Republic of Azerbaijan: 2019 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for the Republic of Azerbaijan
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International Monetary Fund. Middle East and Central Asia Dept.
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Publication Date:
18 Sep 2019
eISBN:
9781513514376
Language:
English
Keywords:
ISCR; CR; government; food price inflation; price; broad money; U.S. dollar; private sector; current account; exchange rate; foreign currency; Oil; Nonperforming loans
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2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Republic of Azerbaijan

Abstract

2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Republic of Azerbaijan

Context

1. Having weathered the economic downturn, Azerbaijan has an opportunity to move to a new growth model and improve its resilience to shocks. With a strong policy response and a rebound in oil prices, growth prospects have brightened, and the banking sector, while still fragile, has stabilized. Nevertheless, the economy remains heavily dependent on hydrocarbon exports1 and public spending. Financial intermediation remains weak, and the de facto pegged ER continues to encourage dollarization as insurance against devaluation and high inflation.

2. A longer-term economic development vision is crucial for achieving sustainable, private sector-led and diversified growth. Given the exhaustibility of hydrocarbon2 resources and the need to create jobs for a young population, Azerbaijan’s economic future depends on its ability to reduce the economic footprint of the state, promote competition, and improve governance and transparency. An integrated macroeconomic, financial, and structural policy framework is needed to avoid procyclicality, ensure adequate savings for future generations, and more effectively respond to unanticipated shocks.

3. The implementation of Fund advice has been mixed. While policy announcements in the fiscal, monetary, and financial sector areas have broadly followed Fund staff’s recommendations, the implementation of policy measures has often been delayed.

Azerbaijan: Implementation of IMF Recommendations

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Recent Developments

4. The recovery is gaining pace. Economic activity in 2018 remained sluggish, owing to a continued downturn in construction and a decline in hydrocarbon output. The economy expanded by 2.4 percent through the first six months of 2019, driven by an uptick in the service sector activity and increased gas production.3 With declining imported food prices under a de facto ER peg, and remaining excess capacity, inflation fell to 2.3 percent in 2018 from 13 percent (y/y) in 2017 and stood at 2.6 percent this June.

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Contribution to Real GDP Growth, 2010–2018

(Percent)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

5. External balances continue to improve. The current account surplus increased by 8.8 percentage points (pp) of GDP to 12.9 percent of GDP in 2018 on firmer oil prices. Despite higher financial outflows, international official reserves of the Central Bank of Azerbaijan (CBA) and the Oil Fund (SOFAZ) rose by 2 pp of GDP to $44 billion (98 percent of GDP). However, competitiveness deteriorated, with a 7 percent appreciation in the real effective ER and a worsening of the nonoil current account deficit.

6. A new fiscal rule was introduced in 2019. The rule requires (i) the year-ahead projected nonoil primary balance (NOPB) as a percent of nonoil GDP to be no worse than the current-year NOPB, and (ii) nominal spending growth not to exceed 3 percent over the previous year’s approved expenditures. “Spendable” oil revenues are also constrained under the rule (Annex III). The rule was announced as part of a broader package of public financial management (PFM) reforms, including a medium-term expenditure framework (MTEF), public debt management strategy, and a budget classification law.

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Summary of Main New Tax Policy Measures

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

7. The fiscal stance is set to reverse from stimulus to tightening. In 2018, the NOPB deteriorated by 1.2 pp to -32.1 percent of nonoil GDP on increased social and infrastructure spending and SOE capital injections, amid slower nonoil revenue growth. The 2019 budget implied consolidation of 1 pp of nonoil GDP under the new fiscal rule. The budget reflected gains from improved revenue administration and new tax policy measures aimed at reducing informality and broadening the tax base. These gains were partially offset by losses from expanding tax deductions, exemptions, and investment tax credits, as well as a reduction of the personal income tax rate. New spending initiatives in 2019 were compensated by cuts in capital spending, expenditure reallocations, and the use of CBA profits under a revised budget passed in June. After these revisions, the 2019 NOPB is still expected to improve by 1 pp of nonoil GDP.

New Spending Packages

Two spending packages were introduced through Presidential Decrees in the first half of 2019. The government’s publicly expressed intention was to compensate the public for the adverse impact of the past devaluations, banking crisis and economic downturn. Parliamentary elections are scheduled for November 2020.

The spending packages contain the following main components:

  • Increases in minimum wages and pensions (0.6 percent of GDP), with the minimum monthly wage (pension) raised from AzN 130 (73) to AzN 180 (130) in April, and to AzN 250 (200) in October 2019.

  • Increases in public sector wages of about 40 percent (1.0 percent of GDP) from September 2019.

  • An NPL resolution / consumer loan bailout, whereby banks and consumers receive some AzN 650 million manat (0.8 percent of GDP) as compensation for past devaluations (see Box 2 for more details).

The packages are expected to affect up to 30 percent of the population and have broad macroeconomic, fiscal, and financial sector implications, as discussed elsewhere in this Staff Report.

8. Monetary and financial conditions remain tight. Since January 2018, the CBA has reduced its refinancing rate from 15 to 8V4 percent and narrowed the interest rate corridor to +/-2 pps around the refinancing rate. Manat base and broad money have expanded, and excess liquidity has remained ample. However, since inflation has fallen faster than nominal interest rates, real interest rates have risen. With the ER fixed at AzN/US$ 1.70 since April 2017 and trading partner currencies depreciating, the nominal and real effective ERs appreciated (by 5–7 percent in 2018), further tightening financial conditions.

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Nonoil GDP and Financial Conditions 1/

(Percent, y-o-y)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: National authorities, Haver, and IMF staff calculations and estimates.1/ FCI components a re weighted by their relative standard deviations.

9. Bank lending has picked up with the recovery in demand. Private sector credit was growing at 11 percent (y/y) as of June, with sizable increases in transportation, trade, and household lending. The uptick in lending, however, has taken place against a backdrop of continued weaknesses in bank balance sheets and supervision (1110, 27). Credit guarantee funds, as well as the creation of the private credit bureau and collateral registry, have contributed to the expansion of credit. Manat household deposits have risen and are de-dollarizing, in part because the government’s blanket guarantee on deposits was extended in March 2019 for one more year.

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Oil, Business and Financial Cycles

(In percent)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: National authorities, Haver, and IMF staff calculations.

10. Despite recent improvements, weaknesses in bank balance sheets persist. The banking system’s reported profitability and capital adequacy have improved, reflecting loan reclassification and restructuring, the reversal of loss provisions, bail-in of creditors, and fresh capital. Financial Market Supervisory Authority (FIMSA) has increased the number of on-site inspections and has updated several regulations. Nevertheless, regulatory forbearance appears to be continuing. Some banks remain undercapitalized with high NPLs and may not be complying with limits on large exposures and related party lending. Moreover, the ultimate beneficial ownership of some banks is opaque. The favorable system-wide capital adequacy ratio (20 percent with a Tier I ratio at 19 percent) is driven by the largest bank, International Bank of Azerbaijan (IBA), whose balance sheet was restructured. Ongoing de-dollarization and near-term ER stability are expected to keep risks from currency mismatches manageable.

11. The authorities are taking steps to address impediments to growth4 Azerbaijan’s Doing Business score rose by 8.45 points to 78.6, with improvements in obtaining credit, construction permits and electricity connections; registering property, paying taxes, and labor regulations. The authorities are also putting in place institutional infrastructure to provide services to small and medium enterprises (SMEs), implement e-government, and create specialized business courts. They are developing a new utility tariff schedule to reduce subsidies and improve SOE health. Digitalization of customs services and launching of the Green Corridor regime in February 2019 have simplified customs clearance procedures, reducing opportunities for corruption. While applauding progress in e-government, a recent EU business climate report stressed the importance of following through on announced reforms and continuing improvements in transparency, education, and market development.5

Azerbaijan: Structural Policy Measures Announced in 2018

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Outlook and Risks

12. Growth is expected to strengthen in 2019, before settling around 2½ percent in the medium term. Real GDP is projected to expand by 2.7 percent in 2019 as the impact of the new spending packages kicks in and the gas pipeline network comes on stream. Subsequently, hydrocarbon growth will stabilize as expanding production from the Shah Deniz II gas project and Azeri Central East oil project compensates for declining oil production in other fields. Nonhydrocarbon growth will rise gradually to around 3.2 percent over the medium term. Moderating capital investment, structural rigidities, and bank weaknesses will weigh on economic prospects. Inflation will remain below 3.5 percent, given the stable ER and low food price inflation. With oil prices projected at around $60 per barrel and the fiscal position improving, the current account surplus will remain sizeable.

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Economic Growth Rates

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: National authorities and IMF staff calculations.

13. Risks are tilted to the downside (Annex II). A decline in oil prices, for example, due to slowing global demand, would worsen fiscal and external positions and put pressure on the ER. Materialization of large contingent liabilities would weaken debt sustainability. Another source of risk stems from the fragmentation and other weaknesses in the policy frameworks and governance, which may result in slower-than-expected progress in implementing structural reforms, cleaning up the banking sector, and improving resilience. Recent increases in public sector wages may propagate to the private sector, creating second-round inflation effects and further undermining competitiveness. Heightened geopolitical tensions are an additional source of risk. On a more positive note, exposure to global financial markets, mainly through SOFAZ, is mitigated by portfolio diversification. Low economic diversification limits exposure to international trade shocks. Upside risks stem from higher oil prices and faster reforms.

14. The authorities broadly shared staff’s views on the outlook and risks. They noted considerable uncertainty about the impact of recent spending measures on domestic demand and inflation in the near term. Over the medium term, the authorities saw larger upside risks to private sector growth from recent structural reform measures. They also considered that the risk of contingent liabilities materializing was negligible, given low interest rates, long durations, and the quality of the underlying projects.

Policy Discussions

There was a consensus that the authorities’ strong policy actions have helped Azerbaijan’s economy weather recent shocks. Many interlocutors believed, however, that deeper policy reforms are needed for more inclusive, sustainable, diversified, and private sector-led growth, with opportunities available to all. Policy discussions focused on policies and frameworks to ensure macro-financial stability, create a new growth model, and foster economic inclusiveness.

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Projected and PIH-consistent Nonoil Primary Deficit 1/

(Percent of non oil GDP)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: National authorities and IMF staff calculations.1/ The gap between actual non-oil primary balance and non-oil primary balance recommend by the Permanent Income Hypothesis The higher the value the greater the effort needed to restore intergenerational equity.

A. Rule-Based Fiscal Policy

15. The authorities and staff agreed that strengthening long-term fiscal sustainability is an important policy priority. Azerbaijan has some fiscal space, given low gross public debt on a downward trajectory, low gross financing needs and largely negative net debt to GDP, and with SOFAZ assets amounting to 82 percent of GDP as of end-2018.6 However, a large gap (23 pps of nonoil GDP) from the long-term Permanent Income Hypothesis (PIH)-based NOPB benchmark of -11 percent of nonoil GDP implies a need for significant adjustment to share exhaustible oil wealth with future generations, notwithstanding the sensitivity of these calculations to the underlying assumptions.

Azerbaijan: Spending Packages, Offsets, and Net Expenditures 1/

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Estimates provided by the authorities.

One-time expenditure.

16. With the recovery underway, the authorities have appropriately shifted to fiscal tightening in 2019. Under the revised 2019 budget, they intend to offset the new expenditures (2.4 percent of GDP, Box 1) by spending reallocations (1.6 percent of GDP), while booking the remaining portion of expenditure (linked to the consumer loan bailout) off-budget, along with the offsetting CBA profit transfer. Although staff records all budget spending and CBA profit transfers above the line, both the authorities’ and staff’s projections imply a 1 pp of nonoil GDP improvement in the NOPB, consistent with the original 2019 budget. Staff supported this stance, both on cyclical and long-term sustainability grounds.

17. Looking ahead, the authorities reaffirmed their commitment to gradual fiscal consolidation. They intend to consolidate the fiscal position by about 1 pp of nonoil GDP yearly in 2020 and beyond. The authorities and staff agreed that this pace of consolidation strikes a good balance between the goals of strengthening buffers and supporting economic growth, but that it would not close the intergenerational equity and external gaps (Annex I). More ambitious fiscal consolidation (3 pp of non-oil GDP cumulatively over the next five years) could be achieved by identifying additional spending efficiency gains and introducing comprehensive revenue and tax reforms. The authorities, however, considered that a faster pace of consolidation was not feasible, given the recent jump in structural expenditures,7 plans to introduce medical insurance, and still sluggish growth.

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Nonoil Primary Balance Components

(Change in percentage points of nonoil GDP)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: National authorities and IMF staff calculations.

18. In staff’s view, improvements in the efficiency of public spending, tax policy, and revenue collection would allow the fiscal position to be consolidated in a growth-friendly way.

  • Spending. The authorities rightly aim to achieve fiscal consolidation mainly through better prioritization and moderation of capital spending. In this context, staff urged the authorities to finalize and implement draft regulations requiring public investment projects to be appraised and selected in accordance with transparent criteria, as well as to broaden public procurement reforms. Advancing planned spending reviews in targeted sectors such as education would also be beneficial. Making public sector wage adjustments rule based and better aligned with performance would help reduce spending rigidities.8 Civil service reform would be useful in this regard. Social spending should be well-targeted and condition-based (Annex V).

  • Revenues. Streamlining tax exemptions would foster revenue mobilization and equity. In this context, staff welcomed the authorities’ work on estimating the cost and efficiency of tax exemptions and urged them to complete it swiftly. Over the medium term, staff also recommended undertaking comprehensive reforms of revenue administration and tax policy to identify additional nonoil revenue gains; staff stands ready to support the authorities in undertaking the respective diagnostic analyses. While recognizing potential benefits of comprehensive reforms, the authorities gave priority to implementing recent tax and revenue administration measures aimed at reducing informality.

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Current and Capital Expenditure, 2018

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

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Employment Status Relative to Informality, 2018

(Percent of total employment)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source : World Bank Development Indicators, and IMF calculations.

19. The authorities and staff recognized that recent spending packages make compliance with the fiscal rule more difficult. Under staff’s projections, nominal expenditure growth will exceed the 3 percent ex ante cap set by the fiscal rule already in 2019. (This is not the case under the authorities’ revised budget as some spending items and CBA profits are recorded off-budget.) Going forward, all agreed that increases in public sector wages, combined with indexation, would make compliance with the rule challenging.

20. The authorities favor refining the rule based on first-year experiences. In this context, staff emphasized the importance of compliance with the rule to build policy credibility and that any refinement should ensure the rule’s ability to foster fiscal discipline in line with long-term fiscal sustainability objectives while avoiding procyclicality (Annex III). The existing rule should continue to be followed until amended by law, and the use of off-budget or other operations inconsistent with best international practices to satisfy the rule should be avoided. Any modifications should be carefully designed, planned and communicated to ensure that the effectiveness of the rule-based framework and confidence in it are not eroded. The authorities have requested technical assistance (TA) to review the application of the rule and consider any needed refinements.

21. Staff stressed that the fiscal rule should be supported by strong PFM practices and processes. The fiscal rule should be linked to the budget through a clear fiscal strategy to guide budget priorities, with a medium-term budget framework in place. The authorities noted that the current rule was implemented at a time when several PFM prerequisites were still at an early stage of development. Plans to implement an MTEF have been announced, work is at conceptual stages, and the aim is to present pilots for three sectors with the 2021 budget. Mandatory in-year and end-of-year reviews of performance under the rule would help to improve accountability and ensure compliance. Systematic identification and monitoring of risks to the fiscal outlook would also help to secure compliance.

22. Better fiscal transparency would also improve macro-fiscal performance and reduce vulnerabilities to corruption (Annex IV). Publishing more timely and comprehensive fiscal data, including detailed information on budgets and outturns, SOE support and investment spending, and fiscal risks would improve macro-fiscal analysis and forecasting as well as accountability and transparency across government, underpinning credibility of the fiscal rule. Greater transparency and better public procurement would improve efficiency and reduce corruption risks. Azerbaijan has joined the IMF’s e-GDDS and is revising reporting in line with the latest Government Financial Statistics Manual. A Fiscal Transparency Evaluation (FTE) would help construct a more comprehensive picture of the public finances and of fiscal risks, take stock of transparency practices, and develop a reform action plan. The authorities emphasized their commitment to fiscal transparency and will consider requesting an FTE.

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Public Financial Management Framework Recommendations

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

23. Staff and the authorities agreed that SOE restructuring is important to reduce demands on the public purse and improve economic efficiency. The largest of over 5,000 active SOEs operate as monopolies in strategic sectors and are too big to fail. Past devaluations, sluggish growth, quasi-fiscal activity, and poor governance have weakened the financial position of most SOEs, which required increased budget support. In response, the authorities have strengthened financial accounting practices, created an SOE monitoring commission, and issued new SOE governance guidelines. They agreed with the importance of adjusting tariff schedules to achieve viability and prioritizing investments to replace aging capital in the electricity, gas, water, railroad and shipping sector SOEs. Staff recommended that commercial and noncommercial activities be separated, and a commercial performance framework enacted. This would help to accelerate privatization.

B. Supporting Monetary Policy

24. The CBA has appropriately started the process of normalizing interest rates. With inflation projected to remain below the midpoint of the CBA’s publicly announced 2 to 6 percent inflation band, inflation expectations well anchored, and the U.S. interest rate futures lower, staff saw room to continue monetary easing. While acknowledging potential room for more cuts, the CBA viewed the monetary stance as less tight than staff and emphasized increased uncertainty about the inflation forecast, given recent fiscal measures. The CBA also noted that the monetary base has expanded rapidly after the crisis, at the same time as the government’s cashless economy program has reduced money in circulation and improved base money stability. The authorities and staff agreed that decisions about future changes in interest rates should be made particularly carefully at this juncture, based on incoming evidence regarding the impact of recent fiscal measures.

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Key Monetary and ER Policy Framework Recommendations

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

25. The authorities and staff saw greater ER flexibility as important for improving competitiveness, facilitating diversification and adjustment to shocks, and promoting better risk management. Staff noted that the de facto peg limited the development of the interbank market and interest rate channel of monetary policy and risked fueling the same macro-financial vulnerabilities that led to the recent crisis. Given firmer oil prices, adequate reserves, and the introduction of the fiscal rule, the timing for introducing ER flexibility was opportune. Moreover, greater ER flexibility along with fiscal and financial sector policy measures, would help to improve Azerbaijan’s external position, which in staff’s assessment, is moderately weaker than implied by fundamentals (Annex I). However, the authorities favored maintaining ER stability at least in the near term. They felt that it helped to maintain confidence and macroeconomic stability and considered that slow progress in diversification and weak competitiveness were mostly due to structural impediments. The CBA plans to move to a hybrid inflation targeting (IT) regime within 3– 5 years, relying both on a nominal interest rate operating target and a stabilized market-determined ER as the nominal anchors, after the necessary conditions were in place. This could set the stage for a fully-fledged IT over the long term.

26. In the meantime, the CBA intends to focus on modernizing its policy framework and addressing structural impediments to IT. Shallow markets, difficulties in liquidity management, banking vulnerabilities, dollarization, and weak transmission suggest the CBA will have difficulty influencing interest rates and inflation. Staff recommended improving the policy framework, including by strengthening CBA independence, operationalizing the de facto floor system, and formalizing the action and communication plan for transitioning to IT. Moreover, the CBA’s analytical and forecasting capacity should be bolstered and its policy toolkit expanded, along with steps to strengthen and deepen the financial system. The authorities plan to continue their ongoing monetary and ER policy TA program with the Fund.

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Bank Deposit and Loan Dollarization

(Percent of total)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: National authorities and IMF staff calculations.

C. Financial Stability and Development

27. There was agreement that while improved, the situation in the banking system remains fragile. Dollarization, unhedged FX positions, and NPLs are still high, with some banks being undercapitalized or insolvent. Notwithstanding progress in removing bad assets from its balance sheet and restructuring its FX liabilities, IBA still does not have a viable business model. Staff stressed that existing undercapitalized banks be given a strict deadline to recapitalize or close, and large banks with narrow capital buffers be required to strengthen them. Supervisory forbearance should be terminated, regulatory norms enforced, and banks’ corporate governance strengthened. Privatization of IBA should be initiated as soon as possible.

28. Strengthening FIMSA’s independence and resources is essential for it to be effective. FIMSA indicated that its current charter provides for full operational independence on budget and staffing issues but that it lacks independence over decisions to grant new licenses. The closure of financial institutions may require political consent. In the authorities’ view, the implementation of several new regulations (including on FX lending) and a new methodology for systemically important banks have bolstered oversight.9 Staff recommended the use of gap analysis against Basel Core Principles to identify specific areas for improvement in supervision and moving quickly to resolve uncertainty over possible extensions of the blanket deposit insurance guarantee. The authorities have requested TA on financial sector regulation and supervision and have expressed interest in an FSAP Update.

New NPL Resolution Program

The program is designed to reduce NPLs and compensate individuals whose debt servicing burden increased due to the 2015 devaluations:

  • Some AzN 650 million has been sent from the state budget to banks. About half of this amount has been retained by banks to pay down overdue retail loans, where applicable. As a result, capital in the banking system is expected to increase by AzN 300 million (7.4 percent of end-2018 system-wide capital). The remaining portion (0.4 percent of GDP) has been sent by banks to individuals (in debit card form) to compensate them for having serviced their outstanding loans at the new (depreciated) ER.

  • Banks are also required to restructure FX retail loans. These loans are redenominated to manat, their terms are extended, interest rates are reduced, and accrued interest and fees are written off. The redenomination to manat exacerbates banks’ open currency positions. To mitigate banks’ FX risk, the CBA will make loans of some AzN 680 million available to banks at low interest rates and under government guarantees. The CBA will also make $215 million worth of dollar-denominated bonds available to banks for purchase. By taking a loan from the CBA in manat and using the proceeds to buy a dollar-denominated bond, a bank can close its open currency position.

29. While the new NPL program will improve household balance sheets, it will have limited impact on the health of the banking sector. The program will boost banks’ liquidity, and the restructuring will reduce loan dollarization. The authorities expect that bank solvency will improve in a small number of banks, as positive effects from government transfers outweigh negative effects of accrued interest write-offs. However, staff and authorities agreed that the program creates moral hazard by undermining incentives for proper risk management of new FX loans and worsens repayment culture. NPLs are likely to remain high after the program (12.9 percent), and uncertainty surrounding NPL estimates will persist.

30. Staff welcomes that the authorities are starting to take a more comprehensive approach to solving the NPL problem. With the banks, FIMSA has been developing an out-of-court settlement system to facilitate NPL resolution. FIMSA is also drafting legal amendments that would enable the creation of asset management companies. They are also assessing possible reforms to the responsible lending law, with an aim toward directing resources to tradable goods sectors. Building on FIMSA’s efforts, staff stressed that an independent and transparent asset quality review (AQR) remains essential to ascertain likely loan recovery rates. On-site inspections of provisioning practices are not a substitute for AQRs. Imposing timetables to resolve NPLs through write-offs or sales and making the process cheaper and quicker are essential. Improving bank governance and rolling back regulatory forbearance would help prevent a weakening in bank balance sheets. Transparent accounting of bad asset management and resolution is also needed.

31. Staff highlighted the importance of a coordinated approach to debt market development. Creating a capital market development strategy in consultation with all relevant stakeholders would soften the FX risk of the sovereign debt profile that exacerbates the fear of floating. Such a strategy would set out a roadmap for developing deeper local currency bond market, with longer tenors, more diversified investor base, market-determined pricing, and enhanced secondary market liquidity. Better coordination among the Ministry of Finance, CBA, and SOFAZ would help ground government’s borrowing and investment decisions in an integrated asset-liability management framework that assesses the risk-return trade-offs as well as broader macro-financial implications. The authorities concurred but felt that a manat bond market could become concentrated among a few domestic investors and crowd out lending to private sector.

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Currency Composition of Public Debt and Guarantees

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: National authorities and IMF staff calculations.

32. Financial data and analysis should be strengthened. While financial institutions are in principle required to publish accurate data, capital and NPL figures in several banks are widely viewed as questionable. This uncertainty discourages banks from participating in interbank transactions. Building on recent TA, FIMSA should verify and start publishing financial soundness indicators, more detailed banking system data, and a financial stability report.

D. Fostering Sustainable, Diversified, and Inclusive Growth

33. Despite recent reforms, structural impediments to private sector growth and job creation persist, including: (i) weak governance and institutions; (ii) limited SME access to credit; (iii) inefficient labor markets; (iv) export concentration; (v) limited product and trade market competition; and (vi) sizeable skill gaps. Azerbaijan scores below emerging market peers on World Bank governance indicators, and the EBRD reports high exclusion gaps in SME finance and labor markets. The size of the state remains large, with state support to struggling SOEs crowding out more growth-enhancing investment. The result is high informality, limited FDI, weak entrepreneurship and SME development, and low productivity.

34. There was a shared view that promoting inclusive growth is critical for Azerbaijan’s economic advancement and resilience (Annex V). The authorities are continuing discussions with the UN on achieving Sustainable Development Goals. They expected that recent spending packages, tax exemptions, and the consumer loan restructuring program will increase the purchasing power of the population. Staff cautioned that broad-based increases in wages that are disconnected from productivity growth are also likely to raise the cost of doing business, disincentivize private sector employment, and weaken competitiveness. In this context, staff emphasized the increased importance of lowering entry barriers, including by applying the Anti-Monopoly Law, to improve market efficiency. The authorities are continuing discussions with the WTO on accession, and staff encouraged completing the WTO membership process, to inject a needed dose of competition into domestic markets and foster diversification. Applying the OECD’s Investment Guidelines would also attract nonoil FDI and know-how. Regarding financial inclusion, staff emphasized the need for expanding financial literacy and promoting competition in the banking sector, to stimulate SMEs and reduce the reliance on tax incentives. Staff noted that continued skill mismatches highlight the importance of prioritizing and improving the efficiency of public spending on education.

Azerbaijan: Inclusive Growth Indicators

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Sources: IMF World Economic Outlook, World Bank, World Economic Forum, International Labour Organization, Transparency International, UNDP, Oxfam International.

Indicators use official sources and surveys to summarize perceptions of the quality of governance and business environments.

35. Addressing governance, anti-corruption and AML/CFT vulnerabilities would also support the creation of a private sector-led, inclusive growth model. In addition to fiscal transparency and procurement, ensuring accountability on oil and non-oil revenue outcomes and banking sector supervision (discussed above and in Annex IV) requires bolstering the anti-corruption framework.10 The July 2018 IACP monitoring report recognized progress in raising awareness about corruption, and in the functioning of the government’s Commission on Combating Corruption. However, limited transparency and engagement hinder assessment and formulation of recommendations. Staff urged stepped-up reforms in line with the UNCAC and the recommendations that the country received to strengthen its anti-corruption strategy and policies, the rule of law, and the enforcement of the asset declarations regime for public officials. Further strengthening the AML/CFT framework, particularly preventive measures, beneficial ownership, risk-based supervision, and enhancing prosecution and conviction, would assist anti-corruption efforts. Continued engagement between the authorities and key stakeholders would facilitate strengthening the anti-corruption and AML/CFT frameworks in the coming years.11

Staff Appraisal

36. The policy priority for Azerbaijan at the current juncture is fostering private sector-led and diversified growth while improving resilience to future shocks. The authorities’ policy response to the recent banking crisis and economic downturn has helped stabilize the economy. The economy has started to recover but remains undiversified and vulnerable to external shocks. The exhaustibility of hydrocarbon resources and the need to create jobs for a young population require creating new sources of growth. Key steps needed in this direction include reducing the economic footprint of the state, promoting competition, and improving governance and transparency. Close integration of policies and coordination among policymakers are essential to maintain macro-financial stability while improving the economy’s ability to adjust to shocks.

37. Continuing fiscal consolidation is important to save an adequate portion of the exhaustible oil wealth for future generations. Most importantly, consolidation should be growth-friendly, achieved by mobilizing higher non-oil revenues, improving the efficiency of public spending, prioritizing investments in human capital, restructuring of SOEs and better targeting transfers and subsidies. While reducing the non-oil primary deficit by 1 percentage point of non-oil GDP would help build precautionary buffers and maintain debt sustainability, further adjustment would be needed to improve intergenerational equity. The external position, which is moderately weaker than implied by fundamentals and desirable policies, would also strengthen as a result.

38. The introduction of a fiscal rule in 2019 was a major step forward. Yet the 2019 spending packages will challenge the authorities’ ability to comply with the fiscal rule. As the authorities consider refining the fiscal rule based on the first-year experience, they must ensure that it fosters fiscal discipline and is robust, sustainable, and credible. Demonstrating a commitment to the fiscal rule by establishing a solid track record will improve credibility. It is also important to complement the fiscal rule with stronger public financial management practices and procedures, as well as greater fiscal transparency and better management of fiscal risks.

39. A further monetary easing appears appropriate, given still tight financial conditions and remaining spare capacity. Transitioning to inflation targeting and greater ER flexibility would help to absorb shocks and promote better risk management. Together with steps to modernize monetary operations and increase issuance of local currency securities, it would foster financial market development, facilitate liquidity management, and provide a benchmark for corporate bonds and a risk-free investment for the private sector. Financial repression, including through interest rate caps, should be resisted.

40. Strengthening financial supervision and increasing competition would enable the financial sector to support economic growth. While the NPL resolution program is likely to improve bank balance sheets, the sector remains fragile and uncompetitive. The NPL resolution program risks worsening the moral hazard and repayment culture, without improving banking sector supervision, governance, or transparency standards. Banks are still not required to disclose their ultimate beneficiaries and enjoy regulatory forbearance, which increases vulnerabilities to corruption. An independent asset quality review would be a critical starting point for assessing the true health of the system. Together with further upgrading and strengthening of financial sector supervision, this would improve confidence and prevent a build-up of future vulnerabilities.

41. Transitioning to a new diversified, private sector-led growth model requires removal of structural impediments. Opening to international trade and investment, reducing the size of the public sector, and improving financial inclusion and governance are essential for a competitive and efficient private sector to develop. Recently announced institutional and regulatory reforms are positive steps that should be followed by effective implementation, monitoring, and assessment to ensure that the underlying policy goals are realized. Better data and transparency would improve decision-making and promote private sector growth and reduce vulnerabilities to corruption.

42. It is recommended that the next Article IV consultation takes place on the standard 12-month cycle.

Figure 1.
Figure 1.

Azerbaijan: Caucasus and Central Asia Macroeconomic Outcomes

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Sources: World Economic Outlook, and IMF staff calculations.
Figure 2.
Figure 2.

Azerbaijan: Real Sector Indicators

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Sources: National authorities, Haver, and IMF staff calculations.
Figure 3.
Figure 3.

Azerbaijan: External Sector

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Sources: WITS, Haver, and IMF staff calculations.
Figure 4.
Figure 4.

Azerbaijan: Exchange Rate

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Sources: National authorities, Haver, and IMF staff calculations.
Figure 5.
Figure 5.

Azerbaijan: Fiscal Sector

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Sources: National authorities, Haver, IMF World Economic Outlook, IMF Public Investment Management Assessment, World Economic Forum, Global Competitiveness Index, and IMF staff calculations.
Figure 6.
Figure 6.

Azerbaijan: Monetary Sector

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Sources: National authorities, Haver, and IMF staff estimates.1/ Reduction of credits in September and October 2015 due to one bank restructuring.2/ According to the 2015 FSAP report, for statistical purposes only overdue payments are classified as non-performing loans (NPLs). The reported time series of NPLs does not fully reflect actual NPLs.
Figure 7.
Figure 7.

Azerbaijan: Deposits and Interest Rates

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Sources: Haver, and IMF staff calculations.
Figure 8.
Figure 8.

Azerbaijan: Business Environment and Governance

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Sources: World Bank Ease of Doing Business, Worldwide Governance Indicators, WEF Global Competitiveness Indicators, World Bank Enterprise Surveys, and IMF staff calculations.1/ Survey-based indicators reflect investors’ perceptions on the business environment.2/ Survey-based indicators summarizes perceptions of quality of governance, higher score indicates better governance. Estimates of governance range from approximately -2.5 (weak) to 2.5 (strong).3/ Uses both official data and survey responses from executives on areas of competitiveness, higher is better.4/ Indices on the prevalence of trade barriers ranking and subcomponents are based on WEF’s quantitative and qualitative assessment of the trade environment. These indicators should be interpreted with caution due to a limited number of respondents, a limited geographical coverage, and standardized assumptions on business constraints, and information availability.
Figure 9.
Figure 9.

Azerbaijan: Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario

(In percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: IMF staff.1/ Public sector is defined as general government.2/ Based on available data.3/ EMBIG.4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.5/ Derived as [(r – π(1 +g) – g + ae(1 +r)]/(1 +g+π+gπ)) times previous period debt ratio, with r – interest rate; π – growth rate of GDP deflator; g – real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).6/ The real interest rate contribution is derived from the numerator in footnote 5 as r – π (1 +g) and the real growth contribution as -g.7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).8/ Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
Figure 10.
Figure 10.

Azerbaijan: Public DSA – Composition of Public Debt and Alternative Scenarios

(In percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: IMF staff.
Figure 11.
Figure 11.

Azerbaijan: External Debt Sustainability: Bound Tests 1/ 2/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.4/ One-time real depreciation of 30 percent occurs in 2010.
Table 1.

Azerbaijan: Selected Economic and Financial Indicators, 2017–24

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Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes the production and processing of oil and gas.

Consolidates State Budget, State Oil Fund of Azerbaijan (SOFAZ), Nakhchevan Autonomous Region (NAK) and State Social Protection Fund.

Includes a transfer of CBA profits (AzN 650 million) in 2019.

Includes the impact of an extraordinary SOFAZ transfer ($1.4 billion) to the CBA in 2017. Includes expenditures for the NPL program in 2019 (AzN 650 million).

Table 2a.

Azerbaijan: Balance of Payments, 2017–24

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

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Sources: Azerbaijani authorities; and IMF staff estimates and projections.
Table 2b.

Azerbaijan: Balance of Payments, 2017–24

(In percent of GDP, unless otherwise specified)

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Sources: Azerbaijani authorities; and IMF staff estimates and projections.
Table 3a.

Azerbaijan: Statement of Consolidated Government Operations, 2017–24

(In millions of manat)

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Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes the extraordinary SOFAZ transfer ($1.4 billion) to the CBA in 2017, and in 2019 a transfer of CBA profits (AzN 650 million) and expenditures for the NPL program (AzN 650 million).

Excludes the impact of the 2017 extraordinary SOFAZ transfer ($1.4 billion) to the CBA.

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

Comprises government deposits in CBA and commercial banks.

Excludes AIOC profit tax, profit oil, and SOCAR profit tax, but includes VAT and excise taxes on oil and gas, tax withholding on the AIOC’s subcontractors, energy subsidies.

Tax revenue excluding AIOC and SOCAR profit tax, and social contributions.

Table 3b.

Azerbaijan: Statement of Consolidated Government Operations, 2017–24

(In percent of non-oil GDP)

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Sources: Azerbaijani authorities; and IMF staff estimates and projections.

Includes the extraordinary SOFAZ transfer ($1.4 billion) to the CBA in 2017, and in 2019 a transfer of CBA profits (AzN 650 million) and expenditures for the NPL program (AzN 650 million).

Excludes the impact of the 2017 extraordinary SOFAZ transfer ($1.4 billion) to the CBA.

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

Comprises government deposits in CBA and commercial banks.

Excludes AIOC profit tax, profit oil, and SOCAR profit tax, but includes VAT and excise taxes on oil and gas, tax withholding on the AIOC’s subcontractors, energy subsidies.

Tax revenue excluding AIOC and SOCAR profit tax, and social contributions.

Table 4.

Azerbaijan: Summary Accounts of the Central Bank, 2017–24

(In millions of manat, unless otherwise specified)

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Sources: Central Bank of Azerbaijan; and IMF staff estimates and projections.

Includes CBA holdings of Aqrarcredit’s bonds as a part of the SPV, and IBA deposits.

Table 5.

Azerbaijan: Monetary Survey, 2017–24

(In millions of manat, unless otherwise specified)

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Sources: Central Bank of Azerbaijan; and IMF staff estimates and projections.
Table 6.

Azerbaijan: External Debt Sustainability Framework, 2014–24

(In percent of GDP, unless otherwise indicated)

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Derived as [r – g – r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Annex I. External Sector Assessment

The external position improved in 2018 on higher oil prices and lower oil-related services imports. Despite a large CA surplus in 2018, the external position is moderately weaker than implied by fundamentals and desirable policies. External stability risks are mitigated by sizable FX reserves.

1. The CA continued to strengthen in 2018. The CA and REER tend to move with oil prices. After a decade of double-digit CA surpluses, the oil price shock of 2014–15 led to a sharp deterioration in the CA. A recovery in oil prices in 2017–18, coupled with a reduction in oil-related construction and business services (as many projects were completed), led to a rebound of the CA to a surplus of 4.1 and 12.9 percent of GDP in 2017 and 2018 respectively. The nonoil CA balance, however, continued to worsen given a marked increase in nonoil imports and meager growth in nonoil exports. In the near term, the overall CA surplus is expected to decline to about 10 percent of GDP as oil prices moderate and the impact of the recent appreciation of the REER kicks in.

uA01fig14

Azerbaijan: Real Effective Exchange Rates and Contributions to Current Account

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Sources: National authorities, IMF World Economic Outlook, and IMF staff calculations.

2. The financial account registered net outflows in 2018. While the acquisition of foreign assets remained relatively stable, foreign liabilities, particularly FDI and portfolio inflows, declined. FDI averaged over 7 percent of GDP in the 2010–17 period but fell to only 2 percent of GDP in 2018.

3. Azerbaijan’s overall reserve coverage is more than adequate according to the IMF’s Assessing Reserve Adequacy (ARA) metric. CBA’s gross official international reserves increased by 7.5 percent, to $5.8 billion (12.2 percent of GDP, 5.1 months of next year’s imports) by end-2018. CBA’s reserves are complemented by foreign assets held by the Oil Fund (SOFAZ) of $38.6 billion (82 percent of GDP) at end-2018. Together CBA reserves and SOFAZ assets are equivalent to 39 months of next year’s imports. The APIA metric, which combines information on imports, broad money and short-term debt, shows that Azerbaijan scores much better than most EMs on all criteria (yellow diamonds). This is the case even after adjusting the APIA metric for the country’s heavy reliance on hydrocarbon exports (green diamond). Reserve coverage scores remain strong into 2024, given strong CA surpluses, rising reserves, and limited increases in external debt (red diamonds).

uA01fig15

Azerbaijan: Exchange Rates and Reserve Adequacy

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: National authorities, Haver, IMF FAD Reserve Adequacy Tool, and IMF staff calculations.Note: The data for EM refer to a sample of 48 emerging markets.

4. Despite sizeable CA surplus, the external position appears to be moderately weaker than implied by fundamentals and desirable policy settings. The assessment is based on the EBA-Lite methodology, which uses regression estimates of CA and REER norms and gaps. Norms are the estimated levels of the CA based on underlying fundamentals, while gaps are the deviations of observed values from the norms. To predict the equilibrium of the CA consistent with structural and policy factors, EBA-Lite uses regression analysis for a large sample of countries. Policy changes that would reduce the external gap over the forecast period include: (i) deeper fiscal consolidation to strengthen long-term fiscal sustainability benchmarks (additional 3.3 pp of nonoil GDP increase in NOPB to -23 percent of nonoil GDP by 2024, mainly through improvements in the efficiency of spending)); (ii) higher public health expenditure (an increase of about 1 pp of GDP to 2.3 percent of GDP by 2024 to get closer to the EM average of 3.5 percent of GDP, accompanied by improvements in the efficiency of healthcare spending); and (iii) financial deepening (for bank credit to the private sector to reach the level of 18 percent of GDP, accompanied by improvements in bank supervision and regulation).

5. The results of the EBA-lite regression-based model point to slight overvaluation of the manat. The EBA-lite methodology estimates a multilaterally-consistent cyclically adjusted CA norm of 13.3 percent of GDP compared to an actual cyclically-adjusted CA surplus of 11.6 percent of GDP in 2018. This results in an estimated CA gap of -1.7 percent of GDP, and a REER gap of 4.9 percent. This indicates that for the CA to be at the norm, the REER should depreciate by 4.9 percent. The results imply a CA gap, driven mainly by the fiscal policy gap. Moreover, the manat has been held constant at about AzN/$ 1.70 since April 2017, while regional trading partners experienced depreciations.

ESR Classification of the Overall Assessments

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Sources: Staff estimates.

Based on an elasticity of -0.35.

Reflects a CA gap range of [-2%, -1%].

6. The bottom-line assessment of the external position is sensitive to assumptions. Assuming no policy gaps, the CA and REER gaps would be -2.4 percent of GDP and 6.8 percent respectively, suggesting weaker external position than implied by fundamentals. Financial deepening and higher healthcare spending lower the CA norm. The intuition is that public health expenditure is akin to a social protection policy that discourages precautionary saving. If the need for additional fiscal consolidation were the only assumed policy gap, the estimated CA and REER gaps of -2.6 percent of GDP and 7.3 percent respectively, would point to a weaker external position. Assuming Azerbaijan needs to bring its level of healthcare spending closer to EM average over the medium term, and promote financial deepening (Annex V), the estimated CA and REER gaps would point to a moderately weaker external position.

CA and REER Gaps Under Different Policy Gap Assumptions

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7. The results of the consumption-allocation commodity module are broadly in line with EBA-Lite regression-based model. The commodity module considers the exhaustible nature of exhaustible commodity income and incorporates the need to smooth consumption over time and between generations. Using the approach developed by Bems and Carvalho (2010), the consumption-allocation commodity module examines annuity payments that are kept either at a constant real annuity or a constant real per capita annuity. The latter is the preferred measure, as it ensures that each person in each generation is allocated the same real resources out of the country’s wealth. The consumption-based allocation model suggests the CA norm of 14.2 percent of GDP for Azerbaijan measured at constant real per capita annuity, whereas the EBA-lite CA methodology suggests 13.3 percent of GDP. A higher CA norm in the commodity module can be explained by the fact that volatile revenue flows motivate more precautionary savings to smooth consumption. The results for per capita annuity imply a CA gap of 1.3 percent of GDP in 2018 that widens to 2.5 percent over the medium term.

uA01fig16

CA and CA Norms Under Consumption-Allocation Commodity Module

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: National authorities, and IMF calculations.

Annex II. Risk Assessment Matrix1

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Annex III. New Fiscal Rule

1. The fiscal rule, adopted in 2018, aims to support macroeconomic stability and intergenerational equity and limit procyclicality of fiscal policy. The rule specifies the NOPB path and the methodology for calculating the annual ceiling of consolidated budget expenditures, including a ceiling on spending out of oil revenues. Given the need for a sizable fiscal adjustment to achieve the PIH benchmarks, the rule is asymmetric, limiting scope for stabilization policy during downturns

2. The main provisions of the rule are as follows:

  • i. A consolidated budget (CB) balance rule: requires the year-ahead projected nonoil primary balance (NOPB) as a percent of nonoil GDP to improve over the current-year NOPB. The NOPB targets are set by the MOF and approved by the President.

  • ii. A CB expenditure rule: restricts nominal spending growth to 3 percent over the previous year’s approved expenditures.

  • iii. Countercyclical rule: CB spending is limited to projected nonoil revenues and “spendable” oil revenues. If projected oil revenues exceed a fixed threshold (30 percent of NFA),1 a portion (20 percent) of the excess is combined with the threshold to calculate “spendable” oil revenues. Conversely, when projected oil revenues are below the threshold, “spendable” oil revenues equal projected oil revenues plus a portion (20 percent) of the shortfall.

  • iv. CB expenditures are set as the lower of provisions (ii) and (iii) above, whilst respecting (i).

  • v. An escape clause: can be enacted whenever actual revenues or financing are 10 percent below the corresponding quarterly forecast or 5 percent below corresponding non-oil revenue forecast, or by a Presidential Decree. If enacted, the Cabinet must present proposals for bringing expenditures back in line with the rule. Initial projections for future years are submitted to the Cabinet by April 15 and revised projections by September 15.

3. Simulations confirm the asymmetric countercyclical properties of the rule. It is countercyclical on upside oil price shocks, allowing for NFA accumulation. The rule’s cap on nominal increase in consolidated expenditures restricts expenditures from exceeding baseline levels even at higher oil prices, maintaining a downward non-oil primary deficit trend. It also enables the build-up of SOFAZ assets. During oil price downturns, the rule requires only partial adjustment of expenditures to cover shortfalls in oil revenues. While allowing some use of SOFAZ assets for stabilization purposes, it safeguards them for future generations.

uA01fig17

Azerbaijan: Application of New Fiscal Rule

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: National authorities, and IMF staff calculations.Note: Several oil price shock scenarios were simulated to assess the outcomes of the rule on the expenditure ceiling, overall balance and NOPB, and SOFAZ assets. The baseline scenario assumes February 2019 WEO oil price forecasts. The remaining scenarios assume a two-year shock in oil prices with a subsequent gradual return to the baseline over the projection period: $60/barrel (the price adopted in the 2019 budget), an upside shock price of $70/barrel and two downside shock prices of $50/barrel and $40/barrel.

4. Possible improvements in the rule include:

  • i. Spending stability and budget predictability: setting the target for the non-oil deficit or the expenditure ceiling over the medium term would result in a more stable path for expenditure growth, making it less dependent on current year oil prices. The spending ceiling and NOPB path would be revised only every three-four years.

  • ii. Flexibility and asymmetric countercyclicality: The rule is less countercyclical in downturns than upturns. With a large fall in oil prices, the rule would imply a larger upfront adjustment. This could be mitigated by placing a floor on the ratio of NFA to annual oil revenues, in combination with limits on nonoil real primary expenditures and the NOPB of SOEs, all within a four-year budget plan. If oil revenues rose above the baseline path assumed in the budget, spending can be increased only by maintaining the same ratio of NFA to oil revenue. By contrast, any shortfall would be covered in the year of the fall but would need to restore the NFA ratio within five years. This would allow increasing spending somewhat with higher oil prices, while avoiding immediate fiscal contraction during oil price declines.

  • iii. Institutional coverage and quasi-fiscal activity: the current institutional perimeter of the rule is the CB. Outside the CB, several other entities in the public sector such as SOEs can conduct fiscal operations on government’s behalf, including delivering subsidies by selling at prices below cost recovery, creating employment, and delivering social programs. Limiting coverage to the CB runs the risk of not capturing such activities. Extending the perimeter to include SOEs will involve a trade-off with the practicality of monitoring the financial operations of SOEs, given limited availability of information on that sector at present.

  • iv. Definitions: NFA should only incorporate liquid assets and easily recoverable financial liabilities (owed by SOEs to the government) to ensure a realistic calculation of available assets. Currently, non-oil expenditure (revenue) is defined to include debt repayments (debt disbursements). The inclusion of these financing flows in the above-the-line aggregates could distort the application of the rule.

  • v. Defining adequate enforcement and reporting requirements: It would be useful to require periodic MOF reporting on fiscal performance compared to the rule and suggestions for remedial measures in case the rule is not followed.

Annex IV. Fiscal Governance

Fiscal Transparency

1. The government has made progress in improving data dissemination. In line with recommendations of the IMF’s Enhanced General Data Dissemination System (e-GDDS), the authorities have started to publish some data through the National Summary Data Page (NSDP), with links to statistics published by the Ministry of Finance, State Statistical Committee, and the Central Bank of Azerbaijan. Regular and timely publication of essential fiscal and macroeconomic data will provide policymakers and stakeholders with easy access to information critical for monitoring economic conditions and policies.

uA01fig18

Fiscal Transparency 2017

(r=0.46 an d p-value = 0. 00)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Sources: International Budget Partnership, Open Budget Index; World Bank; Worldwide Governance Indicators; IMF, World Economic Outlook Database; and IMF staff estimates.

2. The authorities are working on enhancing the quality of government financial statistics (GFS), public-sector debt statistics (PSDS), and fiscal reporting. The Fund has been providing technical assistance to Azerbaijan as part of the three-year Central Asia and South Caucasus Fiscal Transparency Project to assist the authorities in compiling GFS and PSDS in line with the GFS Manual (GFSM) 2014 and PSDS Guide (PSDSG). A detailed narrative is published on the annual budget, providing a description of the main activities and projections for the budget year. Quarterly and annual budget execution reports are also published. The authorities have also established a SOE monitoring commission which is compiling data on the 14 largest SOEs.

3. While these steps are welcome, more could be done. The IMF’s Fiscal Transparency Code (FTC) sets out recommended transparency practices across four main pillars. Some actions that Azerbaijan can take to achieve closer alignment with the standards set in the Code include:

• Reporting: advancing ongoing efforts to publishing fiscal data in line with GFSM 2014 and PSDSG; expanding the budget execution reports with disaggregated data by administrative, functional, or economic classification, and reflecting outturns compared with projections and previous year outturns; and publishing consolidated IPSAS-compliant financial statements.

• Forecasting and Budgeting: including in the budget documentation details of the macroeconomic and fiscal projections for the medium-term and their underlying assumptions; providing more data on budgetary expenditure by functional and economic classification; and publishing details of major investment projects and the associated multi-year costs.

• Risk Analysis and Management: publishing a report on the finances of the SOE sector; continuing to monitor the financial sector for emergent risks; and expanding the information published on fiscal risks with sensitivity analyses based on macroeconomic assumptions, in a comprehensive fiscal risk statement.

• Resource Revenue Management: continuing to publish self-assessments on application by SOFAZ of Santiago principles, pertaining to legal and governance structures, organizational design, and operational practices; and maintaining adherence to EITI standards.1

4. The last Open Budget Index (OBI) identified possible areas for improvement. The OBI assesses whether the government makes key budget documents available to the public online in a timely and comprehensive manner. The 2017 assessment identified the following areas in which Azerbaijan could improve its score in terms of public availability of documents: pre-budget statement, citizens budget, and mid-year review. Closer alignment with the practices recommended by the FTC could also help improve Azerbaijan’s OBI score. The IMF’s Fiscal Transparency Evaluation assesses performance against the Code and develops an action plan to address any identified weaknesses.

Public Procurement

5. Azerbaijan abolished the State Procurement Agency in 2017 and created the State Service for Antimonopoly Policy and Consumer Rights’ Protection in the Ministry of Economy. The new agency oversees the general legal procurement framework, monitoring and auditing of tenders, and resolving complaints and conflicts. The procurement system remains highly decentralized with more than 800 procuring entities.2 Each entity oversees their own tender process, evaluations of bids and final selections. Moreover, Azerbaijan’s procurement fares poorly when benchmarked against other countries.

uA01fig19

Public Procurement Systems 2017

(r=0. 24 an d p -value =0.00)

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Sources: International Budget Partnership, Open Budget Index; World Bank; Worldwide Governance Indicators; IMF, World Economic Outlook Database; and IMF staff estimates.

6. A proposed new State Procurement Law could help modernize the procurement process. It includes provisions for: (i) e-procurement; (ii) an electronic unified register of procurement contracts; (iii) mechanisms to limit participation of nonreliable bidders; (iv) the development of procurement plans; (v) stronger civil servant ethical guidelines; (vi) competitive negotiation rules;3 and (vii) complaint procedures. Implementing the new procurement law would help deliver value for money and suppress opportunities for corruption. Given the large size of public procurement in Azerbaijan, losses due to inefficiencies and abuses can be costly.4 A comprehensive diagnostic assessment of the procurement system would help inform an action plan to strengthen the system beyond implementation of e-procurement.

Annex V. Inclusive Growth

1. Inclusive growth (IG) is a multifaceted concept that captures both the sustainability of the growth model and the extent to which it creates opportunities for all citizens. With nonoil growth relatively slow since 2015 and oil production faltering, promoting equitable, broad-based, and sustainable growth is macro-critical. Azerbaijan performs well compared to its CCA peers in income inequality, life expectancy, and access to schooling. However, it lags in other IG indicators, such as in health and education outcomes, efficiency of social spending, governance and control of corruption, and access to credit by SMEs.1

uA01fig20

Azerbaijan: Human Development and Inequality

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: United Nations Development Programme Human Development Index, and IMF staff calculations. Note: The Human Development Index (HDI) is the geometric mean of life expectancy, expected and mean years of schooling, and gross national income per capita (2011 PPP $). The inequality-adjusted HDI measures the loss in HDI value when inequality is accounted for, and it is based on the Atkinson family of inequality measures. Refer to the technical note for more information: http://hdr.undp.org/sites/default/files/hdr2018 technical notes.pdf.

2. Social spending indicators signal room for improvement. Spending on education, healthcare, and targeted social protection has been shown to promote growth and reduce income inequality (Dollar and Kray, 2002; IMF 2018). Azerbaijan stands out as spending the least in percent of GDP on health and education in the CCA, although in per capita terms it is in line with peers.2 Efficiency of public expenditure is also a concern, as outcomes, particularly in education and healthcare, fall short of those predicted by public outlays.

3. Recent economic spending packages have a social protection element. The statutory minimum wage in Azerbaijan is relatively low compared to regional peers. It has not kept up with increasing cost of living, and the gap between average and minimum wage has been rising. Even with the latest increase in minimum wages, Azerbaijan would still fall below the 0.6 ratio of minimum to average wage recommended by the European Social Charter. Recent steps to raise minimum pensions and minimum wages should help alleviate poverty and reduce inequality.

uA01fig21

Azerbaijan: Minimum and Average Wages

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: Haver Analytics, CBA, ILO, and IMF staff calculations.

4. Low financial inclusion has long been identified as key impediment to inclusive growth. Better access to finance, particularly for SMEs, can provide impetus to private sector growth, employment generation, and diversification. Azerbaijan ranks poorly in access to credit compared to peers. Financial inclusion is particularly problematic for youth compared to other CCA countries, with only 12 percent having a bank account. Lack of trust in banks and high cost of borrowing stand out as top barriers to financial access. High collateral requirements and insufficient credit bureau coverage have been identified as constraints to SME access to financing.3

5. Improving the business climate and governance can lift productivity growth and enable the private sector to play a larger economic role. Private investment has declined precipitously since the Global Financial Crisis. While Azerbaijan has passed laws and regulations to promote competition, implementation is still weak. Azerbaijan ranks poorly compared to regional and EM averages in controlling corruption. Institutional quality and regulatory burden have been identified as the main obstacles to doing business and causes of high economic informality in Azerbaijan (Abdih and Medina, 2013).

Figure 1.
Figure 1.

Azerbaijan: Social Spending and Infrastructure Quality

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Source: TIMSS and PISA evaluations, WEF Global Competitiveness Indicators, IMF Fiscal Monitor October 2017, IMF FAD Expenditure Assessment Tool, and IMF staff calculations. Note: TIMSS and PISA scales are different, but both are centered around 500 with a standard deviation of 100. PISA- Program for International Student Assessment, TIMSS-Trends in International Mathematics and Science Study.1/ For Azerbaijan, health and education expenditure excludes capital expenditure, such as construction of schools and hospitals.2/ Indices on the quality of infrastructure are based on WEF’s quantitative and qualitative assessment of the country environment. These indicators should be interpreted with caution due to a limited number of respondents, a limited geographical coverage, and standardized assumptions on business constraints, and information availability.
Figure 2.
Figure 2.

Azerbaijan: Financial Inclusion

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Note: CCA and CCA oil exporter averages exclude Azerbaijan.Sources: World Bank Ease of Doing Business, Findex Report, IMF World Economic Outlook, and IMF staff calculations.1/ Survey-based indicators that should be interpreted with caution due to a limited number of respondents, a limited geographical coverage, and standardized assumptions on business constraints and information availability.

6. Promoting IG requires transforming Azerbaijan into a more diversified private sector-driven economy with opportunities for all to contribute to and benefit from higher growth. Fiscal reforms should focus on rebalancing spending toward education and healthcare, improving its efficiency, closing infrastructure quality gaps through better governance and procurement, and improved targeting of social protection. Creating fiscal space through revenue mobilization, improved efficiency of spending, and reduced generalized subsidies4 that disproportionately benefit the rich, would free resources for social spending.

Figure 3.
Figure 3.

Azerbaijan: Business Environment

Citation: IMF Staff Country Reports 2019, 301; 10.5089/9781513514376.002.A001

Note: CCA average excludes Azerbaijan.Source: WEF Global Competitiveness Indicators, World Governance Indicators, IMF World Economic Outlook, IMF WP/18/17, and IMF staff calculations.1/ Indices of anti-monopoly effectiveness and trade barriers are based on WEF’s quantitative and qualitative assessment of the trade environment. These indicators should be interpreted with caution due to a limited number of respondents, a limited geographical coverage, and standardized assumptions on business constraints, and information availability.2/ Size of the economy estimated using the MIMIC approach, see IMF 2018f WP/18/17.3/ Survey-based indicators summarize perceptions of control of corruption, higher score indicates better governance. Estimates of range from approximately -2.5 (weak) to 2.5 (strong).

7. Financial reforms should address the demand and supply impediments to SME inclusion: (i) cleaning up banks’ balance sheets and promoting competition, (ii) increasing credit bureau coverage and lowering collateral requirements; (iii) training entrepreneurs; (iv) developing capital markets. Supporting fair competition, improving governance, strengthening property rights, reducing SOE dominance, and rationalizing business regulations is also important.
1

The hydrocarbon sector accounts for some 41 percent of GDP, 92 percent of exports, and 65 percent of fiscal revenues.

2

“Hydrocarbon” and “oil” are used interchangeably in this Staff Report to denote oil, oil products, and natural gas.

3

Three Southern Gas Corridor projects became operational in 2018, with the last one is scheduled to start next year. In 2017, the authorities signed a new production sharing agreement with the consortium of foreign oil companies, which together with the state oil company (SOCAR) extract oil and gas.

4

The country’s strategic and development priorities are described in its “2020 Reform Agenda.”

5

https://eeas.europa.eu/delegations/azerbaijan/64138/eu-business-climate-report-2019_en. The authorities are continuing discussions with the EU on a partnership agreement.

6

SOFAZ’s investment portfolio is highly liquid with 80 percent of assets in short-term money market instruments. While primarily a wealth fund, SOFAZ’s charter allows its resources to be used for “solving important nation-wide problems.” In 2017, SOFAZ made an extraordinary transfer of AzN 3.5 billion to the CBA as part of the government’s stabilization plan. SOFAZ also invests a portion of its assets in the domestic oil sector.

7

According to staff’s preliminary estimates, the full-year effects of the recent wage measures would raise structural budget spending by 7 percent. The public sector wage bill would increase from 5½ percent of GDP to about 7¾ percent in the medium term.

9

FIMSA has identified four systemically important banks that have a CAR requirement of 11 percent, compared to ten percent for the rest of the system.

10

Azerbaijan participates in the OECD Istanbul Anti-Corruption Action Plan (IACP), GRECO (Group of States against Corruption) and OGP (Open Government Partnership). Implementing recommendations of these bodies can contribute to compliance with the UN’s Convention Against Corruption (UNCAC). Azerbaijan is in “inactive” status in the OGP given concerns over engagement with stakeholders (NGOs, CSOs).

11

In the context of implementing the Fund’s Enhanced Framework on Governance, staff did not get the opportunity to discuss issues pertaining to the anti-corruption framework during this consultation. Well after the mission, staff received the authorities’ answers to staff’s questionnaire on governance and will follow up in the course of future surveillance activities.

1

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

1

NFA is defined as the sum of oil fund assets, government deposits, and SOE liabilities to treasury minus public debt (excluding guarantees).

1

Azerbaijan withdrew from the EITI in 2017 but affirmed its commitment to transparency in the sector. The Extractive Industries Transparency Commission was created in 2017. It published two reports, in 2016 and 2017. SOFAZ is a member of the International Forum of Sovereign Wealth Funds (IFSWF) and in 2016 published a self-assessment on application of Santiago principles, pertaining to legal and governance structures, organizational design, and operational practices. The next assessment is due in 2019.

2

A procuring entity is any organization with 30 percent state ownership, which purchases goods and services.

3

Domestic producers will be given preference over foreign producers. For example, winning domestic producer bids can exceed the lowest cost foreign bid by at least 20 percent.

4

Government spending on goods and services and capital projects is about 18 percent of GDP.

1

Azerbaijan presented a voluntary national review of their Sustainable Development Goals in July 2019 (https://sustainabledevelopment.un.org/memberstates/azerbaijan).

2

After a 19 percent jump in 2019, spending on education and health is set to increase by additional 45 percent in 2020.

3

“Financial Inclusion of Small and Medium-Sized Enterprises in the Middle East and Central Asia,” IMF 19/02.

4

Generalized subsidies (for example, tariffs set below cost recovery on fuel, water, electricity) disproportionately benefit the rich, encourage over-consumption, and result in inefficient allocation of resources.

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Cover IMF Staff Country Reports
Republic of Azerbaijan: 2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Republic of Azerbaijan
Author:
International Monetary Fund. Middle East and Central Asia Dept.
Volume/Issue:
Volume 2019: Issue 301
Publisher:
International Monetary Fund
ISBN:
9781513514376
ISSN:
1934-7685
Pages:
72
DOI:
https://doi.org/10.5089/9781513514376.002

Contribution to Real GDP Growth, 2010–2018

(Percent)

Summary of Main New Tax Policy Measures

Nonoil GDP and Financial Conditions 1/

(Percent, y-o-y)

Oil, Business and Financial Cycles

(In percent)

Economic Growth Rates

(Percent of GDP)

Projected and PIH-consistent Nonoil Primary Deficit 1/

(Percent of non oil GDP)

Nonoil Primary Balance Components

(Change in percentage points of nonoil GDP)

Current and Capital Expenditure, 2018

(Percent of GDP)

Employment Status Relative to Informality, 2018

(Percent of total employment)

Public Financial Management Framework Recommendations

Key Monetary and ER Policy Framework Recommendations

Bank Deposit and Loan Dollarization

(Percent of total)

Currency Composition of Public Debt and Guarantees

(In percent of GDP)
Figure 1.

Azerbaijan: Caucasus and Central Asia Macroeconomic Outcomes
Figure 2.

Azerbaijan: Real Sector Indicators
Figure 3.

Azerbaijan: External Sector
Figure 4.

Azerbaijan: Exchange Rate
Figure 5.

Azerbaijan: Fiscal Sector
Figure 6.

Azerbaijan: Monetary Sector
Figure 7.

Azerbaijan: Deposits and Interest Rates
Figure 8.

Azerbaijan: Business Environment and Governance
Figure 9.

Azerbaijan: Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario

(In percent of GDP unless otherwise indicated)
Figure 10.

Azerbaijan: Public DSA – Composition of Public Debt and Alternative Scenarios

(In percent of GDP unless otherwise indicated)
Figure 11.

Azerbaijan: External Debt Sustainability: Bound Tests 1/ 2/

(External debt in percent of GDP)

Azerbaijan: Real Effective Exchange Rates and Contributions to Current Account

Azerbaijan: Exchange Rates and Reserve Adequacy

CA and CA Norms Under Consumption-Allocation Commodity Module

Azerbaijan: Application of New Fiscal Rule

Fiscal Transparency 2017

(r=0.46 an d p-value = 0. 00)

Public Procurement Systems 2017

(r=0. 24 an d p -value =0.00)

Azerbaijan: Human Development and Inequality

Azerbaijan: Minimum and Average Wages
Figure 1.

Azerbaijan: Social Spending and Infrastructure Quality
Figure 2.

Azerbaijan: Financial Inclusion
Figure 3.

Azerbaijan: Business Environment