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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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.