapital Bank doubled its capital by selling 50 percent of its share to three private companies; it plans to sell the remaining state shares by mid-2008.
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Transition Indicators, 2007 1/

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

Source: EBRD Transition Indicators database.1/ The transition indicators range from 1 to 4+, with 1 representing little or no change from a rigid, centrally planned economy, and 4+ representing the standards of an industrialized market economy.
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Doing Business Report Rankings 1/

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

Source: World Bank Doing Business 2008 report, covering the period April 2006 to June 2007.1/ Economies are ranked on their ease of doing business, from 1–178, with first place being the best. A high ranking on the ease of doing business index means the regulatory environment is conducive to the operation of business.

III. Outlook

13. Azerbaijans’s short- and medium-term economic prospects remain strongly dependent on oil sector developments, and on how the authorities manage the related opportunities and challenges. The main risk to the outlook is a major downward correction in oil prices, although unlikely in the short term. However, if loose macroeconomic policies continue, high-inflation expectations would become entrenched, damaging the prospects for robust long-term non-oil growth, and eroding achievements in poverty reduction. The governments’s projects to address infrastructure needs, particularly in energy and transportation, if efficiently executed, would help strengthen the basis for the development of a competitive non-oil sector.

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Azerbaijan: Total Oil Production, 2005-24

(In millions of barrels)

Citation: IMF Staff Country Reports 2008, 214; 10.5089/9781451802719.002.A001

A. Short-Term

14. The growth and external outlook for 2008 remains strong, with overall growth projected atI8½ percent. Non-oil growth—driven by large public expenditure—would moderate to a still high 9 percent. The current account surplus would rise to 40 percent of GDP, reflecting higher oil export volumes and prices. Oil fund assets and international reserves are projected to more than triple from end-2007, to reach $25 billion at end 2008—about 50 percent of projected GDP.

15. Large public spending plans are expected to keep aggregate demand and inflation high in 2008.2 Massive increases in oil revenue underpin a projected overall fiscal surplus of 29 percent of GDP, matched by a major accumulation of oil fund assets. Despite buoyant non-oil revenue, the non-oil primary deficit would worsen by 7 percentage points of non-oil GDP to reach 39 percent, reflecting pension and wage increases of about 40 percent and a 55 percent rise in investment. Heightened aggregate demand would keep inflation close to 20 percent.

16. The implementation of the currency basket arrangement should help limit the impact of imported inflation, by containing the inflationary effect of import price increases triggered by the depreciation of the dollar against other major currencies. Preparing the ground for more flexibility in the future, the new arrangement will also help address the current undervaluation of the manat (Box 3).

Exchange Rate Assessment for Azerbaijan

The macroeconomic balance (MB) approach indicates that Azerbaijans’s real exchange rate is moderately undervalued. The MB approach estimates how much the real effective exchange rate (REER) would have to adjust from the prevailing level to move the current account into positions consistent with medium-term equilibrium—the current account norm. Based on the CGER panel regression coefficients, Azerbaijans’s underlying current account surplus is above the norm by about 7 percent of GDP in 2013.1 This suggests a current REER undervaluation of about 16 percent.

Azerbaijan: Macroeconomic Balance Approach to Exchange Rate Assessment

(In percent of GDP, unless indicated otherwise)

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Sources: Fund staff estimates and projections.

Ratio of population above 65 to prime-age population between 24 and 64.

Ratio of per-capita PPP income to the U.S. level.

According to the baseline projections, which assume real appreciation in the medium term.

The baseline projection is adjusted upward by excluding the assumed real appreciation.

For a country like Azerbaijan, which is undergoing a temporary oil production boom, the standard MB approach does not provide a very robust valuation of the currency. Given Azerbaijans’s oil production profile, the country is bound to register sizable underlying current account surpluses during the peak production years. However, looking beyond the peak production years, Azerbaijans’s underlying current account balance will decline sharply, as exemplified by a fall in the current account surplus from 12 percent of GDP in 2012 to below 1 percent in 2013. A one-year extension in the timeframe of the analysis to 2014 would entail a further decline of the underlying current account, taking it closer to the norm and substantially reducing the measured degree of exchange rate undervaluation. Moreover, a significant portion of the current account surplus is to be accumulated in the state oil fund, reflecting the need to save the oil wealth to achieve intergenerational equity. Thus any normative analysis must allow for this temporary buildup in reserves. Allowing for Azerbaijans’s particular situation, the assessed magnitude of exchange rate undervaluation does not represent an exchange rate misalignment.

Alternative approaches to exchange rate assessment. Data deficiency precludes the application of the equilibrium real exchange rate approach, and the external sustainability approach suffers the same bias as the MB approach. The purchasing power parity approach, which relies solely on the relationship between relative prices and incomes per capita, indicates that Azerbaijans’s REER was undervalued by about 15 percent in 2007.

1Based on the baseline medium-term projections. Following the CGER exercise, the 2013 values of the fundamental variables for Azerbaijan and its trading partners are used to compute the norm. See Methodology for CGER Exchange Rate Assessments, IMF, November 2006.

B. Medium- and Long-Term

17. The staff discussed with the authorities a “baseline” scenario that assumes continued large expenditure increase (Table 8).3 The annual rate of expansion of public spending is projected to slow down over the medium term compared with recent years but will remain at about 30 percent, to support rapid increases in living standards and improved infrastructure. Pressures for continued real wage and pension increases would entrench a wage-price spiral and keep inflation high. High spending would initially support non-oil growth. But persistent inflation and rising labor costs would discourage private sector investment, causing non-oil growth to decelerate to below 5 percent by 2013. Although high oil price projections push forward the fiscal sustainability constraint, and both public and external debt-to-GDP ratios are projected to decline over the medium term (Tables 9 and 10), the rising non-oil deficit would start denting oil fund assets in 2012–2013. Eventually, in the absence of significant fiscal correction before the mid of the decade, an unsustainable debt dynamics would kick in.

Table 8.

Azerbaijan: Selected Economic and Financial Indicators, 2006–13

(Baseline scenario)

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

Includes oil and gas transportation.

The historical data include the statistical discrepancy.

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