Outlook and reform priorities

An oil exporting country, Azerbaijan is in a process of transformation from a public sector-driven economic growth model to a model based on the private sector. Past public-sector led growth has enabled the country to move forward from low-income to upper middle-income status, with a fully modernized economic and social infrastructure. The shocks to oil prices in mid-2014, as well as the steady state reached under the past model, have led the Government to look for new drivers of economic growth. The transformation period has had its own costs, entailing two devaluations of the exchange rate in 2015, downturns in growth, and important vulnerabilities in the financial sector.

Nevertheless, through the implementation of the “Strategic Roadmap for 2020” by the Government since early 2017, Azerbaijan has significantly improved its macroeconomic and financial position. Economic growth has recovered, driven mostly by the non-oil sector. The unemployment rate stands around a record-low level of 5 percent. Inflation was at 2.3 percent on average in 2018, which is 10.5 percentage points below the year before. Despite some remaining fragilities, stability in the banking sector has also been achieved.

The authorities recognize the limitations of public investment as a primary source of growth, and they are well aware of the necessity to promote inclusive, diversified, and private sector-led growth. To this end, a wide range of institutional reforms are being implemented, including easing business procedures, reducing administrative burdens for the private sector, clarifying procedures and increasing transparency in public procurement. The authorities recognize the important role of SMEs as a new engine of sustainable and inclusive growth, and they are focusing on fostering their share in GDP.

The Government is considering a scenario of an additional decline in oil prices and its consequences on fiscal and monetary policy, as well as negative effects on the external sector and additional pressure on the exchange rate. To avoid such consequences, our authorities are focusing on improvement of macroeconomic policy through introducing a rules-based fiscal policy and a new strategy for the management of public debt for the medium and long-run. Work is ongoing to develop a Medium-Term Expenditure Framework, to be implemented in the near future. In its turn, the Central Bank of Azerbaijan has declared to move to an inflation targeting regime over the medium term and has introduced a strategy to this end.

The authorities are aware that the banking sector is facing important challenges and that stability remains fragile. It is well understood that the current credit expansion, especially to households for the financing of consumer goods, could lead to the realization of risks, which in turn could damage financial stability and entail macroeconomic consequences.

Fiscal Policy

The authorities are committed to maintain a prudent fiscal stance. Significant efforts have been made to strengthen sustainability through implementing a new fiscal rule and a public debt strategy; improvements have also been made in the efficiency of public spending, tax policy and administration, and the SOE sector. Our authorities broadly concur with staff on the appropriate pace of growth friendly consolidation over the medium term. In the course of broad ranging Public Financial Management reforms, a new budget classification law has been adopted. Fiscal transparency and accountability have also been improved significantly; data on public finance and budget execution are now broadly disseminated via the new web site of the Ministry of Finance.

An important element of the newly implemented fiscal rule is its aim to decrease oil dependence of budget revenues. Under the rule, the year-ahead projected non-oil primary deficit as a percentage of non-oil GDP has to be below the current year’s balance. Correspondingly, the fiscal rule requires the nominal spending growth rate for the year ahead not to exceed 3 percent of the current year’s approved expenditures.

Two Presidential decrees on social spending packages were signed in the first half of 2019. The first includes important measures to compensate the public for the adverse impact of past devaluations. In parallel, banks received additional financial support from the Government for NPL resolution. The second decree stipulates a significant increase in public sector wages of about 40 percent, which amounts to 1 percent of GDP, and an increase in minimum wages of 92 percent.

Our authorities are strongly committed to abide by the fiscal rule, despite the important increases in social expenditures. The Ministry of Finance is well-aware that a rules-based fiscal policy will support the sustainability of public finances, and enhance credibility and confidence. The authorities have requested FAD technical assistance to review and refine the fiscal rule framework.

Monetary Policy

Our authorities recognize the importance of sound monetary policy for private led economic growth. It is well understood that bank lending needs to be one of the main sources for financing private sector led growth. The authorities are aware that the new model of growth requires more efficiency in monetary policy transmission to domestic demand. The authorities’ agenda for monetary policy is very ambitious and comprehensive. The Central

Bank of Azerbaijan declared its objective to move toward an inflation targeting regime, and has already implemented several preparatory projects. The CBA has asked for technical assistance by MCM.

The primary goal of monetary policy is safeguarding price stability, by maintaining inflation at 4 percent (±2 percent). Since January 2018, CBA has eased monetary policy by reducing the refinancing rate from 15 to 8.25 percent. The authorities’ views concur with staff’s that any further changes in interest rates should be made cautiously. Monetary policy has gained traction through deposit and note auctions by the CBA, which were activated over the past 5 years. Commercial banks also benefited a lot from those auctions in terms of additional possibilities for asset management in an environment of excess liquidity. CBA deposit and notes auctions have enabled the central bank to focus on base money stability to prevent excess currency from circulation and to avoid additional pressures on the exchange rate.

The authorities are well aware of the importance of a floating exchange rate regime in terms of long run macroeconomic stability and economic competitiveness. CBA declared the move to a floating regime in December 2015. It should, however, be noted that the shifting to a de-facto floating regime will take a certain amount of time. To effect a smooth shift, CBA, in close coordination with the Government, is working on building an efficient infrastructure which will allow it to maintain macroeconomic stability. It is well understood by the authorities that reducing pass-through effect of exchange rate movements to domestic prices is an important task for monetary, and more broadly for macroeconomic, policy. These considerations are a significant element of the strategy for the implementation of the CBA’s inflation targeting regime.

Financial Stability

Our authorities share the staff’s views on recent developments in the banking sector. Government bailout programs and a wide spectrum of regulations have mitigated the vulnerabilities observed after the oil price shocks. Capital adequacy, the level of NPLs, profitability, and liquidity ratios have improved. Despite these developments, it is well understood that strengthening financial stability remains an urgent task for the bank supervision authority.

The Presidential Decree of March 2019 on the compensation of the public and banks for the past devaluations also provides financing of an NPL resolution program. The latter is considered an important milestone for improving financial stability. As a result of the implementation of the Decree, banking sector activity, including lending and deposit operations, has increased significantly.

The authorities recognize the importance of a sound institutional framework of for the financial system to bolster stability in a sustainable way. The recently established Credit Guarantee Fund, the private Credit Bureau, and the State Registry for collateral have all enhanced the institutional framework of the financial sector.

Despite macroprudential and institutional improvements, it is clear to our authorities that the transition to private sector-led growth requires new approaches in the business models of the banking sector, as well as strengthened bank regulation and supervision. The agreement signed between the Central Bank of Azerbaijan and “Rothschild Global Financial Advisory” on a strategic partnership could be mentioned as one of the steps to this end.

Structural Policies

Institutional reform is a key priority for our authorities. Our government recognize the importance of well-functioning institutions for enabling private sector-led growth. Azerbaijan has implemented a series of important institutional and structural reforms for maintaining a favorable business and investment climate, and an efficient public administration. According to the World Bank’s “Doing Business Report 2019”, Azerbaijan was among the top ten reformist countries globally, ranked in 25^th place.

The Government has declared judicial reform as one of the important aspects of institutional reforms in Azerbaijan. Our authorities have made enforcing contracts easier by introducing random and automatic assignment of cases to judges, by implementing an electronic case management system for judges and lawyers, as well as an e-system that allows plaintiffs to file initial complaints electronically, and by adopting a consolidated law on voluntary mediation.

The authorities have strengthened access to credit by allowing non-possessory security interests in one category of movable assets without any restrictions on the use of inventory, including future assets extending automatically to products, proceeds and replacements of the original collateral.

On December 28, 2018, the Parliament of Azerbaijan Republic passed the Law on Amending the Civil Code. The amendments, which became effective on the same day, are highly relevant for protecting minority investors, as they directly address the liability of directors in the case of a prejudicial related-party transaction. Specifically, the amendments allow shareholders to hold interested directors and other board members liable when a related-party transaction is considered unfair and a cause of damage to the company in question.