Republic of Azerbaijan
2010 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Azerbaijan
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This paper presents the key findings of the Republic of Azerbaijan’s 2010 Article IV Consultation. In 2009, overall GDP grew at 9.3 percent, but non-oil GDP growth slowed from 16 percent to 3 percent, fiscal and export revenues fell by more than 30 percent, and credit and liquidity conditions tightened substantially. Owing to the authorities’ appropriate policy response, the exchange rate remained stable, inflation dropped dramatically, official poverty rates continued to fall, and financial stability was maintained.

Abstract

This paper presents the key findings of the Republic of Azerbaijan’s 2010 Article IV Consultation. In 2009, overall GDP grew at 9.3 percent, but non-oil GDP growth slowed from 16 percent to 3 percent, fiscal and export revenues fell by more than 30 percent, and credit and liquidity conditions tightened substantially. Owing to the authorities’ appropriate policy response, the exchange rate remained stable, inflation dropped dramatically, official poverty rates continued to fall, and financial stability was maintained.

I. BACKGROUND

  • Major expansions in oil and gas production and large increases in public expenditure generated spectacular growth rates, averaging 20 percent during 2003-08, combined with a rapid decline in official poverty rates, from 45 percent in 2003 to 11 percent in 2009.1 However, the oil boom also led to high inflation, unprecedented credit growth, and unsustainably high non-oil fiscal deficits.

  • While the oil boom has created extraordinary opportunities for economic and social development, it is highly temporary in nature. Oil production is expected to peak in 2014, and oil reserves are expected to be exhausted in 20–25 years unless new discoveries are made.

  • The de jure exchange rate regime has been a peg to a euro-dollar basket since March 2008, but the de facto regime has been stabilized against the U.S. dollar since June 2008 (see Informational Annex I).

  • The last Article IV consultation was concluded on May 23, 2008. The staff report was published and can be found at http://www.imf.org/external/pubs/cat/longres.cfm?sk=22135.0. The next Article IV consultation is expected to take place on the standard 12-month consultation cycle.

Figure 1.
Figure 1.

Azerbaijan: Overview

Citation: IMF Staff Country Reports 2010, 113; 10.5089/9781455204205.002.A001

Sources: Azerbaijani authorities; and Fund staff estimates.1/ Includes oil production of the Azerbaijan International Operating Company (AIOC) only.2/ Excludes foreign financed projects.

II. IMPACT OF THE CRISIS

1. The Azerbaijani economy has thus far withstood the impact of the world economic and financial crisis relatively well.

  • The economy grew at an impressive 9.3 percent during 2009, driven by a pickup in oil production growth,2 as well as continued growth in services and agriculture.

  • Inflation fell dramatically, from more than 20 percent in 2008 to 1.5 percent in 2009, driven by falling international commodity prices, and lower domestic and external demand.

  • Despite mounting depreciation expectations in early 2009, the Central Bank of Azerbaijan (CBA) successfully intervened to keep the exchange rate pegged against the U.S. dollar, which helped to reduce inflation, prevented further dollarization, and avoided a negative impact on households’ and banks’ balance sheets. While the CBA’s gross international reserves fell by 16 percent as a result of its interventions, they remained comfortable at US$5.4 billion (4.8 months of imports of goods and services) at end-2009.

  • The official unemployment rate remained stable, and the official poverty rate declined further from 13 percent in 2008 to 11 percent in 2009, reflecting lower inflation and higher social spending.

2. Nevertheless, Azerbaijan has not been immune to the impact of the global crisis.

  • The large drop in oil prices caused fiscal oil revenues to fall by 35 percent during 2009. Non-oil revenues remained roughly at their 2008 level, but were 17 percent lower than budgeted.

  • The large drops in international commodity prices also caused total exports to fall by over 30 percent during 2009. Non-oil exports fell by about 22 percent, but there was no clear evidence of a loss in market share. Combined with falling remittances, the fall in exports reduced the current account surplus from 35 percent in 2008 to 24 percent of GDP in 2009.

  • A number of state-owned enterprises (SOEs) and banks faced difficulties rolling over short-term foreign liabilities, which triggered a liquidity shortage in the banking system, and contributed to a sharp decline in credit growth.

  • Non-oil GDP growth slowed down from 15.7 percent in 2008 to 3 percent in 2009, with falling output in construction and non-oil manufacturing sectors, further depressing demand for credit and further causing loan portfolios of banks to deteriorate.

  • IMF staff expects non-oil GDP growth to recover to 4.2 percent in 2010, but overall GDP growth to slow down to 2.7 percent. Given that existing oil fields have already reached their maximum production capacity, oil GDP is projected to grow by only 1.3 percent. Inflation is expected to increase to 4 percent, reflecting the recovery of the non-oil sector and the rise in international commodity prices. Growth and inflation will be lower if businesses remain pessimistic or external demand recovers only modestly.

Figure 2.
Figure 2.

Azerbaijan: Impact of the Crisis

Citation: IMF Staff Country Reports 2010, 113; 10.5089/9781455204205.002.A001

Sources: Azerbaijani authorities; and Fund staff estimates.

III. FISCAL POLICY: RETURNING TO A SUSTAINABLE PATH

3. In 2009, the government responded to the crisis with a number of fiscal policy measures that allowed the non-oil deficit to remain broadly unchanged.

  • Despite the large drop in oil prices, the budgeted transfer of resources from the State Oil Fund of Azerbaijan (SOFAZ) was fully implemented, which limited the overall revenue impact.

  • To support SOEs that faced difficulties with repaying foreign debt obligations resulting from the drop in commodity prices, the government provided a capital injection and a government-guaranteed loan to the state oil company (SOCAR), and another such loan to the state-owned aluminum company, in total amounting to US$1.4 billion (3.2 percent of GDP).

  • To support economic activity, profit and income tax rates were cut in 2009, effective 2010, and access to the simplified tax regime was increased by raising the VAT threshold.3

  • The government adjusted for the fall in revenues by cutting non-priority spending and by financing only ongoing capital investment projects in 2009 (Figure 3). As a result, the non-oil fiscal deficit remained broadly unchanged, while the government was still able to increase social spending by 1.8 percentage points of non-oil GDP, mostly for education and social protection.

Figure 3.
Figure 3.

Azerbaijan: Fiscal Indicators

Citation: IMF Staff Country Reports 2010, 113; 10.5089/9781455204205.002.A001

1/ Permanent oil income is calculated as the real return on public sector net assets (oil fund + NPV of oil revenue - public sector debt). The discount factor and real investment return are assumed to be 3.5 percent and 3 percent, respectively. The results are sensitive to these assumptions.2/ Oil price projections are based on the IMF’s World Economic Outlook, and are assumed to beSources: Azerbaijani authorities; and Fund staff estimates.

4. IMF staff welcomed the conservative 2010 budget and the authorities’ renewed commitment to fiscal sustainability, and made the following recommendations:

  • Even if oil prices turn out to be higher than budgeted, additional oil fund resources should not be used to increase government spending given (i) the available room to improve the quality and efficiency of spending, and (ii) the need to significantly reduce the non-oil deficit to secure medium-term fiscal sustainability.4 Estimates of a positive non-oil output gap, while subject to the usual caveats (e.g., WP/06/68), also support a contractionary fiscal stance in 2009 and 2010.

  • To gradually reduce expenditure, the government should (i) improve expenditure efficiency by increasing budget transparency and tightening procurement procedures, particularly for public investment; (ii) lower the current expenditure burden through pension and civil service reform, and better-targeted public services and social safety nets; and (iii) reduce the financial support to SOEs by improving their financial discipline and by better monitoring their quasi-fiscal activities.

  • To increase non-oil revenues, the government should further reduce exemptions, simplify the tax system, and strengthen risk management approaches, along with other measures (Section VI).

Given the caveats involved in output gap estimation, the authorities were not convinced that the output gap was still positive, but they agreed on the medium-term fiscal consolidation path, as well as on the expenditure and revenue reforms, which they stressed would take many years.

IV. EXCHANGE RATE POLICY: MAINTAINING STABILITY

5. Following the transition in March 2008 to a euro-dollar basket peg, the CBA first increased and then reduced the weight on the euro, implying a de facto peg against the dollar.

  • Mounting expectations of exchange rate depreciation in early 2009, fueled by the large depreciations in other countries in the region, caused large deposit outflows and an increase in dollarization, creating additional liquidity pressures for banks.5

  • Despite the strong depreciation pressures, the CBA successfully defended the de facto peg against the dollar by making foreign exchange sales of more than US$1 billion (16 percent of reserves) in February and March 2009. As a result, dollarization was reduced, deposits returned, and a negative impact on households’ and banks’ balance sheets was avoided.

6. IMF staff advised that exchange rate stability will remain appropriate in the short term, while more flexibility will become beneficial in the medium term:

  • Due to the dramatic drop in inflation, the real exchange rate remained close to equilibrium in 2009, or even became somewhat undervalued. Staff estimates based on the Purchasing Power Parity (PPP) approach, External Sustainability (ES) approach, and Equilibrium Real Exchange Rate (ERER) approach all suggest slight undervaluation in 2009, by 4, 6, and 10 percent, respectively (Figure 4).

  • In the short term, there are clear benefits from continuing to peg to the U.S. dollar, given that a significant share of trade is U.S.-dollar denominated, the volatility of capital flows is relatively low, there is a need to stabilize expectations given the recent history of high inflation and high dollarization, and no strong real appreciation or depreciation pressures are expected.

  • In the medium term, however, the benefits from more flexibility will increase as the economy becomes more diversified and more integrated with international capital markets. Based on the ES approach—which defines the sustainable non-oil current account deficit as a constant annuity on Azerbaijan’s net foreign assets, including the present value of oil and gas wealth—the non-oil current account deficit is expected to start exceeding the sustainable level after 2014. This underlines the importance of developing a strategy to promote non-oil exports (Section VI).

  • There are several conditions for moving to further exchange rate flexibility, some of which may only be fully met after more flexibility is, in fact, introduced. A first condition is to strengthen monetary policy, including through increased central bank independence, more flexible and responsive policymaking and policy coordination, and the development of a new credible nominal anchor to replace the peg. A second condition is to improve exchange rate risk management by market participants, including through tighter prudential regulation and supervision. Third, to avoid excessive volatility during the transition, a deep and liquid foreign exchange market needs to be developed, with a reduced market role for the public sector and a coherent intervention strategy.

Figure 4.
Figure 4.

Azerbaijian: Equilibrium Exchange Rate Estimates

Citation: IMF Staff Country Reports 2010, 113; 10.5089/9781455204205.002.A001

Sources: WEO, IFS, and IMF staff estimates.

The authorities fully agreed with the exchange rate assessment, and looked forward to further discussions on the timing, modalities, and conditions for increasing flexibility.

V. MONETARY AND FINANCIAL SECTOR POLICIES: ENSURING FINANCIAL STABILITY

7. During 2009, the CBA successfully maintained financial stability by keeping the exchange rate stable and providing liquidity support to the banking system.

  • To address the tightening of liquidity and credit conditions, the CBA reduced the reserve requirement on deposits from 12 to 0.5 percent, and cut the refinancing rate from 15 to 2 percent between September 2008 and December 2009 (Figure 5). In addition, the CBA allowed the Azerbaijan Mortgage Fund (AMF) to resume its lending activity from July 2009, financed through budget transfers and by the issuance of long-term AMF bonds.

  • Overall, the CBA provided about US$1.1 billion (2.6 percent of GDP) in liquidity support to banks, and another US$1.1 billion in government-guaranteed credit to the state-owned International Bank of Azerbaijan (IBA) for onlending to the state oil and aluminum companies, which required an amendment of the central bank law. In addition, banks and insurance companies were exempted from tax on profits used for recapitalization from 2009 onwards.

  • To further boost confidence in the banking system, the deposit insurance coverage was increased significantly in June 2009, including by raising the deposit limit from 6,000 to 30,000 manat (7.8 times GDP per capita).

Figure 5.
Figure 5.

Azerbaijan: Financial Sector Developments

Citation: IMF Staff Country Reports 2010, 113; 10.5089/9781455204205.002.A001

Sources: Azerbaijani authorities; and Fund staff estimates.

8. IMF staff advice focused on the need to remain vigilant, while working on an exit strategy:

  • While nonperforming loans remain low, they have been rising and are likely to be underestimated. The authorities should, therefore, continue to closely monitor the banking system and strengthen banking supervision by periodically assessing balance sheets, dealing with nonperforming loans on a timely basis, and improving risk management and corporate governance.

  • As financial sector health improves and credit growth resumes, liquidity support should be gradually withdrawn so as to limit fiscal risks and prevent a pickup in inflation. If additional support were to become necessary, this should originate directly from the government budget rather than from the CBA, so as to make transparent the implied quasi-fiscal costs and limit any conflict of interest with the CBA’s supervisory responsibilities.

  • Despite the significant reduction in the refinancing rate and the fall in inflation, average deposit and lending rates remain high, keeping credit and liquidity conditions tight. To bring down interest rates, the authorities should (i) make monetary policy transmission more effective, including by deepening the secondary market for government securities; (ii) facilitate the recovery of collateral by banks; and (iii) increase competition in the banking system, including by privatizing IBA within the next few years, as its market dominance (nearly 50 percent of total banking system assets) and extensive lending to SOEs distorts competition and crowds out private credit.

The authorities agreed on the exit strategy, but preferred not to finance any needed further support directly from the budget, as this would require a supplementary budget and could prevent a swift policy response. While the CBA was of the view that interest rates are largely market-determined, the authorities agreed on the proposed monetary and financial sector reforms, including on the need to privatize IBA in the next few years.

VI. AZERBAIJAN’S MAIN MEDIUM-TERM CHALLENGE: DEVELOPING THE NON-OIL ECONOMY

9. The unexpected fall in oil revenues and the sharp slowdown in the non-oil economy in 2009 have once again illustrated the crucial importance of accelerating reforms to diversify the economy and improve the medium-term outlook for Azerbaijan.

  • Starting from 2010, oil production will no longer be the main source of growth (with the exception of 2014, when the Chirag oil field becomes operational), while non-oil growth will likely no longer be boosted by oil-fueled demand for nontradables. Non-oil exports, which currently account for only 5 percent of total exports, will therefore need to take over as the driver of the economy in the medium term.

  • Azerbaijan’s Doing Business ranking improved significantly in 2009, from 97 to 33 out of 183 countries, driven by the establishment of a “one-stop shop,” a more flexible labor code, and improvements in contract enforcement. However, the country continued to score poorly in the areas of paying taxes, trading across borders, and dealing with licenses. Moreover, Transparency International’s 2009 Corruption Perception Index remained high at 143 out of 180 countries, while important anti-monopoly and investment legislation were recently withdrawn from Parliament.

10. IMF staff recommended that, rather than aiming to stimulate specific export sectors, the most effective way to develop non-oil exports is through further improving the business environment, including through tax, customs, and financial sector reforms:

  • Further progress with tax and customs reforms is crucial for improving the business environment. Regarding tax reforms, the recently introduced tax cuts and the sophisticated electronic tax filing system have already reduced some of the tax burden on businesses,6 but further progress with risk management approaches and reducing exemptions is needed to create a level playing field for all businesses. Regarding customs reforms, the authorities’ continued commitment to join the World Trade Organization (WTO) is welcome, as this requires further improvements in customs legislation and administration, regulations for customs valuation, and customs tariff policy.

  • Further progress with structural financial sector reforms is needed to (i) improve access to credit for the non-oil sector, including through increasing the availability of borrower information to creditors, and accelerating the ability of creditors to access collateral in the event of default; (ii) gradually eliminate directed credit and interest rate subsidies to SOEs; (iii) foster banking sector consolidation through prudential and other means to increase capitalization, efficiency, and confidence; (iv) increase competition in the banking sector by privatizing IBA and encouraging the entry of strategic investors; and (v) address the remaining deficiencies in the area of anti-money laundering and combating terrorist financing (AML/CFT).7

The authorities broadly agreed with the recommendations, and are committed to developing a non-oil export strategy that focuses on improving the business environment.

MEDIUM-TERM OUTLOOK FOR DEBT SUSTAINABILITY

External debt in percent of GDP has declined substantially since oil production took off in 2005, and is expected to remain low in the medium term.

  • Since 2005, the Azerbaijani government has been able to use its rapidly growing oil revenues to finance a large part of domestic investment projects, which reduced external debt from 40 percent of GDP in 2004 to 20 percent in 2009.

  • The government’s intention to issue US$500 million in Eurobonds in 2010 would set a useful benchmark for companies looking to raise funds in international capital markets, while keeping external debt broadly stable at about 20 percent of GDP in the medium term. Even if key variables return to their 2000-09 historical levels, external debt would remain below 30 percent.

Public and publicly guaranteed debt will remain low as well, but may increase moderately in the medium term.

  • The government-guaranteed loans extended to the state oil and aluminum companies in 2009 caused public-sector domestic debt to increase by about 2.7 percent of GDP.

  • The government’s plan to increase the issuance of both T-bills and longer-term government securities is a welcome measure to further develop securities markets. While public and publicly guaranteed debt would increase moderately over the medium term, it is expected to remain low at around 14 percent of GDP. However, public debt could go up to 50 percent if fiscal parameters were to return to their historical 2000–09 levels.

uA01fig02

External Debt-Sustainability Analysis

(In percent of GDP; baseline and historical scenarios)1

Citation: IMF Staff Country Reports 2010, 113; 10.5089/9781455204205.002.A001

uA01fig02a

Public Debt-Sustainability Analysis

(In percent of GDP; baseline and historical scenarios)1

Citation: IMF Staff Country Reports 2010, 113; 10.5089/9781455204205.002.A001

Sources: International Monetary Fund, country desk data, and staff estimates.1/ The historical scenario assumes that key variables (for the external DSA: real GDP growth, nominal interest rate, dollar GDP deflator growth, non-interest current account and non-debt inflows in percent of GDP; for the public DSA: primary fiscal deficit, real GDP growth, nominal and real interest rates, GDP deflator growth, and revenue to GDP ratio) are at their 2000-09 historical averages during 2010-15.
Table 1.

Azerbaijan: Selected Economic and Financial Indicators, 2005–10

article image
Sources: Azerbaijani authorities; and Fund staff estimates and projections

Includes the production and processing of oil and gas.

Includes the transportation of oil and gas (except transportation through the western route), as well as the export tax paid by the state oil company.

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

Historical data includes statistical discrepancy.

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

Table 2.

Azerbaijan: Balance of Payments, 2005–10

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

article image
Sources: Azerbaijani authorities; and Fund staff estimates and projections

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

Table 3.

Azerbaijan: Consolidated Central Government Operations, 2005-10

(In millions of manat)

article image
Sources: Azerbaijani authorities; and Fund staff estimates and projections. 5023.10841 18202.2169 13151.7882 11778.6487 8554.53187 18116.9124

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.

Defined as non-oil revenue minus total expenditure (excluding interest payments) and statistical discrepancies.

Exclues AIOC profit tax, profit oil, SOCAR profit tax, SOCAR export tax, SOCAR contingency payments, and tax credits for SOCAR subsidies grants, but includes VAT and excise taxes on oil and gas, tax withholding on the Azerbaijan International Oil Company’s subcontractors, and SOCAR tax credits for energy subsidies.

Staff projections using the WEO commodity price assumptions.

Table 4.

Azerbaijan: Consolidated Central Government Operations, 2005-10

(In percent of non-oil GDP)

article image
Sources: Azerbaijani 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.

Defined as non-oil revenue minus total expenditure (excluding interest payments) and statistical discrepancies.

Exclues AIOC profit tax, profit oil, SOCAR profit tax, SOCAR export tax, SOCAR contingency payments, and tax credits for SOCAR subsidies grants, but includes VAT and excise taxes on oil and gas, tax withholding on the Azerbaijan International Oil Company’s subcontractors, and SOCAR tax credits for energy subsidies.

Staff projections using the WEO commodity price assumptions.

Table 5.

Azerbaijan: Summary Accounts of the Central Bank, 2005-10

(In millions of manat)

article image
Sources: Central Bank of Azerbaijan; and Fund staff estimates and projections

In 2009, Azerbaijan received general and special SDR allocations from the IMF in the amount of SDR 153.6 millions.

Table 6.

Azerbaijan: Monetary Survey, 2005-10

(In millions of manat, unless otherwise specified)

article image
Sources: Central Bank of Azerbaijan; and Fund staff estimates and projections

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

Table 7.

Azerbaijan: Selected Economic and Financial Indicators, 2005–2015

article image
Sources: Azerbaijani authorities; and Fund staff estimates and projections

Includes the production and processing of oil and gas.

Includes the transportation of oil and gas (except transportation through the western route), as well as the export tax paid by the state oil company.

Historical data includes statistical discrepancy.

Defined as non-oil revenue minus total expenditure (excluding interest payments) and statistical discrepancies.

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