Public Information Notice No. 05/6

Public Information Notice: IMF Concludes 2004 Article IV Consultation with the Azerbaijan Republic

January 21, 2005

On December 22, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Azerbaijan Republic.¹

Background

A three-year arrangement under the PRGF, in an amount equivalent to SDR 80.45 million (50 percent of quota) was approved on July 2, 2001. Four disbursements under this arrangement have been made through December 2003.

Economic developments in Azerbaijan in recent years have been characterized by strong growth and low inflation. Real GDP grew by an annual average of over 10 percent during 2000-03, driven by oil-sector FDI and related spillover effects in the construction and transportation sectors, substantial gains in agriculture following land reform in the mid-1990s, and robust growth in non-oil exports (primarily agriculture and chemical products). Inflation remained low, despite the recent pick up. The real effective exchange rate, which depreciated by 11 percent in 2003, has remained broadly stable in 2004. As of end September 2003, the gross international reserves of the National bank of Azerbaijan (ANB) amounted to US$952 million, providing for over 4.1 months of prospective non-oil import coverage, and the deposits of the State Oil Fund of Azerbaijan (SOFAZ) reached around US$900 million.

Fiscal policy was moderately expansionary in 2003, but tightened in 2004 due to lower-than-budgeted expenditure and strong performance in tax revenue, reflecting the positive impact of tax administration reforms as well as tax policy changes. As a result, the 2004 non-oil deficit as a share of non-oil GDP is now expected to be lower than previously projected. The 2005 budget targets a non-oil deficit of 16.8 percent of non-oil GDP, which is 2.4 percentage points higher than the expected 2004 outcome, but still well below the estimated long-run sustainable level. While the share of wages in total spending is relatively high and rising, reflecting excessive government employment, the level of public sector wages is still low.

Monetary and credit aggregates expanded rapidly in 2003 and the first nine months of 2004, following the ANB's unsterilized purchases of foreign exchange inflows to resist nominal appreciation. Together with the impact of strong government wage increases in the second half of 2003, this contributed to an acceleration in inflation to 6.8 percent at end-April 2004. To slow the growth in monetary aggregates, starting in March, the ANB allowed the nominal exchange rate to appreciate modestly, and began selling ANB bills. These steps helped slow reserve money growth and inflation declined to 4.9 percent at end-September. Utilization of ANB bills as an instrument for sterilization should help the ANB to control inflation, which picked up in October largely due to one time factors.

Deposit growth was nearly 70 percent in the 12 months through end-September 2004, leading to a significant increase in bank lending, albeit from a low base. Nonperforming loans increased slightly at end-2003 relative to end-2002, before declining in the first half of 2004. Nominal Interest rates have continued to decline.

Balance of payment developments remained positive in 2003 and the first half of 2004. The current account deficit increased to nearly 30 percent of GDP in 2003, from just over 12 percent in 2002, and is expected to decline only modestly in 2004, due to oil-related imports financed by FDI. Non-oil exports grew by nearly 45 percent. Public and publicly guaranteed external debt in percent of GDP is projected to decline to 18 percent by end-2004 and 2005, compared to 20 percent at end-2003.

Structural reforms, which slowed in late 2003 and early 2004, accelerated again recently. The authorities adopted a long-term oil revenue management strategy, which is consistent with a sustainable use of oil wealth and growth in non-oil sectors, as well as maintenance of macroeconomic stability. The 2005 budget was based on this strategy. The new Banking System Law is a substantial improvement over the previous one, allowing the authorities to implement many of the Basel Core Principles' recommendations by amending relevant ANB regulations. The newly adopted National Bank Law is consistent with international best practices and calls for higher transparency, improved corporate governance and strengthened ANB independence in banking supervision. The authorities' recent decision to adjust domestic prices of energy products and commit to review and adjust these prices as necessary, at least once a year, is an important step towards reduction of energy-related subsidies and improvement of efficiency in the energy sector.

The first annual report of Azerbaijan's State Program for Poverty Reduction and Economic Development, reflecting extensive consultation with civil society, was completed in May 2004. While some progress has been made in alleviating poverty and reducing the disparities in income distribution, combating poverty remains a key challenge in Azerbaijan.

Azerbaijan accepted the obligations of Article VIII, Sections 2, 3, and 4 effective November 30, 2004, and is committed to maintain an exchange system free of restrictions in making payments and transfers for current international transactions.

Executive Board Assessment

Directors commended the authorities for Azerbaijan's strong macroeconomic performance in recent years reflected in double-digit broad-based GDP growth; rising gross international reserves and savings in the Oil Fund; declining external debt ratios; and relatively low inflation. Directors noted that, while this positive outcome is in part attributable to favorable external factors, including high oil prices and large oil-related FDI, it also reflects prudent financial policies and some progress in structural reforms. Directors expressed concern, however, that—despite the high real GDP growth—the incidence of poverty remains high.

Directors agreed that the main challenge facing the Azerbaijan authorities over the medium- and long-term is to manage effectively a large but temporary surge in oil revenue. In this context, they welcomed the recent adoption of a long-term strategy for the use of oil revenue, which calls for maintaining oil wealth constant in real terms and limiting annual fluctuations in non-oil fiscal deficits. Establishing a sound, transparent fiscal framework was seen as essential for enabling the country's oil wealth to support the sustainable development of the non-oil sector and poverty reduction. In this connection, Directors also underscored the need to strengthen the implementation of the structural agenda, which aims at reducing rigidities, diversifying the economy, and creating an investor-friendly environment. They attached particular importance to enhancing reforms in the financial and energy sectors and improving governance.

Directors supported the government's decision to increase non-oil fiscal deficits gradually over the next three years, consistent with the oil revenue management strategy, as well as with macroeconomic stability and expenditure implementation capacity. They also emphasized that the planned increases in the non-oil fiscal deficits over the medium term should involve a combination of expenditure increases in physical and human capital, as well as tax cuts targeted to non-oil sectors, in order to improve the competitiveness of Azerbaijan's economy. Furthermore, Directors urged the authorities to design and implement targeted social assistance, and increase pro-poor government spending to cushion vulnerable groups against the adverse impact of reforms. In addition, they underscored the need for a comprehensive civil service reform to ensure a steady increase in wages while containing the wage bill.

Directors noted the government's approval of revenue and expenditure plans for major state-owned enterprises in 2004 and the authorities' commitment to add the State Oil Company of the Azerbaijan Republic to the list of monitored enterprises in 2005. They encouraged the authorities to use these plans to strengthen monitoring of these enterprises and take necessary steps to improve their financial performance, in particular in the energy sector. Directors stressed the need to improve financial discipline and transparency in state-owned enterprises, in order to reduce continuing quasi-fiscal subsidies to them.

Directors were encouraged by recent progress in reducing gaps between domestic and world market energy prices. However, they noted that related fiscal and quasi-fiscal subsidies remained high, despite the significant progress made in recent years. In this regard, Directors were encouraged by the authorities' commitment to review domestic energy prices at least once a year in the context of the annual budget process, with an objective of gradually aligning them with world market levels. Some Directors, however, urged the authorities to consider the adoption of an automatic price adjustment mechanism while mitigating any adverse effects on the poor.

Directors were encouraged by the progress made in implementing Azerbaijan's State Program for Poverty Reduction and Economic Development (SPPRED), including the preparation of a Medium-Term Expenditure Framework and Public Investment Program in support of the SPPRED. They noted, however, that links between the SPPRED objectives and the annual budget should be strengthened, and recommended the adoption of a comprehensive strategy to address the current weaknesses in early 2005.

Directors welcomed Azerbaijan's participation in the Extractive Industries Transparency Initiative, but noted that limited progress has been made toward improving governance in other areas. They considered that corruption remains a significant problem in Azerbaijan. Directors, therefore, encouraged the authorities to fully implement the recent Law on Fighting Corruption and Anti-Corruption Decree. In this regard, they urged the authorities to complete the separation of commercial and regulatory functions of public enterprises and ministries, improve the functioning of the courts, reduce red tape, and expeditiously tackle monopolistic tendencies in certain markets.

Directors agreed that the use of the exchange rate as a nominal anchor has served Azerbaijan well, and the overall mix of financial policies has been appropriate. Looking forward, they stressed that the planned increases in non-oil deficits in the medium term are likely to intensify real appreciation pressures. Given limited sterilization capacity, Directors recommended accommodating these pressures through nominal exchange rate appreciation, which will be key to achieving the authorities' objective of maintaining a low inflation rate.

Directors welcomed the continued remonetization of the economy, which likely reflects macroeconomic stability and increased confidence in the banking sector. At the same time, they expressed concern that rapid credit growth associated with this process could overwhelm banks' ability to evaluate credit risks. Directors therefore urged the authorities to strengthen banking supervision to ensure that this rapid credit growth does not adversely affect the quality of banks' loan portfolios.

Directors welcomed recent progress in financial sector reforms, including the adoption of the Banking System Law and the National Bank Law, and the implementation of reform steps to foster competition in the banking sector. However, many Directors expressed concern about slow progress in privatizing the remaining two state-owned banks and urged the authorities to press ahead with their privatization plans. Directors also encouraged the authorities to accelerate other financial sector reforms recommended by the Financial Sector Assessment Program, including further liberalization of the market for the provision of all banking services to the government, the strengthening of anti-money laundering legislation, further development of the government securities market, and improvements of corporate governance and accounting and auditing standards.

Directors commended the authorities for their recent acceptance of the obligations of Article VIII, Sections 2, 3, and 4 of the IMF Articles of Agreement and their continued commitment to maintain an exchange system free of restrictions on the making of payments and transfers for current international transactions.

Directors praised the Azeri authorities for the continued improvement in the quality of macroeconomic statistics, and welcomed their commitment to subscribe to the Special Data Dissemination Standard in early 2005.