Public Information Notice No. 03/67

Public Information Notice: IMF Concludes 2003 Article IV Consultation with the Azerbaijan Republic

June 4, 2003

On May 14, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Azerbaijan Republic.¹

Background

Azerbaijan's economic performance remains strong, owing to both a favorable external environment and prudent macroeconomic policies. Driven by a strong growth in oil-related foreign direct investments and associated spillover effects, real GDP grew 10.6 percent in 2002. Inflation remains low, with the 12-month CPI inflation at 3.3 percent as of end-2002. The gross international reserves of the National Bank of Azerbaijan (ANB) amounted to about US$720 million at end-2002, providing for 4 months of non-oil import coverage, and the deposits of the State Oil Fund of Azerbaijan (SOFAZ) grew to nearly US$700 million by year-end. The sanctioning of the Baku-Tbilisi-Ceyhan (BTC) oil pipeline, and of the associated full field development of the Azeri-Chirag-Guneshi oil field in 2002, will contribute to a sharp boost in foreign direct investments (FDI) through 2005, and in oil and gas exports thereafter.

The stance of fiscal policy remained prudent in 2002. Tax revenue collection increased by about 1 percent of GDP in 2002 relative to 2001, while nontax revenue and grants as a share of GDP remained broadly unchanged. Increases in expenditures during 2002 exceeded the improvement in revenue collection, largely due to investment spending, including on the BTC pipeline. This resulted in a modest increase in the non-oil deficit relative to 2001. The non-oil deficit, however, remained below the sustainable level, consistent with the authorities' intentions to very gradually increase their use of oil revenue.

There was a modest increase in real monetary aggregates during 2002, almost entirely due to foreign currency deposit growth. Reflecting the growth in deposits, bank credit to the economy grew by about 17 percent in 2002 (following 12 percent growth in 2001). Nominal interest rates continued to decline during 2002, but spreads between deposit and lending interest rates remain high at nearly 10 percentage points.

The nominal exchange rate of manat vis-à-vis the US dollar has remained fairly stable, with the ANB intervening in the foreign exchange market largely to smooth temporary fluctuations around a modestly depreciating trend. The real effective exchange rate depreciated by over 8 percent during 2002, following a depreciation of about 6 percent in 2001, continuing a trend that has been ongoing since mid-1999, thus supporting the competitiveness of the Azeri economy.

Azerbaijan's external position improved further during 2002. Oil sector exports grew 11 percent during the year, largely due to higher oil prices relative to 2001, and non-oil exports grew by about 25 percent, led by agricultural and chemical products exports. While the current account deteriorated compared to 2001, this reflected a surge in oil-sector related imports, which were more than financed by higher net FDI. Public and publicly guaranteed external debt remained unchanged during 2002, at about 23 percent of GDP.

Structural reforms continued throughout 2002, and the authorities accelerated implementation of key reforms towards late-2002. Significant progress has been made in enhancing financial discipline in the energy sector, with quasi-fiscal subsidies in the energy sector reduced from over 22 percent in 2000 to about 11 percent in 2002. In addition, the domestic prices of natural gas, crude oil and oil products have been unified with estimated long-term world market prices, except for kerosene and diesel fuel due to social concerns. The authorities are committed to bring the prices for these two products to world market levels in 2004, as they develop a safety net to protect vulnerable elements of the society. The authorities have also made significant progress on a number of governance issues. The reforms in tax and customs administrations continued during 2002-including a 40 percent reduction in the number of tax officials, combined with a significant increase of salary for remaining staff-and the number of businesses requiring licenses was reduced by about 85 percent during the year. During 2002 there were some modest tax reforms, consisting of small reductions in the payroll and profit tax rates, as well as several measures aimed at broadening the tax base. The Poverty Reduction Strategy Paper that was approved in early 2003 is well-designed and based on broad consultative process. Its effective implementation should contribute greatly to reducing poverty in Azerbaijan.

Executive Board Assessment

Executive Directors commended the authorities for Azerbaijan's continued strong macroeconomic performance during 2002, reflected in double-digit and broad-based GDP growth, maintenance of inflation at a single-digit level, stability in the foreign exchange market, and an increase in international reserves. Directors noted that, while a favorable external environment had contributed to this positive outcome, the prudent financial policies adopted by the authorities and-despite some delays-progress in structural reforms had played an important role. In particular, they welcomed the actions taken to develop infrastructure for the effective management of the country's oil wealth and improve the transparency of this process.

Directors noted, however, that despite these impressive macroeconomic achievements, poverty remains pervasive in Azerbaijan and the economy is heavily dependent on the oil sector. They stressed that, to consolidate macroeconomic gains, strengthen the basis for sustained and diversified economic growth, and alleviate poverty, the authorities should develop a medium- and long-term strategy for the use of the expected boom in oil revenues and for putting the energy sector on a sound financial footing, and should continue the aggressive implementation of structural reforms.

Directors agreed that monetary and exchange rate policies remain appropriate, and should continue to aim at maintaining low inflation while preserving the competitiveness of the economy. They observed, however, that the planned increase in oil fund spending for 2003 and over the medium-term, as well as the expected strong increase in oil-related foreign direct investment flows during 2003-2005, will present challenges for the Azerbaijan National Bank (ANB) as it seeks to sterilize the resulting increase in liquidity and maintain the competitiveness of the economy. In that context, Directors supported the ANB's plan to increase the range of monetary policy instruments, including the issuance of ANB bills. Nevertheless, in view of the present limited scope for open market operations, Directors stressed that fiscal policy remains the key tool for macroeconomic management, and encouraged the authorities to strengthen policy coordination between the Ministry of Finance and the ANB as planned.

Directors noted that the prudent fiscal policy adopted by the authorities has been vital to maintaining low inflation and keeping public and publicly-guaranteed debt at moderate levels. They welcomed the focus on the non-oil deficit for assessing the overall fiscal policy stance. Directors agreed that, in view of pressing needs for infrastructure and social spending, the moderate increase in the non-oil deficit in 2003 is appropriate, and also consistent with a long-term strategy of conserving a significant share of oil revenues for future generations. They encouraged the authorities to save any higher-than-budgeted oil revenue in 2003 to provide a cushion against possible future declines in oil prices.

Directors were encouraged by the authorities' plans to strengthen fiscal management and improve the tax system. In this context, they welcomed the recent passage of the draft amendments to the Budget Systems Law, which will ensure closer integration of the state and oil fund budgets into a comprehensive budget and improve accountability. Directors also welcomed the authorities' commitment to reunify enterprise profit tax rates in 2004, and to broaden the tax base including through a significant reduction in VAT exemptions. They expressed concern, however, that the planned introduction of special economic zones (SEZs) could undermine tax and customs administrations reforms and lead to a significant erosion of the tax base. Directors urged the authorities to carefully reconsider the introduction of SEZs, and in any event, to limit tax incentives to standard exemptions of indirect taxes related only to exports.

Directors underscored that financial discipline in the energy sector remains key to macroeconomic stability and economic efficiency in Azerbaijan. They commended the authorities for the energy sector reforms introduced in recent years, including steps to make energy subsidies explicit in the 2000 budget, which have contributed to a significant reduction in explicit and implicit energy subsidies. They were also encouraged by the recent unification of nearly all domestic energy prices with estimated long-run world market prices. Directors, noted, however, that energy-related subsidies remain considerable and urged the authorities to continue energy sector reforms, including by further increasing collections for utility services, and accelerating the restructuring of the State Oil Company of Azerbaijan Republic and the utility companies. They also encouraged the authorities to introduce in 2004 a mechanism for adjusting domestic energy prices regularly to keep them broadly in line with world market prices, while mitigating any adverse impact on the most vulnerable groups.

Directors noted the ongoing reforms in the banking sector, but expressed concern at the slow progress in privatization of the International Bank of Azerbaijan and BUS Bank. Directors welcomed the recent presidential decrees establishing timetables for their privatization and instructing the government to accelerate efforts to privatize these two banks. Directors also urged the authorities to accelerate other financial sector structural reforms to help deepen financial intermediation, including adoption of a new Banking System Law, strengthened enforcement of the bankruptcy law, improved regulations related to the use of collateral, and enhanced competition in the banking sector including through increasing the participation of foreign banks and tendering for government banking services.

Directors encouraged the authorities to continue efforts to improve governance, which they considered crucial to improve the investment climate and prospects for private sector-led growth. In this connection, Directors noted that the creation of the oil fund has contributed to a significant improvement in the transparency of the use of oil revenues. They were also encouraged by continued reform in tax and customs administrations, and the significant reduction in the number of businesses requiring licenses.

Directors commended the authorities for the broad participatory process in preparing Azerbaijan's State Programme on Poverty Reduction and Economic Development, which provides a comprehensive development strategy for poverty alleviation. They stressed that to ensure a successful implementation of this strategy, the sequencing for priority actions needs to be closely linked with annual budgets through the Medium Term Expenditure Framework and Public Investment Program. In this context, Directors encouraged the authorities to continue institutional capacity building within the government for strategy formulation, implementation, monitoring and evaluation, and resource management.

Directors welcomed the quality and timeliness of the data provided by the Azeri authorities, while urging them to address the remaining weaknesses as summarized in the recently published data module of the Report on the Observance of Standards and Codes, with a view to eventual participation in the Special Data Dissemination Standard.