Azerbaijan Republic and the IMF

Press Release: IMF Completes Third Review Under Poverty Reduction and Growth Facility Arrangement with the Azerbaijan Republic
December 19, 2003

Country's Policy Intentions Documents

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Azerbaijan RepublicLetter of Intent
December 4, 2003

The following item is a Letter of Intent of the government of Azerbaijan Republic, which describes the policies that Azerbaijan Republic intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Azerbaijan Republic, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

Mr. Horst Köhler
Managing Director
International Monetary Fund
700 19th Street
Washington, DC 20431

Dear Mr. Köhler:

1. On May 14, 2003, the IMF Executive Board endorsed the completion of the second review under Azerbaijan's Poverty Reduction and Growth Facility (PRGF) arrangement, which is in support of our economic reform program. We would like to take this opportunity to inform you about our continuing implementation of this program, as well as our policy intentions for the rest of 2003 and 2004, and to propose revised performance criteria, indicative targets and structural benchmarks for end-December 2003, as well as for 2004. This letter should be read as additional to our original letter of intent and Memorandum of Economic and Financial Policies, dated June 15, 2001, as well as our letters of February 6, 2002 and April 23, 2003.

2. Our performance relative to the quantitative performance criteria and indicative targets for end-March, end-June and end-September 2003, as well as the proposed quantitative performance criteria and indicative targets for December 2003 and 2004 are presented in Table 1. Performance relative to these targets and criteria will be measured as detailed in Annex I of our April 23, 2003 letter. The fourth and fifth reviews under our PRGF arrangement are scheduled for completion by February 15, 2004 and August 15, 2004, respectively.

3. The proposed performance criteria and indicative targets, as well as our program policies and objectives described below, are fully consistent with our State Program for Poverty Reduction and Economic Development (SPPRED).

Macroeconomic Developments

4. Macroeconomic developments continue to be consistent with our program targets, with real GDP growth in the first nine months of 2003 of 10.4 percent compared to the same period a year earlier, and 12 month consumer price inflation through October of 2.6 percent. All quantitative and structural performance criteria for end-June 2003 were met, as were all but two indicative targets for end-March, end-June and end-September 2003. While the reserve money target was exceeded modestly on all three dates, in light of the continuing low inflation it is clear this higher reserve money reflects more rapid than anticipated recovery in manat money demand. In addition, the target on unpaid budgetary expenses was exceeded by about 0.2 percent of GDP at end-March, with these excess unpaid bills almost eliminated by end-June. As of end-September, the stock of unpaid bills was within program targets. The temporary increase in unpaid bills was the result of selected ministries that had received allocations to pay their bills, but had not yet done so. To address this issue, the Ministry of Finance will issue instructions to all ministries that, when they receive an allocation to pay a bill, that bill must be paid within 10 days. If the bills are not paid in that time period, future allocations to that ministry will be reduced.

5. The key energy sector investments—the Baku-Tbilisi Ceyhan oil export pipeline (BTC), the first phase of development of the Azeri-Chirag-Guneshli oil field (ACG), and the Shah-Deniz gas field and associated export pipeline—are proceeding according to plan. BTC should be operational in early 2005, in time for the oil from the first phase of ACG, while Shah Deniz gas should start flowing sometime in 2006.

6. We continue to believe the program targets for consumer price inflation and real GDP growth for 2003 remain appropriate. For 2004, we envision a slight decline in the real GDP growth rate due to a temporary slowdown in oil sector production, and will continue to target 2.5 percent annual inflation.

Progress on Structural Reforms

7. Structural reforms have been in line with our program commitments and objectives. The two end-June structural performance criteria, which focused on fiscal reforms, were met. First, the important amendments to the Budget Systems Law—which were drafted in close cooperation with Fund and Bank staff, and were designed to enhance the legislative foundation of the Oil Fund and ensure the full integration of its expenditures into a parliamentary-approved consolidated budget—were enacted in May 2003. In June we issued improved regulations on VAT refunds—the second structural performance criterion—which were designed in consultation with Fund staff. We have also met the end-June structural benchmark calling for the creation of a revenue forecasting commission; this commission has proven extremely valuable in improving the process of preparing revenue projections for the 2004 budget.

8. Other important fiscal reforms have also been implemented in 2003. First, the state oil company, SOCAR has worked closely with the Ministry of Taxes on a monthly basis to determine its legal tax liability, and has each quarter ensured that it fully met its tax obligations as determined by the Ministry of Taxes. As oil prices through September were higher than assumed in the budget, SOCAR's tax payments have exceeded the levels projected in the budget. Consistent with our program commitments, the Ministry of Finance has saved the additional revenues in the first two quarters of 2003 (73 billion manat, or 0.2 percent of GDP) as a cushion against possible future declines in oil prices and thus tax payments by SOCAR. The amount to be saved in the third quarter is being determined. Finally, we have continued to implement the reform program for the State Customs Committee, and our efforts to improve tax administration, including through increased reliance on performance indicators for the Ministry of Taxes; these performance indicators were designed in consultation with the former FAD resident advisor.

9. In one area our structural reform efforts have not met with as much success as we had hoped. While we have fully reflected the subsidies to Azerenergy and Azerigas in the state budget (a structural benchmark), and provided loans to Azerchemia to replace the previous quasi-fiscal subsidies from SOCAR, we have not yet had success in improving financial discipline in these enterprises and thereby reducing these subsidies—the ultimate objective of these reforms. Our efforts to reduce the subsidies have been made more difficult by the increase in oil product prices in early 2003. As a result, we will be taking a number of steps, discussed below, to strengthen our efforts to reduce these subsidies.

10. We have also continued to make significant progress in reforming the banking sector. While difficulties in finalizing the details of the draft new Banking Sector Law prevented us from adopting that law by end-June (the final structural benchmark for end June), we have now submitted that law to parliament.

11. The process of privatizing International Bank of Azerbaijan (IBA) has moved forward. Consistent with our intention to sell 20 percent of IBA to EBRD, thereby reducing government ownership of the bank to 30.2 percent, we signed a Memorandum of Understanding on this issue with EBRD in May 2003, and have hired a consultant to conduct an evaluation of the bank, in line with our goal of proposing to the EBRD the sale of a 20 percent share by end-2003. We are also well advanced in our restructuring of BUS Bank, to prepare it for privatization.

12. To facilitate the privatization of IBA, the ANB in July extended a 100 billion manat, 15-year loan to MOST Bank, at 2 percent interest and without collateral, which MOST Bank then used to purchase certain non-performing loans from IBA. MOST Bank purchased these assets, as it felt it had better opportunities to collect.

Monetary Policy and Financial Sector Reforms

13. We remain committed to adhering to the monetary program and targets previously established for 2003, except that, as money demand is recovering in 2003 more rapidly than had been expected when our monetary program for 2003 was first designed, we propose to accommodate this growing money demand by revising upward our reserve money indicative target for the year, as indicated in Table 1.

14. We will not, however, adjust the monetary program to accommodate the monetary implications of the MOST Bank loan. To offset the monetary impact of this transaction, and ensure that we are still able to adhere to the program performance targets on Net Domestic Assets of the ANB, the ANB is selling to banks government securities currently held by the ANB. In addition, ANB regulations have been revised to prohibit any loans with maturity greater than 6 months, and loans without proper collateral. These regulations will also be reflected in the new Central Bank Law, which we will submit to parliament in 2003, seeking its adoption in the first quarter of 2004. The ANB has entered into an agreement with MOST Bank, specifying steps the bank will take to ensure that it is in compliance with all prudential requirements, including an agreed timetable for increasing its capital base as needed. Finally, notwithstanding the maximum 15-year maturity, MOST Bank will be repaying this loan as it collects on the underlying credits; indeed, they have begun modest repayments already.

15. We have reviewed the draft Banking System Law, in cooperation with the staffs of the Fund and World Bank, to ensure that it is consistent with Basle Core Principles, and we will seek its passage by parliament by the end of 2003.

16. For 2004, we anticipate a continuation of the recovery of money demand, with velocity of manat broad money declining by roughly 10 percent. Our proposed 2004 monetary program is consistent with this growing money demand, as well as with the continuation of low inflation. We will continue our informal exchange rate targeting, which has served Azerbaijan well, allowing for modest nominal depreciation in 2004.

17. We will take all steps necessary to ensure the signing of a sales agreement on the sale of 20 percent of IBA to the EBRD before the end of 2003, and immediately after completing this sale we will announce a tender for the sale of all remaining government shares in IBA. As the discussions with EBRD have been complex, the process is not moving as quickly as we had hoped at the time of our April 23, 2003 letter to the IMF Managing Director. As a result, we will not be able to meet our previous objective of issuing a tender for all remaining shares of IBA by end-December 2003, and request that this performance criterion be revised, with a new target date of end-June 2004. We will also recapitalize IBA during 2004, to ensure that it is in compliance with capital adequacy requirements.

18. With regard to BUS Bank, we have issued a tender for consulting services, with the aim of privatizing this bank by end-2004, including by offering at least 25 percent of the bank to a strategic investor in the second half of 2004. We have decided, in consultation with Fund and World Bank staffs, to now allow BUS Bank to begin making loans for the first time—an important step in making this bank attractive to potential investors. However, to limit the risks to the government and to the financial system, the amount of such loans will initially be limited to not more than 5 percent of the bank's statutory capital.

19. In line with our efforts to improve competition in the banking system, in addition to privatizing these banks, the ANB has announced the elimination of the remaining ceiling on foreign bank participation. In 2004, the Ministry of Finance will, as a pilot project, tender for the provision of government banking services in at least three regions, as a first step toward full tendering for such services starting in 2005. We will ensure that the final version of the new Law on Accounting, a draft of which has already been submitted to Parliament, is fully satisfactory to the Fund and the World Bank, and that it is consistent with International Accounting Standards (IAS). To improve access to credit for our farmers, in consultation with Fund and World Bank staff, we have decided to merge our Rural Investment Fund and Agrocredit, creating a larger and more effective non-bank credit institution on the basis of a detailed business plan. Finally, once the FSAP report has been completed, we intend to move aggressively in implementing reforms recommended in that report.

Fiscal Policy and the 2004 Consolidated Budget

20. Azerbaijan is at an important juncture, as we prepare for the inflow of the growing oil revenue beginning in 2005. We are aware of the challenge this revenue confronts us with: the need to ensure that it is used to benefit our population, and that it does not become the resource curse that such revenue has been in many countries. We are also aware that this challenge is made even greater by the temporary nature of this oil revenue; according to current projections, our oil revenues will return to current levels within the foreseeable future.

21. As a result, we attach the highest priority to the development of a long term, coherent strategy for the use of oil revenue. We have created a commission, chaired by the Prime Minister and including the Ministers of Finance, Economic Development and Taxes, the chairman of the ANB, and the directors of SOCAR and the State Oil Fund (SOFAR). This commission is charged with preparing a long term oil revenue management strategy for consideration and approval by the Cabinet of Ministers and submission to the President no later than end-March 2004. This timing will ensure that this strategy forms the basis of the preparations of the 2005 budget. We will work in close cooperation with the Fund and World Bank staffs to develop this strategy, seeking to ensure that it is consistent with short run and long-term economic stability, and with our SPPRED. We will also ensure that this strategy is based on sound and transparent fiscal rules that limit the exposure of the budget to volatility in oil revenues. At the same time, we will work to further strengthen our Medium Term Expenditure Framework and Public Investment Program.

22. Our initial work on such a strategy has led us to conclude that we should gradually increase our use of oil revenue, but we are not yet ready to do that in 2004, as we are not sufficiently advanced in our preparation of this strategy. As a result, in our 2004 consolidated budget, the non-oil deficit, excluding BTC financing, is only modestly higher as a share of GDP than in 2003.


23. We will introduce several tax policy reforms with the 2004 budget; these reforms are intended to improve the efficiency of tax policy, facilitate tax administration, reduce the tax burden on the non-oil sectors of the economy, and encourage firms currently operating in the shadow economy to join the formal economy. First, we will reunify the enterprise profit tax for all non-oil enterprises, replacing the current tax rates, which vary from 10 to 25 percent, with a uniform rate of 24 percent. The only exception to this unified tax regime will be for the agriculture sector, where we will renew, on an unchanged basis, our long-standing tax exemption. We will also impose on selected highly profitable non-oil state owned enterprises a mandatory dividend payment, yielding 45 billion manat for the 2004 budget. The variations in the enterprise profit tax rates that have been in place in 2003 were an initial attempt to encourage economic development of Azerbaijan's regions. In lieu of these tax preferences, we will work with the staffs of the IMF and the World Bank to design and adopt a comprehensive program for regional development that is consistent with our broader policies.

24. Second, in an effort to ease the tax burden on the lowest income workers, and to simplify the personal income tax (PIT) system, we will increase the income exempt from the PIT from 100,000 manat to 150,000 manat per month. We will also replace the current three rate system (12, 25 and 35 percent), with a two rate system: 14 percent for virtually all incomes, and 35 percent for high income workers (above 3 million manat per month).

25. Third, we have reduced the list of VAT exemptions by 20 percent (based on 2002 import values). Partially offsetting these reductions, in light of the rising cost of grain in the region, we have temporarily extended VAT exemptions to grain imports from October 1, 2003; this exemption will be eliminated no later than October 1, 2004 and will not be renewed. We have also adopted a Cabinet of Ministers decree stating that, in the future, the VAT exemption list will only be revised by the Cabinet of Ministers once a year, in the context of the annual budget preparation.

26. Fourth, we are continuing the process of gradually reducing the number of imported goods subject to specific import duties, and reducing the weighted average import tariff. Following the changes that took effect on October 1, 2003, there is only one more step remaining. As a result, by April 1, 2004, specific import duties will only apply to excisable goods, and the weighted average tariff will have been reduced to 6.5 percent.

27. Finally with regard to revenues, we intend to build on our success in collecting taxes from SOCAR. In the 2004 budget, we will include in the budget our commitment to save any revenues resulting from oil prices higher than envisioned in the budget (US$20 per barrel), as a cushion against future price declines.


28. The main innovation in expenditures in 2004 will come from our increased use of Oil Fund money to finance high priority expenditures identified in our SPPRED. First, we have identified key infrastructure projects—including school construction, and the building of critical roads and sewerage systems—and will finance them through the budget. However, while there are great infrastructure needs in Azerbaijan, as a result of the massive energy sector investment projects underway the construction industry is growing rapidly. To avoid overheating in this sector, we are reluctant to increase total capital expenditures too rapidly. Therefore, we are targeting an increase in domestic and foreign financed capital expenditures in the consolidated budget of about 8 percent. In 2005, as BTC and other big investment projects wind down, we will increase capital expenditures in the budget more aggressively.

29. Second, we will continue our efforts to resettle refugees and internally displaced persons who have spent over 12 years living in tent camps and other similar housing.

30. There will be no substantial changes in current expenditures. In particular, there will be no wage or pension increases in 2004, except for targeted increases designed to align salaries for selected positions across ministries. These increases are primarily related to our attempts to improve governance and fight corruption. We will also begin to implement a civil service reform program, aimed at improving and simplifying the civil service salary grid; for 2004, the expected cost of this reform is manat 90 billion. If the civil service reform costs less than currently anticipated, the excess budgeted funds will not be spent.

31. Finally with regard to expenditures, we have reviewed the operations of the Baku Metro, and have included an increased allocation for that enterprise which should enable it to avoid arrears, and thereby eliminate what has been a quasi-fiscal subsidy of the metro. We will review the Baku Metro tariff during 2004, with the aim of reducing the fiscal subsidy. There will also be some increase in the allocation for subsidies to Azerenergy, Azerigas and Azerchemia, due to difficulties in controlling those subsidies, as discussed below. Indeed, it is now clear that the amount allocated for those subsidies in 2003 is inadequate. We have thus included in the 2004 budget a provision of manat 450 billion, for the remaining 2003 subsidies and offsetting tax credit for SOCAR.

Pension Reform

32. The government of Azerbaijan has embarked on an aggressive program of reform in the pension system, in consultation with the staffs of the World Bank and the Fund. First, we have transferred responsibility for calculating pensions to the Social Protection Fund (SPF), the organization responsible for paying them, from the Ministry of Labor, and have transferred the responsibility for paying family allowances to the Ministry of Labor from the SPF. The aim of this is to have full responsibility for pensions in the SPF, but to remove responsibility for family allowances from the SPF. All SPF receipts and payments will continue to be made through the treasury. To enhance the SPF's ability to monitor its financial flows, the appropriate offices of the Ministry of Finance will provide the SPF with reports every 10 days on all SPF payments made, by taxpayer. The SPF will then be able to reconcile, on a timely basis, the inflows into the SPF subaccount of the treasury single account with the reports made to it by taxpayers.

33. Second, we are in the process of creating individual accounts in banks or post offices for all pension recipients, into which future pension payments will be deposited. We are also preparing to issue electronic cards to pension recipients, so that they can withdraw their pensions from their accounts without need for interacting with bank officers. We will begin this in Baku, and by the end of 2004 hope to have equipped 45 percent of all pension recipients with such cards. Finally, we are in the process of reviewing international experience, with the aim of finding improved methods for paying pensions to rural pensioners.

External and Domestic Debt

34. Our public and publicly guaranteed external debt remains at very modest levels. We are continuing to work with Kazakhstan, Turkmenistan and Uzbekistan to resolve modest disagreements with them regarding external debts. The government of Azerbaijan has no overdue external debt obligations to other creditors. In addition, we have recently reached agreement on the rescheduling of Georgia's obligations to us, in line with that country's Paris Club agreement.

35. We are continuing our efforts to strengthen our debt management system and have requested technical and financial assistance for domestic debt management, as well as for upgrading of hardware and debt management software. We are also in the process of revising the Law on Public Debt and are seeking technical assistance in this regard.

Energy Sector Financial Discipline

36. We are continuing our aggressive efforts to strengthen financial discipline in the energy sector. In 2003, we have transferred what were previously quasi-fiscal subsidies—with SOCAR providing fuel without payment to Azerenergy, Azerigas and Azerchemia—into explicit budget subsidies or loans. This has increased the transparency of these subsidies, making it clearer both to policy makers and to the public how much the government is paying to subsidize these sectors, and it has ensured that the burden of these subsidies is borne by the government, not by SOCAR. Unfortunately, as noted above, these subsidies have continued to grow in 2003, rather than declining as we had intended.

37. There has been modest progress in improving collections from end-users, with gas and electricity collections rates of roughly 49 and 33 percent, respectively, in the first half of 2003. This has enabled Azerenergy and Azerigas to pay SOCAR for roughly 20 percent and 2 percent, respectively, of the fuel they have consumed so far in 2003, up from virtually zero in the past. However, energy consumption by these companies—particularly Azerenergy and Azerchemia—has grown substantially in 2003, greatly exceeding our expectations.

38. To begin the process of reducing these subsidies, and ensuring improved financial discipline in state owned enterprises (SOEs), the government has taken the following steps. First, we will seek for the first time to impose hard budget constraints on four of the largest SOEs—Azerchemia, Azerenergy, Azerigas, Baku Metro. These enterprises have all been required to produce detailed revenue forecast and expenditure plans for 2004, which are consistent with the 2004 state budget allowance for subsidies, and these plans will be reviewed and approved by the Cabinet of Ministers by end-January 2004. Second, the government will require these companies to report on the implementation of these plans, on at least a quarterly basis, to the Ministries of Finance, Taxes and Economic Development. These ministries will, in turn, report to the Cabinet of Ministers, who will take whatever decisions are necessary to ensure that the budgets are adhered to—including, if warranted, financial penalties and changes in management. These reports will be shared with the staffs of the Fund and World Bank, and will be the basis for ensuring strict government control of, and reduction in, subsidies. Starting with the 2005 budget, it is our intention that any remaining subsidies will be provided in cash from the state budget. Third, we will initiate IAS financial and energy audits of these companies during 2004, which will provide important information for our efforts to introduce structural reforms in these companies. Finally, the process of corporatizing these enterprises has begun, with the aim of establishing corporate boards and public reporting requirements for each of them by the end of 2004. Corporatization will be an important step toward our goal of privatizing these enterprises.

39. We have also begun considering, in consultation with the staffs of the Fund and World Bank, the design of a mechanism for the future automatic adjustment of domestic oil product and natural gas prices, to keep them in line with world market prices. In consultation with Fund and World Bank staff, we will design and adopt such a mechanism before the end of 2003. During the first quarter of 2004, we will consult with Fund and World Bank staff and reach a decision on the timing for the implementation of this mechanism. In addition, we are working with the staff of the World Bank to develop a mechanism for cushioning the vulnerable against the necessary adjustment in kerosene and diesel fuel prices-the two remaining oil products whose price remains below world market levels. Unfortunately, designing an effective, targeted safety net has proven more difficult than we had hoped, and we will not be able to implement this reform in 2004.

Program Monitoring

40. Our letter of April 23, 2003, paragraph 57, spelled out structural performance criteria and benchmarks for end-December 2003. As noted above, we request that the performance criterion on the issuance of a tender for all remaining government shares of IBA by end-December 2003 be revised, with the new deadline for this performance criterion now being end-June 2004. In addition to the commitments described there, we propose two additional end-December performance criteria: 1) the adoption of the new Banking System Law, as described in paragraph 15; and 2) the submission to parliament of the new Central Bank Law, with the Law clearly limiting the maturity of any central bank loans to not more than six months, and requiring acceptable collateral for all such loans.

41. We also propose the following structural performance criteria for end-March 2004: 1) the approval by the Cabinet of Ministers of a long-term strategy for oil revenue management, based on published fiscal rules that reduce the exposure of the budget to volatility in oil revenues; 2) the adoption of the Central Bank Law incorporating the provisions identified in paragraph 40; and 3) the approval, no later than end-January 2004, by the Cabinet of Ministers of annual expenditure plans and revenue projections for Azerchemia, Azerenergy and Azerigas for 2004. Finally, we propose that a Cabinet of Ministers review of the ministerial report on the implementation in the first quarter of 2004 of the expenditure plans and revenue projections of Azerchemia, Azerenergy and Azerigas, including the taking of any decisions that may be necessary to ensure these annual budgets are adhered to, be an end-June structural benchmark under this program.

42. The fourth review of our PRGF Arrangement will focus on continued progress in energy sector reforms—particularly on the process of controlling the subsidies to Azerenergy, Azerigas and Azerchemia, and the timetable for the full operation of the automatic adjustment mechanism for oil product and natural gas prices—banking sector reforms, and the development of a comprehensive long-term strategy for the use of oil revenue.

43. The government and the ANB believe that the policies discussed above, combined with the policies described in our previous letters and MEFP, are adequate to achieve the objectives of the program, but we will take any further measures that may become appropriate for the purpose. Azerbaijan will consult with the Fund on the adoption of these measures, and in advance of revisions to the policies discussed above, in accordance with Fund policies on such consultation.


Artur Rasi-zade
Prime Minister
Azerbaijan Republic
  Avaz Alekberov
Minister of Finance
Azerbaijan Republic

Farhad Aliev
Minister of Economic Development
Azerbaijan Republic
  Elman Rustamov
Chairman, National Bank
Azerbaijan Republic


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