Republic of Azerbaijan: Concluding Statement of the IMF Mission
September 25, 2007
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
An IMF staff team from the Middle East and Central Asia Department led by Vitali Kramarenko visited Baku during August 30-September 6, 2007 to discuss:
(i) macroeconomic policies for the remainder of 2007 and (ii) the draft 2008 budget and the underlying macroeconomic framework.
The mission would like to thank the authorities for their excellent cooperation and warm hospitality.
Azerbaijan has started to benefit from a large but temporary oil production boom. Increased oil-related financial resources have enabled the government to boost population's incomes and scale up development expenditure. These efforts have resulted in a significant poverty decline and supported growth in nontradable activities. However, inflation is running in double digits, the real effective exchange rate appreciation is accelerating, and the growth in the tradable non-oil sector is slowing down.
The authorities' intention to realize expenditure savings in 2007 and reduce significantly the non-oil primary fiscal deficit in 2008 are steps in the right direction in addressing key macroeconomic risks. The current fiscal plans, if accompanied with greater exchange rate flexibility, are consistent with a gradual reduction in inflation while providing adequate resources for financing the government's development agenda. Moreover, the envisaged fiscal adjustment would reduce real appreciation pressures and would put the non-oil primary fiscal deficit onto a more sustainable path.
In what follows, this statement describes recent developments and a short-term macroeconomic scenario. This scenario reflects the mission's evaluation of the current draft 2008 budget and assumes a more proactive monetary policy. The statement also highlights options for additional fiscal measures (2-3 percent of non-oil GDP), which, if adopted, would help achieve faster disinflation.
Real and external sector developments continue to be dominated by the dynamism of the oil sector. In the first half of 2007, rapidly increasing oil production boosted real GDP growth to 35 percent year-on-year and contributed to a further strengthening of Azerbaijan's net external position. At the same time, non-oil real GDP growth, excluding oil and gas transportation, is estimated to have decelerated to 6.9 percent year-on-year from 8.2 percent in 2006.
Expansionary macroeconomic policies stimulated rapid domestic demand growth, fueling the inflation of consumer prices and real estate valuations. Budgetary expenditure increased by about 50 percent year-on-year in the first half of 2007 on the heels of an 80 percent increase in 2006. In the face of the rapid fiscal expansion and sizeable banks' external borrowing, monetary policy remained accommodating in the context of a de facto slowly appreciating crawling exchange rate peg to the dollar, which resulted in rapid money and banking credit growth. Against the backdrop of capacity constraints, the resulting buoyant domestic demand growth fueled inflation which has stayed at about 15 percent in recent months. Also, real estate prices have increased by 40 percent since the beginning of the year.
Short-term macroeconomic outlook
Near-term fiscal policy intentions are broadly consistent with gradual disinflation. The government intends to exercise fiscal restraint in the fourth quarter of 2007, and the current draft 2008 budget targets a significant moderation in expenditure growth. These efforts, if accompanied with greater exchange rate flexibility, would result in a decline in the officially reported inflation rate by end-2008 from the current level of about 16 percent.
Exceptionally rapid growth and a further strengthening of the external position are projected to continue. A large increase in oil production is expected to maintain real GDP growth at about 30 percent in 2007 and 23 percent in 2008, and to further strengthen the external position. Non-oil real GDP growth, excluding oil and gas transportation, is projected to decelerate to 7 percent in 2007 and 6.5 percent in 2008, in part reflecting a further real effective exchange rate appreciation that is expected to occur mainly on account of the fiscal expansion undertaken in recent years.
The authorities' intention to reduce the non-oil primary fiscal deficit from the budgeted level in 2007 is a step in the right direction. The budgeted increase in non-oil revenues of 33 percent appears realistic. Regarding expenditure, the mission welcomes the authorities' intention to achieve current expenditure savings. It also believes that additional savings could be realized by (i) curtailing explicit energy subsidies in light of the recent progress in improving collection on utility payments; and (ii) introducing stricter vetting procedures for selecting investment projects.
The non-oil primary fiscal deficit would be reduced to about 36 percent of non-oil GDP in 2008 from 40 percent in 2007 based on the mission's evaluation of the current draft 2008 budget. The envisaged fiscal tightening would contain domestic demand growth and reduce the fiscal dominance over monetary policy. In addition, it would help reduce the extent of real exchange rate appreciation, mitigating external competitiveness pressures. At the same time, the government will be able to continue its program of poverty reduction and economic modernization without overstretching its implementation capacity. From a longer-term perspective, the reduction in the non-oil primary fiscal deficit to 36 percent of non-oil GDP in 2008 is warranted by fiscal sustainability considerations, and it would need to be further reduced to about 20 percent of non-oil GDP by 2012 to conform to the long-term oil revenue management strategy.
The current draft 2008 budget appropriately targets a significant moderation in expenditure growth, but more adjustment can be achieved. This moderation is largely attributable to the elimination of explicit energy subsidies (3 percent of non-oil GDP). To achieve this goal, the authorities should intensify their efforts to increase collection on utility tariffs from customers and ensure timely tax payments by utility and energy companies. While the capital expenditure-to-non-oil GDP ratio is expected to decline by 2 percentage points in 2008, its intended nominal increase of about 14 percent would provide sufficient resources to continue with the projects underway and start new critically important projects. In this regard, the mission advises the authorities to make faster progress in improving the management of the public investment program in cooperation with the World Bank and bilateral donors. In addition, the mission sees some scope for cuts in expenditure on goods and services that is projected to increase by 2.5 percent of non-oil GDP. With respect to other current expenditure, the envisaged increase in the wage bill and social spending would ensure a further increase in the real incomes of the public sector employees and those benefiting from pensions and social assistance.
While the authorities' determination to implement tax administration measures deserve full support, the targeted increase in non-oil revenue of about 35 percent is subject to a significant downside risk. The mission estimates that a 27-30 percent increase in non-oil revenue is a more realistic target which fully accounts for the buoyancy of imports and domestic demand. In addition to tax administration measures, the authorities are advised to consider a reduction in VAT exemptions and in implicit energy subsidies (which are not envisaged in the current draft 2008 budget) with a view to modestly reduce direct tax rates, easing external competitiveness pressures on the private sector.
The mission also encourages the authorities to implement the following fiscal management measures in the context of the 2008 budget approval process in cooperation with the World Bank and bilateral donors:
• Building on the work of the recently established interagency macroeconomic forecasting group and analytical studies of the oil fund, submit to parliament a medium-term fiscal framework containing: (i) detailed estimates of oil wealth; (ii) a medium-term path for the non-oil primary fiscal deficit consistent with fiscal sustainability, including the assessment of risks associated with temporary deviations from this path; (iii) a quantified medium-term expenditure framework, including a list of public investment projects; and (iv) the budgets of the state-owned enterprises of macroeconomic importance.
• Strengthen the auditing capacity of the chamber of accounts (supreme audit institution).
Monetary policy and banking system stability
Fiscal restraint should be accompanied with an immediate monetary policy tightening to achieve disinflation and reduce the risk of entering a price/wage spiral. Allowing for greater exchange rate flexibility and adopting manat base money as the primary operating target of monetary policy will help pursue a more proactive monetary policy. To tighten monetary conditions, the Azerbaijan National Bank (ANB) should scale down its unsterilized purchases of foreign exchange, which is key to reducing the 12-month manat base money growth to about 80 percent by end-2007 and about 40 percent by end-2008. Reduced intervention would lead to faster nominal exchange rate appreciation. The mission also recommends making the refinancing rate positive in real terms for signaling purposes and allowing interest rates on ANB notes and treasury bills to increase while ramping up offered amounts. Base money targets and interest rates should be reviewed in a timely manner if the inflation forecast starts to deviate from the desired disinflation path.
While the banking system appears resilient to likely shocks, rising credit risk should be closely monitored. All officially reported banking system prudential indicators, including those pertaining to asset quality, have strengthened, and compliance with prudential regulations has improved in recent months. Furthermore, the authorities' stress tests show that the banking system is resilient to interest and exchange rate shocks of moderate magnitude. However, rapid credit growth raises concern about a potential deterioration in banks' loan portfolios, which may only manifest itself with a lag. Therefore, the ANB should continue to strengthen its capacity in analyzing credit risk and to review the adequacy of the banks' risk management policies and procedures. Moreover, decelerating credit growth through a monetary policy tightening as described above would reduce credit risk. In this regard, risks associated with a monetary policy tightening (e.g., exchange rate appreciation and higher interest rates) appear to be manageable and lower than those stemming from a potential deterioration in credit quality.