Republic of Azerbaijan and the IMF
I. ECONOMIC BACKGROUND
1. The economic reform program which the Azerbaijan authorities have implemented from early 1995 has succeeded in achieving sustained financial stability and rising economic growth. Consumer price inflation was close to zero throughout 1997 and 1998, and real GDP growth rose from 6 percent in 1997 to 8½ percent in the first three quarters of 1998. Although the oil sector remains the main engine of economic growth, there were welcome signs of a broadening of the recovery in 1998, with increases in output in agriculture, services and industry, though recently non-oil activity appears to be slowing again. In the oil sector, exports of crude oil from the new fields began in November 1997 and have risen more rapidly than expected, and seven new oil exploration contracts with foreign consortia were concluded during 1998. Foreign direct investment has amounted to US$1.1 billion in 1998 (nearly US$150 per capita), about one quarter of which went to the non-oil sector.
2. While the pace of structural reforms has slowed lately, important progress has nonetheless been made in implementing the reforms needed to transform Azerbaijan into a market economy. The foreign trade regime and domestic prices have been liberalized. Small scale privatization has been completed. A thorough restructuring of the banking sector has begun, and banking supervision strengthened. The tax system is being modernized and the tax administration strengthened, and an effective treasury system has been introduced to improve expenditure management. However, the pace of private sector development, and reform of the public sector to improve governance, have been slower than planned over the past year, and much remains to be done in these areas to complete the transformation.
3. Two severe external shocks experienced during the year have been instrumental in delaying the implementation of the structural reform agenda. First, the economy was badly hit by the collapse of the world oil price early in 1998. This had a major impact on government revenues, which are likely to be 3 percent of GDP lower than budgeted in 1998. Despite substantial cuts in expenditures and efforts to strengthen tax collections, the fiscal deficit in 1998 is likely to exceed the budget target by perhaps ¾ percent of GDP. In addition, lower oil exports have increased the current account deficit and led to a lower-than-expected accumulation of official reserves, with the manat appreciating by less than was previously envisaged.
4. These external effects have intensified as a result of a second shock associated with the crisis in Russia. Initially, the psychological impact of developments in Russia led to pressure on the exchange rate as Azeri residents sought to exchange manats for dollars. However, through intervention and a tightening of liquidity, the Azerbaijan National Bank (ANB) succeeded in holding the exchange rate and restoring confidence. Over the longer term, however, the balance of payments will be adversely affected by a drop in import demand from Russia—still Azerbaijan's largest export market, accounting for around a quarter of total exports in 1997—and by increased caution by potential foreign investors in the region. These developments will inevitably impact adversely on economic growth and increase the need for balance of payments financing.
5. The challenge in the period ahead will be to adjust macroeconomic policy to cope with these shocks so as to maintain financial stability, and, in this more difficult external economic environment, refocus attention on structural reforms to eliminate constraints on the growth of the non-oil economy.
6. To meet this challenge, the strategy for 1999-2001 aims at accelerating the market transformation through an ambitious program, building on the policies set out in the Policy Framework Paper for 1998-2000, to raise living standards for the whole population by ensuring that the benefits of oil development are widely spread. Macroeconomic policies will focus on maintaining a stable financial environment through tighter liquidity and further fiscal consolidation, so as to avoid "importing" higher inflation from neighboring countries, while avoiding excessive real exchange rate appreciation which could stifle growth of output and jobs in the non-oil sector.
7. The key to sustaining broad-based growth lies in an intensification of structural reforms in the following priority areas:
a strengthening of governance through deep reforms of the public sector, including improved expenditure management, civil service reform and downsizing, restructuring of the central administration, and judicial reform—all designed to improve the delivery of public services and to free the private sector from unnecessary interventions by the public bureaucracy; reforms of the tax administration and tax policy, to raise revenues and encourage balanced growth and business development; completion of the restructuring of the banking sector, and development of markets for government and corporate securities, to ensure adequate financing will be available for viable investments; a deepening and broadening of the privatization process, by extending it to larger and more valuable enterprises, increasing the involvement of foreigners, and improving the auction procedures for medium and large enterprises; reform of public enterprises, including the state oil company (SOCAR) and the power sector—which play a key role in the chain of payment arrears throughout the economy—and preparation for their eventual privatization; completion of the privatization of agricultural land and distribution of land titles, and a recasting of the government's role in the agricultural sector to focus on support for essential infrastructure investment-in recognition of the important role a successful agricultural sector could play in generating jobs and distributing income widely.
8. Full implementation of these policies is projected to lead to real GDP growth averaging around 7 percent a year in 1999-2001, underpinned by an increase in the investment ratio from 35 percent of GDP in 1998 to 45 percent in 2001 (Table 2). While most of the investment will continue to be in the oil sector, non-oil and public sector investment are also projected to increase. Rising investment will be financed largely by foreign direct investment, and the current account deficit will increase further to 38 percent of GDP in 2001, before declining in later years as oil exports rise strongly. After declining in 1998 reflecting lower growth in non-oil GDP, national savings are projected to rise, on account of fiscal consolidation, rising real incomes, and improved confidence in the banking system. Although the large external deficit is expected to be financed mainly by direct investment, recent external shocks from the oil market and Russia have increased the external financing need, and increased support from the international community will be needed to ensure that the balance of payments is fully financed.
9. The aim of fiscal policy will be to reduce the fiscal deficit of the general government, from an estimated 4¼ percent of GDP in 1998 to 1½ percent of GDP in 2001. Sources for financing the projected deficit will include oil bonuses, privatization receipts, program and project loans from the World Bank and other international donors, and treasury bill issues. There will be no net credit from the ANB to the government.
10. Although further expenditure reductions will be sought, the scope for an overall reduction in the expenditure-GDP ratio is limited, because of likely costs associated with structural reforms (e.g., interest payments associated with bank restructuring and severance costs associated with employment reduction). Deficit reductions will therefore depend mainly on measures to strengthen revenues, through both changes in tax policy and improvements in tax administration (paragraphs 29-30). Reflecting these measures, government receipts are projected to increase from 17 percent of GDP in 1998 to 21 percent of GDP in 2001.
11. Government expenditures are likely to be around 21½ percent of GDP in 1998 and are projected to increase to just over 22 percent of GDP by 2001. The broad aim of expenditure policy will be to expand capital investment and restructure expenditures in the social sectors, so as to improve efficiency and raise the quality of services. Large employment reductions are required in the law enforcement agencies, health and education sectors, and cultural institutions, which together account for more than 85 percent of the wage bill. At the same time there is a need for targeted wage increases, to attract and retain high quality staff. Reforms of the social safety net will focus on improving the targeting of public assistance and rationalizing social security contributions.
12. Monetary policy will continue to aim for low levels of inflation, although the recent events in Russia are a serious challenge to the banking system and the stability of the manat. Consequently, achievement of the program's inflation objective in 1999 will require tighter liquidity management than was previously envisaged, to restore confidence in the manat. Nonetheless, both nominal and real interest rates are expected to decline, reflecting sustained low inflation and a steady strengthening of the financial system.
13. Cautious financial policies and a flexible approach to the exchange rate will remain the basis for building a strong international reserve position. In the light of turbulence in the oil market and international financial markets, somewhat greater variability in the exchange rate is likely than in the past. However, intervention will continue to be used to dampen excessive volatility. The authorities will monitor exchange rate developments carefully, so as to ensure that policy remains consistent with financial stability and a competitive non-oil economy, and stand ready if necessary to make adjustments to fiscal and domestic credit policies to achieve these objectives. In addition, Azerbaijan intends to accept the obligations of Article VIII, Sections (ii), (iii), and (iv) of the Fund's Articles of Agreement in the near future.
14. External sector policies will aim at strengthening the balance of payments and rendering it less vulnerable to external shocks. This will require strong structural and financial policies, and a flexible approach in the management of the exchange rate, to facilitate adjustment to changes in the terms of trade resulting from large swings in the oil price or other external shocks.
15. In recent years, significant progress has been made in liberalizing the trade regime . Virtually all trade restrictions have been removed. One remaining restriction is the requirement for pre-registering exports on credit, or barter by enterprises in which the public sector is a majority shareholder. While the government believes that such a restriction does not seriously limit the flexibility of the trade system, it will, nonetheless, remove this stipulation in 1999. In addition, the authorities intend to reduce the general import tariff rate from 15 percent to 10 percent by the year 2001. However, in view of fiscal pressures, earlier plans to cut the rate to 12 percent in 1999 have been postponed. The government is actively seeking Azerbaijan's accession to the WTO, with assistance from the donor community, though the process remains at a relatively early stage.
16. Continued progress in the implementation of structural reforms is needed if the medium-term macroeconomic objectives of growth and stability are to be sustained. While the government's reform agenda is broad-based and inclusive, limitations in administrative capacity require prioritizing the key structural reforms, as set out in paragraph 7 above. Also, with the aim of achieving a more diversified economic base, the government intends to strengthen sector-specific reforms.
Public sector reform
17. The government will give the highest priority to a medium-term program to improve the public sector's performance within a market environment. The program will constitute the key element of the government's strategy to fight corruption. It will include major reforms in the following areas:
public expenditure control and financial management; civil service reform; restructuring of ministries and improvements in administrative capacity; and adoption of an effective and independent judiciary.
Public expenditure control and financial management
18. Expenditure planning and management will be strengthened. A revised law on the state budget, establishing new budgetary procedures, will be prepared and submitted to parliament during 1999. These procedures will be used in the preparation of the 2001 budget, which will also include detailed plans on outlays for extrabudgetary funds. With this budget, a medium-term financial framework (MTFF) will also be presented. In line with the new procedures, expenditure ceilings will be communicated to all ministries early in the budget preparation process. To assist in budgetary implementation and forecasting and to broaden the coverage of treasury reports, a financial planning unit will be established; treasury operations will also be computerized in 1999. In line with these efforts, commitment accounting will be introduced to prevent the accumulation of new budgetary arrears, and steps will also be taken to pay off old arrears through budgetary allocations for this purpose.
19. In addition, the government will, in 1999, establish a macroeconomic policy group in the ministry of finance, drawing together expertise in budget, treasury, revenue forecasting and financing matters, to track the government's financial program, assess fiscal consistency with the country's macroeconomic objectives, and serve as liaison with the ANB. Building on current work supported by the Know How Fund, the government will request further technical assistance, including from the IMF and World Bank.
20. During 1999, the government's capacity in financial management will be strengthened on several fronts. The functions and responsibilities of the two audit institutions will be restructured. The capacity of the finance inspectorate of the ministry of finance for conducting systems-based auditing, and ensuring compliance with recognized accounting standards, will be enhanced. In line with these measures, government guarantees on local and external loans will also be strictly monitored by the ministry of finance, with explicit limits on these in the annual budget law. With the support of the World Bank, the government will strengthen the newly established state procurement agency. Further steps will be taken in 1999 to develop the legal and institutional framework to regulate and manage public procurement.
21. As capital expenditures increase, improvements will be needed in public investment planning . Beginning in 1999, the government will seek technical assistance to develop the capacity of line ministries and local authorities to perform project appraisals. Preparation of the annual budget will aim to improve coordination between past capital investment decisions and future recurrent costs. To this end, the ministries of finance and economy will prepare, with World Bank assistance, a public investment plan (PIP) for the next three years. This will be consistent with the government's external debt strategy and will refrain from providing government guarantees for commercial projects.
22. The government will continue to accumulate oil signature bonuses in a special account at the ANB, from which a portion will be used to finance the deficit and the remainder saved. The significant growth in oil revenues expected in the medium term highlights the need to establish effective management and fiscal transparency in the investment and use of these resources. In 1999, the working group on oil resources, a government committee appointed to assess and make specific recommendations, will design a plan for the management of future oil revenues, balancing macroeconomic considerations with developmental objectives. In line with these efforts, the government will establish institutional arrangements which will clearly define the relationships between the government, SOCAR, and the oil consortia; and, in coordination with the budget process, proper financial controls over these resources will be introduced. SOCAR will provide regular reports to the cabinet of ministers and ministry of finance on the amounts of bonus payments received and expected.
Civil service reform and downsizing
23. A newly organized civil service will strengthen administrative capacity and raise the quality of government decision making. By June 1999, the government will develop and submit to parliament new civil service regulations. With World Bank support, a medium-term civil service reform strategy with clearly defined and monitorable action plans will also be developed. The new civil service law will differentiate between political appointments and civil service positions; allow for performance-based evaluations and promotions; provision for merit-based recruitment; and include incentives to enhance the service orientation of civil servants, who will have clearly defined rights and obligations. A professional code of conduct (including disclosure of income and assets, and rules to prevent conflict of interests) to ensure the integrity of civil servants will also be developed. The implementation of the new civil service law will begin in 2000, and will be overseen by the cabinet of ministers.
24. The government will address jointly the issues of low wages and over-employment in the public sector. There will be no generalized increase in civil service salaries in 1999, and any increase will be used to reduce wage compression. To address the problem of excessive government employment, a treasury-based staffing review will be conducted by March 1999. From January 1999, a hiring freeze will be introduced and a severance pay package will be in place by June 1999, following which a phased reduction of public employment will begin. At the same time, the government will strengthen control procedures by requiring the submission of salary claims to the Treasury to include the authorized number of positions and the actual number of employees in each spending unit.
Restructuring of ministries and the central administration
25. An important component of the structural reform program will be a comprehensive restructuring of the government , based on its appropriate role in a market-based economy. Beginning in 1999, the government will reconfigure ministerial level entities and reduce the total number of ministries, state committees, and other central organs. The functions of the ministries will be refocused on policy making and regulation, while making them more accountable. Duplication of ministerial functions will be eliminated and budgetary support for activities deemed obsolete will be discontinued. Efforts will also be made to hive off non-core government activities to the private sector.
26. The cabinet of ministers (COM) apparatus will be streamlined, restructured and reformed, so as to focus on high level policy coordination and advice for the cabinet and prime minister. It will relinquish its existing command and control functions and avoid duplication or overlap with ministries' policy and regulatory functions. To strengthen administrative capacity of the government's economic team, an economic policy group will be established to assist the cabinet of ministers in tracking and monitoring agreements with international economic organizations.
27. While key judicial legislation was passed in the early years of transition to facilitate the functioning of a market economy, stronger action is needed to promote independence of the judiciary and enhance its capacity. The adoption of the law on courts and judges in 1997 provides the appropriate framework for reforming the judicial system. In this regard, the authorities will, by March 1999: establish and appoint the council of judges; present the complete civil and procedural codes to parliament; and complete a detailed plan to form additional courts based on the new law. Draft legislation on the procuracy and police is being prepared, to strictly limit the power of prosecutors and the police to litigation in criminal cases. Parliament is expected to approve the legislation by June 1999; pending such approval, a presidential decree will be issued to limit the role of law enforcement agencies to criminal cases, and restrict their investigations and control of the economic activities of economic agents.
28. The government plans to adopt and publish a comprehensive medium-term strategy of judicial and legal reform to be prepared in 1999 with World Bank assistance. The reforms will be based on the adoption of a legal framework for prosecuting separately civil and criminal cases, and for effectively administering legal professionals, in a manner consistent with the current market environment. In this context, the government will implement all necessary measures to ensure: (i) the independence of the judiciary; (ii) the competence and integrity of the legal profession; and (iii) the public accessability of the judiciary. An optional system of dispute resolution will also be introduced. To expedite the development of the reform strategy, the government shall appoint a member of the presidential commission on legal reform to coordinate World Bank technical assistance.
Tax administration and policy
29. The government will undertake a broad range of tax measures to strengthen revenues and reduce distortionary effects of the tax system. Key tax administration measures to be adopted in early 1999 include stronger powers to collect tax arrears such as enforcement of notices of levy to collect from delinquent taxpayers' bank accounts and those of their debtors, liens on property, and the seizure and sale of physical property. In addition, computerization of tax collection agencies will be expanded, the large taxpayers unit (LTU) reinforced, and the audit function strengthened.
30. A greatly simplified tax code, designed to broaden the tax base, reduce distortions and encourage new investment, will be in force from mid-1999. It will include a substantial reduction in VAT exemptions and a move to the destination principle for VAT on trade with CIS countries. The VAT rebate mechanism will also be improved, permitting changes in procedures that should reduce abuse of certain exemptions. During 1999, regulations will be issued requiring enterprises to adopt internationally accepted accounting standards, with the objective of switching the VAT and enterprise profits tax to an accruals basis by 2000.
Bank restructuring and supervision
31. To better mobilize domestic and foreign savings, the government and the ANB will continue to strengthen the banking system. Azerbaijan's banking system remains dominated by the four large state-owned banks, while the remainder of the system—mainly small private banks—is highly fragmented. The authorities are fully committed to the complete divestiture of all four state banks by 2001. The government has approved the privatization plan for the International Bank, and the bank will be offered for sale by May 1999. In support of this, the government will issue securities to cover its loan guarantees to that bank. A plan for the Savings Bank has also been developed, and it is expected to be offered for sale by September 1999. A twinning arrangement for Prominvestbank has recently begun which, over time, should form a sound basis for future bank operations and prepare the bank for privatization no later than 2000. Agroprombank is also slated to be privatized or liquidated before 2001. To establish the magnitude of non-performing loans, the loan portfolio of Prominvestbank will be reviewed by the recently established commission, no later than March 1999. The future role of Agroprombank will be assessed in the context of a rural finance strategy currently being developed.
32. The ANB will continue to strengthen bank supervision, building upon both the organizational changes within the institution and the uniform implementation of prudential regulations across commercial banks. Since October 1998, an IMF resident advisor has been assisting the central bank in both bank supervision and restructuring. Measures will be adopted to address the issue of staff limitations in fulfilling supervisory functions. In addition, the ANB will ensure that banks adhere to the timetables set for increasing minimum capital levels, which are to be equivalent to the EU levels by 2001, and for making acceptable loan-loss provisions. Compliance with prudential regulations will be closely monitored by the ANB and strict sanctions will be imposed in the event of non-compliance. To encourage competition from foreign-owned banks, a broad-based and equitable approach to development of the banking system will be adopted, including relaxation of current constraints on foreign banks' capital. Progress will continue to be made with improving and rationalizing the payments system.
Financial market development
33. The depth and breadth of financial markets remains limited in Azerbaijan. In the absence of well-developed capital markets, fiscal and monetary policies are not fully effective, and the lack of indirect monetary instruments constrains active liquidity management. Hence, the government will seek to increase the volume and variety of its securities by extending its use of treasury bills and by converting into securities more of its outstanding debt to the ANB. This would provide a stronger basis for broadening the treasury bill market to include non-bank and foreign participation. The authorities will also support the development of the secondary market for treasury bills, enabling the ANB to more effectively utilize open market operations. Nonetheless, with prudent fiscal policies in effect, the volume of government securities offered in the market may be limited. In light of this, the government also plans to take additional measures to encourage the development of markets for corporate securities and other nongovernment financial instruments.
34. An expanded treasury bills market and the establishment of a market for corporate securities will require the introduction of an independent securities commission to regulate the market. A securities law providing for such a commission was approved by the President in September 1998, and the commission will be established in early 1999.
35. Significant progress has been made in the privatization of small public enterprises ; in this category, the government has been able to privatize assets valued at about 6.5 percent of GDP. Most small-scale enterprises have been transferred to the private sector, while 944 medium- to large-scale enterprises (20 percent) have been privatized using check and cash auctions. However, the government is aware of the need to deepen the privatization effort. Accordingly, beginning in 1999, the state property committee (SPC) will begin to focus on case-by-case privatization of the larger and more valuable enterprises.
36. Major steps will be taken to improve the privatization process . By end-March 1999, the 1999-2000 privatization program will be approved by parliament. In this connection, the government will formally authorize a complete list of large and valuable enterprises to be privatized as part of the 1999-2000 privatization program, including clear identification of those to be privatized through voucher auctions. The new program is also expected to improve the voucher pricing system. To achieve the program's objectives, the SPC will develop appropriate procedures for case-by-case privatization and select international financial advisors to accurately assess privatization options; consultants will also be selected to assist in establishing an independent stock exchange facility and a central depository system. In this regard, the securities commission will monitor all stock exchange activities and regulate investment intermediaries.
37. As the government's privatization exercise is expected to increasingly divest large public enterprises on a case-by-case basis, plans are being prepared to put up for sale five major enterprises with the assistance of reputable international investment advisors. The international tender for the privatization exercise shall be issued by June 1999. In addition, all enterprises and warehouses under the Concern for Auto Transport and Azercontract shall be transferred to the SPC and offered for sale to the private sector or liquidated during 1999.
Infrastructure and energy
38. The government is committed to removing impediments to investment and growth in the critical areas of power, water, and transportation . To this end, the provision of infrastructure services is being rationalized. To overcome the serious problem of low collection rates, the government has instructed Azerigas, Azerenergy, the Railways, Apsheron Water, and other service enterprises to: cut off service to delinquent customers after 60 days; fully utilize the 1997 bankruptcy law and its collection provisions; and expedite the settlement of arrears. Prices for infrastructure services to households have been moving towards marginal costs and, with the exception of refugee assistance, most exemptions were repealed in 1997. Water supply metering has also been introduced in the Baku area. In line with this, the government will continue to expand the program for the metering of household gas consumption. A review of all other services (including rental and transport fees) will also be made to introduce a phased plan for eliminating any remaining generalized subsidies. If targeted subsidies are deemed to be necessary, these will be fully reflected in the budget.
39. Privatization of most road transport services has significantly improved the sector's efficiency. By the end of 1999, the government intends to restructure the Caspian Shipping company and demonopolize maritime services, including the introduction of a new maritime code. Competitive bidding procedures are being introduced by most public enterprises in the infrastructure sector and, by the end of 1999, all construction and maintenance units of the railway and the roads department (Azeravtoyol) will be separated as independent entities able to respond to competitive tenders.
40. High priority is attached to the development and restructuring of enterprises in the power sector . An audit of the electricity company, Azerenergy, will be conducted on the basis of which plans to corporatize it will be prepared, with a view to fostering competition. By the end of 2000, existing generating capacity is expected to be provided by four or five joint-stock companies; additional demand would be supplied by private power companies. To resolve the collection problem, private operators will be allowed to manage the distribution system in conjunction with the municipalities. Subsequently, the government plans to restructure the gas industry along similar lines by splitting and commercializing the production, distribution, and storage of gas products. Over the next three years, full privatization of the power sector is planned, with government focusing on strengthening its regulatory role.
41. In support of the planned reforms, the government will provide the necessary legal and regulatory framework . A national energy agency will be established in 1999, supported by new laws on energy and gas. A new ministry of transportation is expected to be established in early 1999, and parliamentary approval will also be sought for the water law and the establishment of a national commission to regulate water resources.
42. The government will continue to encourage joint ventures with foreign investors in the petroleum sector . To this end, plans are being prepared to establish the legal framework for investment in the oil sector and the government's role in it. With World Bank financial support, the government intends to commission an audit of the activities of SOCAR, the state petroleum enterprise, by an internationally recognized accounting firm, to be completed by September 1999. Also in 1999, the process of restructuring SOCAR will begin with World Bank assistance; non-essential activities will be hived off to the private sector, and core functions, such as the refining of oil products, will be separated and commercialized. In support of the restructuring exercise, the government will prepare in 1999, a detailed strategy to rationalize and modernize Azerbaijan's large oil refinery capacity.
43. Considerable progress has been made in dismantling the former state and collective farms and issuing land titles to farmers, in accordance with the land reform laws passed in 1997. This has resulted in the creation of a variety of farming structures, ranging from small family farms to medium and large joint stock companies. About 26 percent of rural land titles have been issued so far, and the remainder is expected to be issued by mid-2000. Simultaneously, machinery and other assets are being distributed to private farmers. A revised version of the land code will be submitted to parliament and the law on pledges has been approved. Passage of these laws will form the basis for the creation of land markets. Further, the institutional and legal framework for a unified land and real estate registration system is being developed, with the assistance of TACIS.
44. Although the large state agricultural concerns and enterprises have been privatized, further restructuring and the development of financial intermediaries to support the rural sector is needed. Post privatization problems are already emerging in the wheat/bread and cotton sectors. While the privatization of the state bread concern has eliminated former economic distortions, consumer preference has increased the demand for imported quality wheat by bakeries, rather than the use of domestic wheat. Cotton ginneries have been privatized almost entirely to foreign investors, but it is too early to assess the impact on producer prices and productivity. The World Bank and other donors are currently assisting the government to improve the competitiveness of the agricultural sector in the areas of extension, education and research, rehabilitation of irrigation and drainage infrastructure, rural credit, land registration, and input and output marketing mechanisms. In this regard, the government plans to encourage private sector participation in the provisioning of agricultural support services.
45. The ministry of agriculture is in the process of being restructured, and has been separated from the former agro-industrial concerns. A new organizational structure reducing the number of departments and staff is contemplated. Further reforms are expected to achieve: (i) re-organization of the present decentralized agricultural services, now scattered over 56 raions; (ii) improved coordination with other state committees responsible for all related aspects of agriculture, and (iii) enhanced capacity for strategy, policy formulation, design, and implementation of regulatory functions.
46. As of end-June 1998, the stock of interenterprise arrears amounted to about manat 12 trillion, about 70 percent of GDP. The large accumulation of interenterprise arrears in the energy sector, in particular, now threatens to undermine market discipline throughout the economy. Arrears have encouraged barter transactions among enterprises through "netting-out" operations, and the loss in tax revenue, as a result of such transactions, has adversely affected the government's budget. During 1999, to discourage the accumulation of new interenterprise arrears, the government will: (i) continue to avoid accumulating budgetary arrears to enterprises; (ii) stop the practice of offsetting tax liabilities against government liabilities; (iii) penalize enterprises who have failed to pay tax liabilities, including through the implementation of bankruptcy procedures; and, (iv) adjust, for the purpose of taxation, the definition of turnover to include offsetting operations. Stocks of existing interenterprise arrears will be settled as soon as payment discipline is enforced and new payment arrears are no longer accruing.
Education and health
47. While expenditures on education and health will remain around their current levels in proportion to GDP, the composition of spending in both sectors will be altered in an effort to improve efficiency (Table 3). In this connection, the presidential commissions on education and health, established under the program to develop comprehensive reform plans, will actively begin to pursue these objectives.
48. In 1999, the aim of reforms in the education sector will be to increase resources to under-funded inputs (including writing materials, textbooks and library books, upgrading and maintenance of facilities, and teacher training). These inputs will be targeted to the system of primary education, with the aim of delivering the largest social benefits. The authorities will also develop a new curriculum to better fulfill the human resource needs of the developing private sector economy, by identifying and eliminating obsolete specializations. In this regard, a detailed education reform strategy has been designed by the presidential commission.
49. As there is serious over employment in the education sector, retrenchment will be an important policy goal in 1999. Measures to reduce employment will focus on diminishing non-teaching positions, and developing clear standards for promotions and wage increases. By the end of the program period, the government will introduce other reforms, including a system of transparent user fees for higher education, targeted scholarships for low-income students, and encouragement of private sector participation in the sector.
50. The system of health care in Azerbaijan has over-invested in curative health at the expense of preventative health care. To resolve this and other impediments in the health sector, the government is prepared to take several measures. These will include: encouraging the expansion of private sector activities in health care under a proper regulatory framework; strengthening the public sector's role as provider of primary health care; rationalizing existing health facilities through mergers in a manner consistent with basic health service coverage; and strengthening the viability of public health care facilities to function as self-financing entities. In 1999, the government will also undertake a review to identify those facilities that can be privatized or closed.
51. The extensive application of informal user charges for drugs, food, and ambulances has reduced the demand for health treatment by the poor. To increase low-income household access to health care, the authorities will develop a package of basic health services, to be provided free of charge to the population at large from 2000.
Strengthening the social safety net
52. The process of reorienting the public sector will temporarily raise the need for social safety net provisions. To complement policies to encourage voluntary separation from the public sector, the tasks of the employment fund will be expanded in 1999 to provide retraining and job-locating services.
53. While a substantial portion of the population collect social benefits, the size of this support is low; for example, average retirement benefits are only US$11 per month. To improve the level of benefits to the truly needy, the government will better target benefits such as child and maternity allowances and continue to raise the official pension age . It will also increase the employees' contribution rate with the objective of reaching 5 percent by the end of the program period, with an offsetting reduction in the employers' rate. As a first step towards a two-tier pension system, the government will, by 2000, introduce individual pension accounts for employee contributions. A unique identity system will be designed for all contributors with a view to gradually including the full labor force.
54. In 1999, the social protection fund will begin to seize employers' assets in an effort to recover social security contribution arrears. Over the next three years, a system of withholding will be developed so that employers who pay wages will have to pay social security contributions, and a system of penalties for non-complying employers will be introduced. The contribution system for the self-employed will also be modified by basing their payroll taxes on presumptive income in accordance to the taxpayer's profession.
Reconstruction of war-damaged areas
55. The government is fully committed to improving the welfare of internally displaced persons (IDP) who have been adversely affected by the Nagorno-Karabakh conflict. To coordinate support from the donor community and ensure the efficient utilization of resources in this effort, the government has established the International Advisory Group.
56. The government's strategy in helping the IDPs will be based on: (i) resettlement on a voluntary basis, with broad public and institutional participation; (ii) providing support for a period of one year, consisting of the basic necessities; (iii) rehabilitating the key physical and social infrastructure to minimum standards, with the aim of providing the maximum equitable benefits with the least feasible cost; and, (iv) implementing cost recovery for the provision of basic needs, based on the ability to pay as determined by five-year forecasts of cash income.
57. Azerbaijan has begun to deal with environmental liabilities inherited from the former Soviet Union, including pollution and loss of bio-diversity. A rising Caspian Sea level has added to these problems. While some environmental improvement has been observed as pollution from heavy industries has diminished, the government is aware of the need to build a more effective environmental management system .
58. Environmental priorities have been established through the development of a national environmental action plan prepared with World Bank assistance. To implement a first set of priority measures, the government will undertake an environmental investment project for which World Bank funding has been approved. These measures aim to prevent the irreversible loss of valuable bio-diversity (sturgeon stock), to pilot cost-effective approaches to the management of hazardous waste, to clean up oil pollution, and to strengthen environmental legislation and institutions. In addition, through the Caspian Sea program, efforts will be made to mitigate the negative impact of the rising level of the sea.
59. The government intends to develop sound environmental legislation and regulations . In this connection, the system of fees and fines for the oil industry, and the government's capacity to enforce these, will be strengthened. Stronger incentives will be provided to enterprises who comply with the high environmental standards. The government's strategy also gives priority to strengthening environmental institutions, particularly at the local level. To gain public support, the government intends to increase awareness and to expand participation in environmental management at the community level.
Improving macroeconomic statistics
60. The government will continue to implement a medium-term program to improve economic statistics , with technical assistance from the IMF, the World Bank, the Organization for Economic Cooperation and Development, the United Nations Development Program, and other bilateral and multilateral donors and creditors. The program developed by the interagency working group represents a positive step in this process. Short-term objectives are to improve data on financial market activities and external debt, and begin a program of publishing the main financial and economic indicators on a monthly basis, and a quarterly review by the ANB of economic developments. In addition, the government will assign a specific agency to compile timely data on oil-related activities.
III. EXTERNAL FINANCING AND DEBT MANAGEMENT
61. The long-term balance of payments prospects of Azerbaijan appear promising, but short-term pressures have increased as a result of recent external shocks. These factors, together with rising imports of goods and nonfactor services related to the oil sector, are expected to more than offset the increase in oil production and exports, leading to a further widening of the current account deficit in the near term (1999-2001). Although oil sector activities will be financed by foreign direct investment, increased support from multilateral and bilateral donors is likely to be required over this period. Over the longer term, as oil exports rise steeply in the next decade, the current account should move into surplus, though the timing of this is uncertain.
62. External financing requirements during 1999—2001 are tentatively projected at US$6½ billion, after allowing for an adequate build up of foreign reserves (Table 4). Financing needs are expected to be covered by foreign direct investment in the oil sector (including oil bonuses), other private capital inflows (including privatization receipts), and disbursements from multilateral and bilateral institutions. External financing requirements during October 1998—September 1999 are projected at US$1.7 billion; these are expected to be met by direct investment, primarily targeting the oil sector, official capital flows, and privatization proceeds.
63. Azerbaijan's external debt is projected to remain modest during 1999-2001. At the end of 1998, medium- and long-term public and publicly guaranteed debt is estimated at US$540 million (12½ percent of GDP). In 1997, an agreement was reached with Russia to cancel all mutual outstanding debt obligations, and a loan from the EU was fully repaid in September 1997. Despite its low level of indebtedness, Azerbaijan intends to limit the amount of new debt that it contracts or guarantees on nonconcessional terms for the program period and beyond. Medium-term projections suggest that external debt would reach 17 percent of GDP in 2000 before falling to 7 percent of GDP by 2005. This would entail a reduction in the debt service ratio by the end of the period. Further progress in the implementation of the reform agenda would allow Azerbaijan to reduce its perceived risk considerably, foster foreign non-oil direct and portfolio investment, and thus achieve its ambitious growth targets without substantial recourse to foreign borrowing.
IV. TECHNICAL ASSISTANCE
64. Given Azerbaijan's limited technical capacity, a well designed and extensive array of technical assistance will be required to implement the reforms discussed above. As indicated in the policy matrix (Table 1), assistance from various sources will be needed. Fiscal reform will require further IMF assistance in tax policy and administration, and expenditure management. The authorities have recently appointed an IMF-supported resident advisor on banking supervision and restructuring, and receive assistance on the payments system through regular visits by IMF experts. World Bank assistance will be sought in bank restructuring, privatization, environment, and public sector reform (including legal, civil service and pension reform). Also, continued technical support from the World Bank will be needed for sectoral reforms in energy, health and education, and the reconstruction effort. In the transport sector, the EBRD's assistance will be particularly important; EU-TACIS is also providing assistance for the restructuring of public enterprises and statistical support. Technical assistance will also be needed in the areas of collecting and analyzing energy-related data, national accounts, and price statistics. For further technical assistance requirements, the government will seek grant financing from the donor community.