Public Information Notice No. 06/44

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Republic of Azerbaijan

April 25, 2006

On March 27, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Azerbaijan.¹

Background

In 2005, Azerbaijan was in its third year of double-digit real GDP growth, and inflationary pressures that arose in early 2004 appear to have subsided. From the mid-1990s to the early 2000s, macroeconomic stability, some progress in structural reforms, and massive inflows of oil-related Foreign Direct Investment (FDI) contributed to an increase in oil export potential and a pick-up in non-oil output growth. During 2004-early 2005, higher oil prices and expansionary policies also added to the growth momentum of the non-oil economy, while reviving inflationary pressures. After rising to 15.4 percent in April 2005, inflation has recently declined to single digits mainly due to prudent management of the state budget and a tightening in monetary policy, but a revision to the Consumer Price Index (CPI) compilation methodology and informal price controls were also contributing factors. While the rapid economic growth has resulted in a reduction in poverty, the level of poverty remains high.

Rising oil prices and export volumes have contributed to a significant strengthening of Azerbaijan's external position. The current account deficit declined to 5 percent of GDP in 2005 from 30 percent in 2004. In both years, this deficit reflected large oil sector-related imports which were financed by foreign direct investment. The public and publicly guaranteed external debt was reduced to about 14 percent of GDP, and gross official reserves and oil fund assets increased to US$1.2 billion and US$1.4 billion, respectively, by end-2005.

Fiscal policy was tightened in 2005. The central government non-oil primary balance declined by 1.5 percent of non-oil GDP in 2005, as rapid non-oil revenue increases more than offset higher spending. The revenue buoyancy was attributable to significant improvements in revenue administration, higher excises on energy products, and the rapid growth of the tax bases for consumption and personal income taxes. The State Oil Company of the Republic of Azerbaijan (SOCAR) appears to have contained its spending.

The temporary exit from the fixed peg to the dollar in 2005 was key to the recent decline in inflation. In response to mounting inflationary pressures, the Azerbaijan National Bank (ANB) exited the de facto fixed peg to the dollar in February 2005 and tightened monetary policy. These efforts led to a decline in money and credit growth by September 2005. However, the exchange rate was fixed again in late September 2005, when appreciation pressures were at their peak. In the fall of 2005, nominal money demand started to fall on account of political factors, but credit continued to grow at about 50 percent on a twelve-month basis, as banks funded their loan portfolios using foreign liabilities and increased government deposits.

Progress in structural reforms has been uneven. Some fiscal reforms have advanced, including a strengthening of the budget formulation process, the preparation of the legislative framework for establishing targeted social assistance, the creation of a civil service reform committee, the participation in the Extractive Industries Transparency Initiative, and an increase in some regulated utilities and energy prices. While competition pressures in the banking system have increased, the International Bank of Azerbaijan has preserved significant market power and its preferential treatment by the government and state-owned enterprises (SOEs). Furthermore, only limited progress has been made in improving financial discipline and corporate governance of SOEs, and privatization of the remaining two state-owned banks has stalled. The new Anti-Corruption Law became effective on January 1, 2005, but additional effective measures should be undertaken to improve the business climate.

The short-term outlook for real GDP growth is favorable, but keeping inflation in single digits represents a major challenge. Real GDP is projected to grow by more than 20 percent in 2006, mainly owing to rapid growth of oil production. Thanks to a significant increase in oil export volumes, Azerbaijan will register a large current account surplus and a further strengthening of the external position in 2006. The growth momentum in non-oil output is also expected to remain strong on account of the continuation of the oil-related investment boom, increased foreign borrowing, and expansionary policies. The attendant rapid growth in domestic demand is projected to spill over into a significant increase in imports. But given capacity constraints in the non-oil sector, buoyant domestic demand will also cause inflation to rise again during 2006.

Executive Board Assessment

Directors welcomed Azerbaijan's impressive macroeconomic performance, with GDP growing briskly and inflation reduced to single digits. Directors commended the prudent fiscal and monetary policies, and progress in some areas of structural reforms that had contributed to this outcome, with economic growth spurred by a significant increase in oil production and the spillover effects of oil-related investment on the non-oil economy. They stressed that the current favorable prospects provide a unique opportunity for supporting economic diversification. While recognizing that strong economic performance has resulted in a decline in poverty, Directors encouraged the authorities to assign a high priority to further reductions in the poverty rate, which remains a concern.

Directors considered that the short-term growth and external outlook was favorable, mainly reflecting the projected significant increase in oil production. They agreed that risks to the outlook were low, given the size of the expected oil production increases and the continued spillover effects of the associated oil sector investment.

Directors agreed that, over the medium-term, the main challenge will be to manage the temporary boom in oil production. In this regard, they recognized that a significant increase in oil revenues during the next five years will lead to large external current account and budget surpluses. In this context, Directors stressed the importance of formulating a medium-term fiscal strategy, incorporating estimates of Azerbaijan's hydrocarbon wealth, to ensure the long-term sustainability of public finances and to avoid excessive real exchange rate appreciation that could undermine the competitiveness of the non-oil economy.

Directors observed that the prospective rise in Azerbaijan's oil income will support an increase in spending to address pressing development needs. However, they emphasized that short-term demand management considerations, limited implementation capacity, and longer-term sustainability issues justified a more modest increase in the non-oil primary fiscal deficit in 2006 than currently budgeted. In this context, Directors recommended preparing an expenditure reduction plan to minimize the risks of resource waste associated with stoppages of capital spending projects.

Directors welcomed the authorities' intention to resume the transition to a managed float and called for enhancing the ANB instrument independence. However, they expressed concern that inflationary pressures could reemerge as a result of the prospective sizeable fiscal expansion and limited exchange and interest rate flexibility. They also questioned whether the large sterilization efforts envisaged by the authorities will be feasible, given the limited absorption capacity of the domestic securities market, and the largely open external capital account. Looking forward, Directors welcomed the authorities' decision to move to full-fledged inflation targeting in the medium term and encouraged the authorities to prepare and implement a plan of supporting measures.

Directors welcomed recent steps taken to improve the ANB's supervisory capacity and urged the authorities to further strengthen the enforcement of prudential regulations and consider their tightening in light of the increasing risks associated with rapid credit growth, the potential for further exchange rate appreciation, and the increasing exposure of domestic banks to foreign borrowing. They looked forward to the adoption of Anti-Money Laundering/Combating Financing of Terrorism legislation that is being drafted with Fund technical assistance.

Directors also underscored the need for intensifying fiscal reforms, in order to ensure longer-term sustainability of public finances. In particular, they advised the authorities to operationalize their long-term oil revenue management strategy, further improve fiscal transparency, reform the corporate governance of state-owned enterprises, reduce energy subsidies, and enhance public investment program management. Directors commended the authorities' continued participation in the Extractive Industries Transparency Initiative.

Directors underscored the need to press ahead with key growth-oriented structural reforms aimed at reducing rigidities, diversifying the economy, and creating an environment favorable to private sector growth. In particular, they emphasized that fostering competition in the banking system, including the eventual privatization of the two remaining state-owned banks, along with improving the business climate and governance were essential for raising the growth potential of the economy. At the same time, Directors cautioned the authorities against subsidizing the non-oil economy and granting tax advantages for non-oil foreign direct investment, and observed that an across-the-board reduction in taxation of the non-oil economy could be considered as an alternative.

Directors noted the authorities' commitment to improve further the quality of data in close consultation with Fund staff and to subscribe to the Special Data Dissemination Standard in the near future.

Directors welcomed the authorities' continued interest in a Fund-supported program. They encouraged them to demonstrate strong commitment and political will to improve governance and transparency ahead of such an arrangement.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. This PIN summarizes the views of the Executive Board as expressed during the Executive Board discussion based on the staff report.