Public Information Notice No. 98/62

Public Information Notice: IMF Concludes Article IV Consultation with Azerbaijan

August 17, 1998

On June 26, 1998, the Executive Board concluded the Article IV consultation with Azerbaijan Republic ¹.

Background

Following the break up of the Soviet Union, Azerbaijan’s economy suffered from serious macroeconomic imbalances. Real GDP declined by around 60 percent between 1991 and 1995, by which time high inflation had eroded real incomes, the exchange rate had weakened and international reserves were nearly depleted. These developments reflected the collapse of traditional trade links, a sharp deterioration in the terms of trade as suppliers moved to world market pricing, the military conflict over the Nagorno-Karabakh region, and large fiscal deficits financed by money creation.

Prospects for growth, however, improved radically in September 1994 with the signature of the first oil production sharing agreement between foreign investors and the Azeri state oil company (SOCAR), which granted development rights for three existing large oil fields to an international oil consortium. Since then, a number of similar agreements have been signed, regulating both oil production and exploration.

In early 1995 the Azeri authorities started a comprehensive stabilization program supported by the ’s structural transformation facility. Fiscal and credit policies were tightened, while a number of structural reforms were introduced, mainly in the areas of exchange and trade liberalization. The results were impressive. The nominal exchange rate against the dollar stabilized, monthly inflation rates dropped from more than 50 percent in late 1994 to low single digits in the second half of 1995, and GDP started to recover in 1996.

Economic reforms have continued over the past two years, supported first by a stand-by arrangement with the IMF in 1996 and then by a three year arrangement under both the extended Fund facility and the enhanced structural adjustment facility (ESAF). The reform program has also been supported by the World Bank, including through a structural adjustment credit. Macroeconomic policies have achieved a rapid stabilization of the economy. The general government deficit amounted to 1¾ percent of GDP in 1997 and was significantly lower than expected during the first quarter of 1998, despite the adverse revenue impact of lower oil prices, reflecting both expenditure restraint and some revenue raising measures by the authorities. The Azerbaijan National Bank (ANB) refrained from financing the deficit through monetary creation and kept the growth of manat reserve money consistent with low inflation, despite the impact of large capital inflows.

In response to these policies, twelve month consumer price inflation has been close to zero since late-1997, while the manat’s strength has continued. At the same time, the recovery gained momentum in 1997, with real GDP growth increasing to 5¾ percent from 1¼ percent in 1996, fueled by a surge in foreign direct investment. In late 1997, exports of the first new-oil production began. The current account deficit remained large at 24 percent of GDP, reflecting imports connected to oil sector development, but official reserves more than doubled to 16 weeks of import cover (excluding oil sector operations). During the first quarter of 1998 the pace of economic activity accelerated further, with annual growth rising to around 9 percent, as the revival in economic activity spread to both agriculture and industry.

There were also a number of important steps in the structural area during 1997 and early 1998. These included: (i) a significant strengthening of banking supervision and changes in prudential regulations for commercial banks; (ii) full liberalization of the trade regime; (iii) the passage of legislation to improve tax collections; and (iii) measures to improve accountability in government purchases.

In addition the authorities continued their efforts to restructure the four state-owned banks, and to implement the treasury system so as to strengthen control over public finances. The sale of government owned assets proceeded at a quick pace, with 40-60 enterprises sold each month through the auction process.

The authorities plan to speed up the reform efforts in the period ahead by: (i) completing the restructuring of the four state owned banks; (ii) restructuring public expenditure through a reduction in public sector employment and improvements in the provision of health and education services; (iii) improving the transparency of the privatization process and accelerating large scale privatization; and (iv) strengthening the legal framework by adopting market-oriented legislation.

At the same time, the authorities intend to maintain cautious monetary and fiscal policies to consolidate the success in macroeconomic stabilization.

Executive Board Assessment

Executive Directors commended the authorities for their success in achieving macroeconomic stabilization under the economic reform program supported by the ESAF and extended arrangements. In particular, they welcomed the fact that firm macroeconomic policies had succeeded in bringing annual inflation close to zero, while strong economic revival was under way. Directors noted, however, that the progress on structural reform had been mixed, and significant differences remained as regards the performance of the various sectors of the economy. They urged the authorities to accelerate the pace of reform efforts, in order to meet the severe challenges that Azerbaijan continues to face, particularly with regard to reducing high unemployment and poverty and developing the non-oil sector.

Directors supported the authorities’ intention to maintain strict macroeconomic policies despite the impact of the recent decline in oil prices on government revenues. They welcomed the revenue measures already taken to partially offset the impact of lower oil prices, and some Directors encouraged the authorities to give further consideration to contingency measures for ensuring the achievement of the deficit target. Directors urged the authorities, however, to avoid across-the-board expenditure compression, which would weaken the budgetary process.

Directors supported the authorities’ approach to exchange rate policy, which sought to smooth the short-term fluctuations and prevent excessive nominal appreciation, as large capital inflows linked to oil developments placed upward pressure on the manat. To strengthen the effectiveness of monetary policy, especially in sterilizing foreign exchange operations, Directors encouraged the authorities to move rapidly to develop the credit and treasury bills markets.

Directors commended the authorities for implementing important structural reforms, which had advanced the transition toward a market economy. However, they stressed the need to complement the gains in macroeconomic stabilization with an intensification of the structural reform efforts, including in the agricultural sector, to ensure that the recovery is broadly based and sustainable and to improve the climate for private sector activity. Directors regretted the limited progress to date in restructuring government expenditures and in strengthening expenditure control. They stressed that such reforms were essential to ensure the medium-term sustainability of the fiscal position.

While noting the steps being taken to develop a strong and competitive financial system, Directors stressed that restructuring of the banking sector was a priority task. Delays in solving the problems of four state-owned banks could hamper private sector development, particularly the small- and medium-sized enterprises, and threaten the recovery of the non-oil economy. Thus it was essential that the privatization of both the International Bank and the Savings Bank be completed according to schedule, and that quick and firm actions be taken to address the problems of the other two state-owned banks. Close cooperation between the central bank and ministry of finance was seen as essential to ensure success in these efforts. Noting thatone-third of banks were not in compliance with prudential regulations, Directors stressed the importance of stricter enforcement and improved banking supervision.

Directors welcomed the authorities’ plan to tackle governance issues forcefully and to improve fiscal transparency. They stressed that this had to be accomplished through a strengthening of the legal framework along market-oriented lines, improved financial control and accountability in the public sector, increased transparency in the privatization process, and, more generally, a reduction in the scope of government intervention in the economy. They commended the authorities’ intention to overhaul the government’s administrative structure, so as to improve the efficiency and effectiveness of public services, and urged them to complete the preparatory work quickly and move forward with the implementation of administrative reform in the 1999 budget.

Directors supported the authorities’ policy of saving part of the oil-signature bonuses resulting from production-sharing agreements with foreign oil investors, and welcomed the establishment of a working group to make early plans for the optimal use of future oil revenues. They encouraged the authorities to establish an institutional mechanism that would preserve wealth for future generations, but stressed that any such mechanism should make fully transparent the use of the funds.