Azerbaijan: Aide Mémoire for the 2008 IMF Staff Visit Discussions
December 16, 2008
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.
Against the background of the ongoing global financial turmoil and incipient recession, the mission discussed with the authorities economic developments in Azerbaijan during 2008, the 2009 budget, and the short-term outlook and policy responses to the impact of the crisis on the domestic economy. Starting from a strong economic situation at the onset of the crisis, and given its still limited integration in the global financial system, Azerbaijan is expected to weather the short-term impact of the crisis relatively well under the current policy plans. The yet unknown scope of the global recession, its impact on neighboring trading partners, and the reaction of investors and consumers in Azerbaijan, make this preliminary assessment subject to a larger than usual degree of uncertainty.
1. The economy maintained a very strong growth performance over the first 10 months of 2008. Growth in the oil sector is estimated at 10 percent, notwithstanding some slowdown since August, due to external events and technical disruptions to offshore production. Non-oil activity responded strongly to the exceptional fiscal stimulus and growth accelerated to about 15 percent, led by a robust expansion in construction, services and agriculture. Inflation rose above 20 percent between April and October, on account of buoyant domestic demand, driven by an expansionary fiscal policy and an accommodative monetary stance, in the context of rising international food and commodity prices, and persistent domestic supply constraints. Booming oil exports and prices up to August, and the contractual shift in the profit-sharing ratio of the oil consortium in favor of the government in 2008, have all contributed to a major strengthening in the external position and to the accumulation of substantial foreign assets. At end-September, Azerbaijan's gross official reserves and state oil fund assets jointly reached $16 billion, six times the size of public external debt.
2. The ongoing global financial turmoil has so far had limited impact on Azerbaijan's financial sector, but a credit slowdown may be forthcoming. An undeveloped financial market, the rather low dependency of domestic banks on "hot" capital inflows, and a very strong international reserve position helped to shield Azerbaijan from the early impact of the crisis. In addition, the Azerbaijan National Bank (ANB) responded quickly and appropriately to the situation. In April, the ANB started tightening liquidity to slow down rapid credit growth and strengthened prudential regulations and supervision, to counter banks' inadequate risks assessment and management practices. As a result, banking soundness indicators at end September showed that Azerbaijan's banks entered this period of turmoil and uncertainty in a relatively solid position, and standard stress testing results pointed to the system's good resilience to shocks. When external and domestic liquidity conditions reversed in October, the ANB promptly reduced reserve requirements and policy rates, and signaled its willingness to provide temporary liquidity to solid banks that had been hit by the unexpected reversal of inflows from foreign banks. However, after a few years of rapid credit expansion, banks portfolios are likely to be particularly sensitive to a now expected slowdown in economic growth and the quality of loans is likely to deteriorate, reducing banks' earning potential and their capacity to extend new credit.
3. The economic outlook remains relatively benign, but highly sensitive to the unstable external environment and the performance of the oil sector. The global slowdown has provided Azerbaijan with the immediate benefit of reversing the high inflation trend that has afflicted the economy since late 2005. A sharp decline in international food and commodity prices reduced year-on-year inflation to 19 percent at end-November and end-2008 inflation is now projected at 17 percent. A further slowdown in oil growth to 6 percent at year-end and the fall of oil prices entail a slower accumulation of foreign assets during the last quarter of 2008. Still, the end-2008 external position will be stronger than envisaged under the supplementary 2008 budget. Non-oil GDP growth will also decelerate to 13 percent in response to global developments. The 2009 outlook is quite uncertain. Assuming some persistence of the offshore technical problems up to March-with oil and gas production plans otherwise fully implemented-oil sector growth should rise to 18 percent. If the moderate fiscal expansion of the 2009 budget is fully implemented, while banks pace down their credit activity to strengthen their balance sheet, non-oil growth would decelerate to 6 percent. Inflation is projected to decline to 9 percent by end 2009, reflecting falling international food and commodity prices and cooling domestic demand. The external position would remain strong and the accumulation of strategic foreign assets should continue, albeit at a slower pace. The outlook is subject to downside risks, mainly related to a further decline in oil prices and technical impediments to the realization of the 2009 oil extraction plans. Unfavorable economic developments in the region could also negatively affect non-oil sector activity.
4. The mission welcomes the more moderate pace of fiscal expansion in the 2009 budget. The 2009 fiscal plans are reasonable despite what now appears a too optimistic assumption on oil prices. A reassessment of the budget towards mid-year would provide the benefit of some more clarity regarding the consequences of the ongoing financial crisis and global economic slowdown, both on oil and non-oil domestic activity. The mission believes that recently implemented and planned structural reforms would help support non-oil activity in Azerbaijan. However, if the global recession turns out to be deeper and domestic non-oil growth decelerates quicker than expected during the first half of 2009, the mission believes that, in contrast to other countries in the region, the solid foreign asset position of Azerbaijan and the expected overall fiscal position provide sufficient room to withstand a possibly severe economic slowdown.
5. Progress in strengthening the quality and efficiency of public investment becomes even more urgent in the current context. The mission welcomes the recent adoption of the decree to establish clear rules for the selection, execution, monitoring and auditing of public investment projects, and looks forward to the new guidelines being finalized before mid-year. We also encourage the authorities to undertake a serious attempt to evaluate the results of the large public investments of the last three years with respect to their original objectives. This exercise would provide useful lessons on what worked well and what did not in the implementation of public investment projects. In addition, the government should make progress towards preparing the annual budget spending plans of the various ministries in the context of a detailed medium-term expenditure framework. This is particularly relevant for multi-year investment programs, which should be fully disclosed in the budget document that is submitted to the Parliament.
6. Monetary policy needs to strike a better balance between ensuring that inflation expectations set firmly on a downward trend and the support of non-oil growth. The mission assessed that the reduction of policy rates by 7 percentage points over 2 months was excessive-particularly with inflation still in the high double digits-and much larger than the policy loosening pursued by lower-inflation countries in the region. Even under the expectation of a substantial decline in inflation, policy rates at the current level would remain negative in real terms in 2009. In addition, given that the transmission mechanism does not seem to work, rate cuts are not likely to have the intended effect on banks' lending rates, hence on economic activity. We recommend that the ANB do not reduce the policy rates from the current level until inflation expectations are more firmly anchored to lower levels.
7. The ANB decision to avoid a basket-induced depreciation of the dollar/manat exchange rate at a time of high uncertainty was, on balance, well grounded. On the one hand, this decision implied that that the use of the two-currency basket regime, which had been successfully implemented by market participants since late March, was temporarily suspended. On the other hand, the major volatility in the exchange rate between the two currencies in the basket peg of the manat (the dollar and the euro) would have implied a notable depreciation of the manat against the dollar, with the potential of triggering panic and re-dollarization. The mission recommends that as soon as excess volatility in the bilateral exchange rate of the basket currencies subsides, the ANB return to the full implementation of the two currency basket exchange rate regime. This system has served the country well by introducing the idea of two-sided exchange rate risk to market participants. More exchange rate flexibility will be essential if the ANB still plans to move to inflation targeting in the future.
8. Banks in Azerbaijan will face new risks arising from the impact of the global financial crisis and domestic economic slowdown. Strong supervisory vigilance by the ANB is therefore critical. Reported capital adequacy and liquidity ratios of the banks remain satisfactory and on average well above minimum requirements. The 2009 budget provision to inject additional capital into IBA will further strengthen capital adequacy in the system. Banks' profitability has remained strong in 2008, but asset quality is deteriorating, and some banks will likely face difficulties to rollover foreign loans that are due in 2009. With the quality of some assets in banks' portfolios worsening, the ANB will need to ensure that banks provision adequately for rising non-performing loans. Moreover, should real estate prices deteriorate, it is important that banks increase provisioning for the declining value of collateral, unless additional assets are pledged to back up loans. Over the last couple of years, the ANB has been reinforcing its supervision capacity and has tightened prudential regulations in the face of rapidly increasing risk-taking by banks. The recent understanding it has reached with some banks on monitorable plans to reduce excessive credit risk is a welcome development. In addition, the ANB has established high-frequency monitoring of liquidity conditions and is well informed on the upcoming maturities of banks foreign loans for the whole of 2009. The mission considers that, if needed, the authorities are prepared to provide assistance to solvent banks that may face temporary liquidity crunches, including through the ANB lender-of-last-resort facility.
1 An IMF mission team visited Azerbaijan during December 10-17, 2008. The team would like to thank the authorities for the frank and informative discussions during its stay. The mission reviewed recent economic and financial developments, particularly the 2009 budget and the impact of the ongoing global financial crisis. This statement represents the mission team's views, and not necessarily those of the IMF.