## 1. New Spending Packages

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### Context and recent macroeconomic backdrop
- Economy structure:
  - Hydrocarbon sector accounts for "some 41 percent of GDP, 92 percent of exports, and 65 percent of fiscal revenues."
- Growth and inflation:
  - Real GDP expanded by "2.4 percent through the first six months of 2019."
  - Inflation: "2.3 percent in 2018" and "2.6 percent this June."
- External balances and reserves:
  - Current account surplus increased by "8.8 percentage points (pp) of GDP to 12.9 percent of GDP in 2018."
  - International official reserves of the CBA and SOFAZ rose by "2 pp of GDP to $44 billion (98 percent of GDP)."
- Exchange rate and monetary policy:
  - De facto peg: AzN/US$ "1.70" since April 2017.
  - The CBA "cut the main refinancing rate by 7¾ pp to 8¼ percent" since early 2018.
- Fiscal position:
  - Nonoil primary balance (NOPB) deteriorated by "1.2 pp to -32.1 percent of nonoil GDP" in 2018.
  - 2019 budget implied consolidation of "1 pp of nonoil GDP" under the new fiscal rule.

### New spending packages — main components
- Purpose: Introduced through Presidential Decrees in the first half of 2019 to compensate the public for the adverse impact of past devaluations, banking crisis and economic downturn; parliamentary elections scheduled for November 2020.
- Main components:
  - Increases in minimum wages and pensions ("0.6 percent of GDP"):
    - Minimum monthly wage raised from "AzN 130 (73)" to "AzN 180 (130)" in April, and to "AzN 250 (200)" in October 2019.
  - Increases in public sector wages of about "40 percent (1.0 percent of GDP)" from September 2019.
  - An NPL resolution / consumer loan bailout providing "some AzN 650 million manat (0.8 percent of GDP)" as compensation for past devaluations.
- Coverage and implications:
  - The packages are expected to affect "up to 30 percent of the population".
  - They have broad macroeconomic, fiscal, and financial sector implications.

### Fiscal and financial implications and rule-based policy
- Fiscal rule (2019) requires:
  - (i) the year-ahead projected NOPB as a percent of nonoil GDP to be no worse than the current-year NOPB, and
  - (ii) nominal spending growth not to exceed "3 percent" over the previous year’s approved expenditures.
  - “Spendable” oil revenues are also constrained under the rule.
- 2019 budget adjustments:
  - New spending initiatives in 2019 were compensated by cuts in capital spending, expenditure reallocations, and the use of CBA profits under a revised budget passed in June.
  - After revisions, the 2019 NOPB is still expected to improve by "1 pp of nonoil GDP."
  - Authorities intend to offset new expenditures ("2.4 percent of GDP, Box 1") by spending reallocations ("1.6 percent of GDP") and off-budget recording plus CBA profit transfer for the remainder.
- Medium-term consolidation plans:
  - Authorities intend to consolidate the fiscal position by about 1 pp of nonoil GDP yearly in 2020 and beyond.
  - Staff noted a more ambitious consolidation of "3 pp of non-oil GDP cumulatively over the next five years" could be achieved via spending efficiency gains and revenue/tax reforms, although authorities considered faster consolidation infeasible given recent increases in structural expenditures.
- Public financial management and transparency (recommended):
  - Link fiscal rule to budget via clear fiscal strategy and MTEF.
  - Conduct mandatory in-year and end-of-year reviews and systematically identify and monitor fiscal risks.
  - Publish COA report on budget execution, updates on fiscal performance and projections, pre-budget fiscal strategy statement, consolidated IPSAS-compliant financial statements, and a fiscal risks statement.
  - Consider requesting a Fiscal Transparency Evaluation (FTE).

### Outlook and risks associated with packages and policy stance
- Growth and inflation projections:
  - Real GDP projected to expand by "2.7 percent in 2019."
  - Nonhydrocarbon growth to rise gradually to "around 3.2 percent over the medium term."
  - Inflation expected to remain below "3.5 percent" given the stable ER and low food price inflation.
- External assumptions:
  - Oil prices projected at "around $60 per barrel"; current account surplus will remain sizeable with improving fiscal position.
- Downside risks:
  - A decline in oil prices would worsen fiscal and external positions and put pressure on the ER.
  - Materialization of large contingent liabilities could weaken debt sustainability.
  - Fragmentation and weaknesses in policy frameworks and governance may slow reform implementation and bank cleanup.
  - Public sector wage increases may propagate to private sector causing second-round inflation effects and undermining competitiveness.
  - Heightened geopolitical tensions.
- Upside risks:
  - Higher oil prices and faster reforms.

### Policy discussions and authorities’ views
- Authorities broadly shared staff's views on outlook and risks; uncertainty about near-term impact of spending on domestic demand and inflation.
- Authorities saw larger upside risks to private sector growth from recent structural reforms.
- Authorities considered contingent liability risk negligible given low interest rates, long durations, and project quality.
- Consensus: strong policy actions helped weather shocks, but deeper reforms needed for inclusive, sustainable, diversified, private sector-led growth.
- Agreed policy focus areas:
  - Ensuring macro-financial stability.
  - Creating a new growth model.
  - Fostering economic inclusiveness.

### Monetary policy and exchange rate recommendations
- CBA actions and stance:
  - CBA has started normalizing interest rates; the main refinancing rate was cut by "7¾ pp to 8¼ percent" since early 2018.
  - Monetary base expanded rapidly after the crisis; cashless economy program reduced money in circulation.
- Staff recommendations:
  - Room to continue monetary easing given still tight financial conditions and spare capacity.
  - Transition to inflation targeting (IT) and greater ER flexibility recommended to absorb shocks and improve risk management.
  - Strengthen CBA independence, operationalize de facto floor system, bolster analytical capacity, and expand policy toolkit.
  - Operational measures: publish forecasts, activate liquidity forecasting, use interest rate policy and FX operations more actively, issue LT notes at market rates, introduce overnight OMO instruments, adjust reserve requirement ratio, and increase ER transparency.
- Authorities’ approach:
  - Favor maintaining ER stability in near term; CBA plans to move to a hybrid IT regime within "3–5 years" with possible longer-term full IT once conditions are met.
  - Authorities requested TA to review application of the fiscal rule and for monetary and ER policy.

### Financial stability, banking sector, and NPL resolution program
- Banking sector indicators and concerns:
  - Private sector credit growing at "11 percent (y/y)" as of June.
  - System-wide capital adequacy ratio "20 percent" with a Tier I ratio at "19 percent" (driven by IBA).
  - Regulatory forbearance appears to be continuing; some banks undercapitalized, high NPLs, and possible noncompliance with large exposure and related party limits.
- Staff recommendations:
  - Under-capitalized banks should be given strict deadlines to recapitalize or close.
  - Require large banks with narrow capital buffers to strengthen them.
  - End supervisory forbearance, enforce regulatory norms, strengthen corporate governance, and privatize IBA as soon as possible.
  - Strengthen FIMSA’s independence and resources; conduct gap analysis against Basel Core Principles and consider an FSAP Update.
- New NPL Resolution Program (Box 2):
  - "Some AzN 650 million" sent from the state budget to banks.
    - About half retained by banks to pay down overdue retail loans.
    - Capital in the banking system expected to increase by AzN 300 million ("7.4 percent of end-2018 system-wide capital").
    - Remaining portion ("0.4 percent of GDP") sent by banks to individuals (debit card form) to compensate for servicing loans at the depreciated ER.
  - Banks required to restructure FX retail loans: redenominated to manat, terms extended, interest rates reduced, accrued interest and fees written off—redenomination exacerbates banks’ open currency positions.
  - Mitigants:
    - CBA to make loans of some AzN 680 million available to banks at low interest rates under government guarantees.
    - CBA to make $215 million worth of dollar-denominated bonds available to banks for purchase to close open currency positions.
- Program effects and risks:
  - Will improve household balance sheets and boost banks’ liquidity; restructuring reduces loan dollarization.
  - Authorities expect bank solvency to improve in a small number of banks where transfers outweigh write-offs.
  - Staff and authorities agreed program creates moral hazard, undermining incentives for proper FX risk management and repayment culture.
  - NPLs likely to remain high after the program ("12.9 percent"), and uncertainty in NPL estimates will persist.
- Supervisory and resolution recommendations:
  - Conduct an independent and transparent asset quality review (AQR).
  - Impose timetables to resolve NPLs through write-offs or sales; make processes cheaper and quicker.
  - Improve bank governance and roll back regulatory forbearance.
  - Ensure transparent accounting of bad asset management and resolution.
  - Develop out-of-court settlement system and enable asset management companies via legal amendments.

### Financial market development and debt management
- Priorities:
  - Develop deeper local currency bond market with longer tenors, diversified investor base, market-determined pricing, and enhanced secondary market liquidity.
  - Coordinate Ministry of Finance, CBA, and SOFAZ within an integrated asset-liability management framework to assess risk-return trade-offs and macro-financial implications.
- Authorities’ concern:
  - A manat bond market could become concentrated among a few domestic investors and crowd out lending to the private sector.

### Structural impediments, governance, and inclusive growth
- Persisting structural impediments:
  - (i) weak governance and institutions; (ii) limited SME access to credit; (iii) inefficient labor markets; (iv) export concentration; (v) limited product and trade market competition; (vi) sizeable skill gaps.
- Consequences: high informality, limited FDI, weak entrepreneurship and SME development, low productivity.
- Policy directions:
  - Lower entry barriers and apply Anti-Monopoly Law to improve market efficiency.
  - Complete WTO membership process.
  - Apply OECD Investment Guidelines to attract nonoil FDI and know-how.
  - Expand financial literacy, promote banking competition, prioritize efficient public spending on education, and improve SME access to credit by increasing credit bureau coverage and lowering collateral requirements.
- Governance, anti-corruption, and AML/CFT:
  - Stepped-up reforms urged in line with UNCAC; strengthen anti-corruption strategy, rule of law, and enforcement of asset declarations.
  - Strengthen AML/CFT framework—preventive measures, beneficial ownership, risk-based supervision, prosecution and conviction.

### Key statistics and medium-term projections (selected exact figures)
- GDP and prices:
  - GDP at constant prices growth: 2019 "2.7"; 2020 "2.1"; 2021 "2.1"; 2022 "2.2"; 2023 "2.3"; 2024 "2.5"
  - Consumer price index (period average): 2019 "3.2"; 2020 "3.3"; 2021 "3.4"; 2022 "3.5"; 2023 "3.5"; 2024 "3.5"
- Fiscal aggregates (Percent of GDP):
  - Total revenue and grants: 2019 "39.1"; 2020 "37.8"; 2021 "37.2"; 2022 "36.0"; 2023 "34.9"; 2024 "33.9"
  - Total expenditure: 2019 "34.7"; 2020 "34.4"; 2021 "34.2"; 2022 "33.8"; 2023 "33.1"; 2024 "32.4"
  - Overall fiscal balance: 2019 "4.4"; 2020 "3.4"; 2021 "3.0"; 2022 "2.2"; 2023 "1.7"; 2024 "1.5"
  - Non-oil primary balance (in percent of non-oil GDP): 2019 "-31.1"; 2020 "-30.0"; 2021 "-29.1"; 2022 "-28.1"; 2023 "-27.1"; 2024 "-26.1"
- Public debt and assets:
  - General government gross debt (Percent of GDP): 2019 "19.7"; 2020 "18.6"; 2021 "16.7"; 2022 "15.1"; 2023 "13.6"; 2024 "9.9"
  - Oil Fund Assets (in millions of U.S. dollars): 2019 "40,986"; 2020 "42,421"; 2021 "43,361"; 2022 "43,746"; 2023 "43,883"; 2024 "43,942"
- External and reserve metrics:
  - Current account (Percent of GDP): 2019 "9.7"; 2020 "10.0"; 2021 "7.7"; 2022 "6.9"; 2023 "7.2"; 2024 "7.7"
  - Gross official international reserves (US$ millions): 2019 "5,926"; 2020 "6,226"; 2021 "6,526"; 2022 "6,826"; 2023 "7,126"; 2024 "7,426"
- Banking and financial sector:
  - Private sector credit growth: "11 percent (y/y)" as of June.
  - System-wide capital adequacy ratio: "20 percent"; Tier I ratio: "19 percent".
  - NPLs post-program likely remain "12.9 percent."

### Staff appraisal: priorities and recommendations (summarized)
- Main policy priority: foster private sector-led, diversified growth while improving resilience to shocks.
- Fiscal:
  - Continue fiscal consolidation to save an adequate portion of exhaustible oil wealth.
  - Make consolidation growth-friendly: mobilize higher non-oil revenues, improve spending efficiency, prioritize human capital, restructure SOEs, and better target transfers and subsidies.
  - Reducing the non-oil primary deficit by "1 percentage point of non-oil GDP" recommended to build precautionary buffers.
- Monetary and market development:
  - Further monetary easing appears appropriate.
  - Transition to IT and greater ER flexibility recommended.
  - Modernize monetary operations and increase issuance of local currency securities.
  - Resist financial repression, including interest rate caps.
- Financial supervision and competition:
  - Independent AQR to assess true health of system.
  - Upgrade and strengthen financial supervision; increase competition.
- Structural reforms:
  - Remove impediments by opening to trade and investment, reducing public sector size, improving financial inclusion and governance.
  - Improve data and transparency to support decision-making and reduce corruption vulnerabilities.

*Source: IMF staff report excerpt.*

### 1. New Spending Packages _______________________________________________________________________ 6

### 1. New Spending Packages

### Context and recent macroeconomic backdrop
- Economy: Heavily dependent on hydrocarbon exports; hydrocarbon sector accounts for "some 41 percent of GDP, 92 percent of exports, and 65 percent of fiscal revenues."
- Growth and inflation:
  - Real GDP expanded by "2.4 percent through the first six months of 2019."
  - Inflation: "2.3 percent in 2018" and "2.6 percent this June."
- External balances and reserves:
  - Current account surplus increased by "8.8 percentage points (pp) of GDP to 12.9 percent of GDP in 2018."
  - International official reserves of the CBA and SOFAZ rose by "2 pp of GDP to $44 billion (98 percent of GDP)."
- Exchange rate and monetary policy:
  - De facto peg: AzN/US$ "1.70" since April 2017.
  - The CBA "cut the main refinancing rate by 7¾ pp to 8¼ percent" since early 2018.
- Fiscal position:
  - Nonoil primary balance (NOPB) deteriorated by "1.2 pp to -32.1 percent of nonoil GDP" in 2018.
  - 2019 budget implied consolidation of "1 pp of nonoil GDP" under the new fiscal rule.

### New spending packages — main components (Box 1)
- Purpose: Introduced through Presidential Decrees in the first half of 2019 to compensate the public for the adverse impact of past devaluations, banking crisis and economic downturn; parliamentary elections scheduled for November 2020.
- Main components:
  - Increases in minimum wages and pensions ("0.6 percent of GDP"):
    - Minimum monthly wage raised from "AzN 130 (73)" to "AzN 180 (130)" in April, and to "AzN 250 (200)" in October 2019.
  - Increases in public sector wages of about "40 percent (1.0 percent of GDP)" from September 2019.
  - An NPL resolution / consumer loan bailout providing "some AzN 650 million manat (0.8 percent of GDP)" as compensation for past devaluations.
- Coverage and implications:
  - The packages are expected to affect "up to 30 percent of the population".
  - They have broad macroeconomic, fiscal, and financial sector implications.

### Fiscal and financial implications highlighted in the report
- Fiscal rule introduced in 2019 requires:
  - (i) the year-ahead projected NOPB as a percent of nonoil GDP to be no worse than the current-year NOPB, and
  - (ii) nominal spending growth not to exceed "3 percent" over the previous year’s approved expenditures.
  - “Spendable” oil revenues are also constrained under the rule.
- 2019 budget adjustments:
  - New spending initiatives in 2019 were compensated by cuts in capital spending, expenditure reallocations, and the use of CBA profits under a revised budget passed in June.
  - After revisions, the 2019 NOPB is still expected to improve by "1 pp of nonoil GDP."
- Banking sector and NPLs:
  - Bank lending: private sector credit growing at "11 percent (y/y)" as of June.
  - Banking system ratios: system-wide capital adequacy ratio "20 percent" with a Tier I ratio at "19 percent" (driven by IBA).
  - Ongoing regulatory concerns: regulatory forbearance appears to be continuing; some banks remain undercapitalized with high NPLs and possible noncompliance with limits on large exposures and related party lending.
  - Policy actions: new NPL recovery program for private individuals, creation of a private credit bureau, and new secured transactions and collateral laws are being implemented.

### Outlook and risks associated with the spending packages and broader policy stance
- Growth projections:
  - Real GDP projected to expand by "2.7 percent in 2019."
  - Nonhydrocarbon growth to rise gradually to "around 3.2 percent over the medium term."
- Inflation and external outlook:
  - Inflation expected to remain below "3.5 percent" given the stable ER and low food price inflation.
  - With oil prices projected at "around $60 per barrel" and the fiscal position improving, the current account surplus will remain sizeable.
- Downside risks (Annex II):
  - A decline in oil prices would worsen fiscal and external positions and put pressure on the ER.
  - Materialization of large contingent liabilities could weaken debt sustainability.
  - Fragmentation and weaknesses in policy frameworks and governance may slow implementation of structural reforms, bank cleanup, and resilience building.
  - Recent public sector wage increases may propagate to the private sector, creating second-round inflation effects and further undermining competitiveness.
  - Heightened geopolitical tensions are an additional source of risk.
- Upside risks:
  - Higher oil prices and faster reforms.

*Source: IMF staff report excerpt.*

### 14.      The authorities broadly shared staff's views on the outlook and risks. They noted

### 14.      The authorities broadly shared staff's views on the outlook and risks. They noted

### Policy discussions
- Authorities broadly shared staff's views on the outlook and risks, noting considerable uncertainty about the impact of recent spending measures on domestic demand and inflation in the near term.
- Over the medium term, authorities saw larger upside risks to private sector growth from recent structural reform measures.
- Authorities considered the risk of contingent liabilities materializing negligible, given low interest rates, long durations, and the quality of the underlying projects.
- Consensus that strong policy actions helped Azerbaijan’s economy weather recent shocks, but deeper policy reforms are needed for more inclusive, sustainable, diversified, and private sector-led growth.
- Policy discussions focused on:
  - Ensuring macro-financial stability.
  - Creating a new growth model.
  - Fostering economic inclusiveness.

### Rule-Based Fiscal Policy
- Agreed priority: strengthen long-term fiscal sustainability.
- Fiscal position context and fiscal space:
  - Low gross public debt on a downward trajectory.
  - Low gross financing needs and largely negative net debt to GDP.
  - SOFAZ assets amounting to 82 percent of GDP as of end-2018.
- Intergenerational equity gap:
  - A large gap (23 pps of nonoil GDP) from the PIH-based NOPB benchmark of -11 percent of nonoil GDP implies significant adjustment needed.
- 2019 fiscal stance and measures:
  - Authorities shifted to fiscal tightening in 2019.
  - Revised 2019 budget: intend to offset new expenditures (2.4 percent of GDP, Box 1) by spending reallocations (1.6 percent of GDP), while booking the remaining portion of expenditure (linked to the consumer loan bailout) off-budget, along with the offsetting CBA profit transfer.
  - Both authorities’ and staff’s projections imply a 1 pp of nonoil GDP improvement in the NOPB, consistent with the original 2019 budget.
- Medium-term consolidation plans:
  - Authorities intend to consolidate the fiscal position by about 1 pp of nonoil GDP yearly in 2020 and beyond.
  - Authorities and staff agreed this pace balances strengthening buffers and supporting growth, but it would not close intergenerational equity and external gaps (Annex I).
  - More ambitious consolidation (3 pp of non-oil GDP cumulatively over the next five years) could be achieved via spending efficiency gains and comprehensive revenue and tax reforms, but authorities considered faster consolidation infeasible given recent jump in structural expenditures, plans to introduce medical insurance, and still sluggish growth.
- Staff recommendations on making consolidation growth-friendly:
  - Spending:
    - Prioritize and moderate capital spending.
    - Finalize and implement draft regulations requiring public investment projects to be appraised and selected with transparent criteria.
    - Broaden public procurement reforms.
    - Advance planned spending reviews in targeted sectors such as education.
    - Make public sector wage adjustments rule based and better aligned with performance; pursue civil service reform.
    - Ensure social spending is well-targeted and condition-based (Annex V).
  - Revenues:
    - Streamline tax exemptions; staff welcomed authorities’ work on estimating cost and efficiency of tax exemptions and urged completion.
    - Undertake comprehensive reforms of revenue administration and tax policy to identify additional nonoil revenue gains; staff stands ready to support diagnostic analyses.
    - Authorities prioritized implementing recent tax and revenue administration measures aimed at reducing informality.
- Fiscal rule implications:
  - Recent spending packages make compliance with the fiscal rule more difficult; staff projects nominal expenditure growth will exceed the 3 percent ex ante cap in 2019 (not the case under authorities’ revised budget given off-budget recording).
  - Increases in public sector wages, combined with indexation, would make compliance challenging.
  - Authorities favor refining the rule based on experience; staff emphasized importance of compliance to build credibility and avoid procyclicality.
  - Existing rule should continue until amended by law; avoid off-budget operations inconsistent with best practices.
  - Authorities requested TA to review application of the rule and consider refinements.
- Public financial management (PFM) and transparency:
  - Fiscal rule should be supported by strong PFM: link rule to budget via clear fiscal strategy, implement medium-term budget framework (MTEF), conduct mandatory in-year and end-of-year reviews, and systematically identify and monitor fiscal risks.
  - Better fiscal transparency would improve macro-fiscal performance and reduce corruption vulnerabilities.
  - Suggested transparency actions (summarized):
    - Publish the Chamber of Accounts (COA) report on budget execution, assessing ex-post compliance under the fiscal rule.
    - Publish updates on the economy, fiscal performance, and projections.
    - Strengthen strategic phase of budget preparation and publish pre-budget fiscal strategy statement.
    - Implement medium-term expenditure framework and improve selection, execution, and evaluation of public investment projects.
    - Establish mechanism for periodic targeted spending reviews.
    - Publish statement of fiscal risks and strengthen fiscal risk management and SOE oversight.
  - Consider requesting a Fiscal Transparency Evaluation (FTE).
- SOE restructuring:
  - Over 5,000 active SOEs; largest operate as monopolies in strategic sectors and are too big to fail.
  - Past devaluations, sluggish growth, quasi-fiscal activity, and poor governance weakened most SOEs, requiring increased budget support.
  - Authorities actions: strengthened financial accounting, created SOE monitoring commission, issued new SOE governance guidelines.
  - Staff recommendations:
    - Adjust tariff schedules to achieve viability.
    - Prioritize investments to replace aging capital in electricity, gas, water, railroad and shipping sector SOEs.
    - Separate commercial and noncommercial activities and enact commercial performance framework to accelerate privatization.

### Supporting Monetary Policy
- CBA has started normalizing interest rates.
- Inflation and policy context:
  - Inflation projected to remain below the midpoint of the CBA’s publicly announced 2 to 6 percent inflation band.
  - Inflation expectations well anchored; U.S. interest rate futures lower.
  - Staff saw room to continue monetary easing; CBA viewed stance as less tight than staff and emphasized uncertainty about inflation forecast given recent fiscal measures.
  - Monetary base expanded rapidly after the crisis; government’s cashless economy program reduced money in circulation and improved base money stability.
  - Authorities and staff agreed future interest rate changes should be made carefully based on incoming evidence on fiscal measures’ impact.
- Exchange rate (ER) flexibility and transition to inflation targeting (IT):
  - Staff: greater ER flexibility important for competitiveness, diversification, adjustment to shocks, and better risk management; de facto peg limited interbank market development and interest rate channel and risked fueling macro-financial vulnerabilities.
  - Given firmer oil prices, adequate reserves, and the fiscal rule introduction, timing for ER flexibility was opportune; staff assessed Azerbaijan’s external position as moderately weaker than fundamentals (Annex I).
  - Authorities favored maintaining ER stability in near term to maintain confidence and macroeconomic stability; attributed slow diversification and weak competitiveness to structural impediments.
  - CBA plans to move to a hybrid IT regime within 3–5 years, relying on a nominal interest rate operating target and a stabilized market-determined ER as nominal anchors, after necessary conditions are in place; this could lead to fully-fledged IT over the long term.
- Strengthening monetary policy framework and operations:
  - Staff recommendations:
    - Strengthen CBA independence and operationalize the de facto floor system.
    - Formalize action and communication plan for transition to IT.
    - Bolster analytical and forecasting capacity and expand policy toolkit.
    - Strengthen and deepen the financial system.
  - Suggested operational measures (summarized):
    - Create detailed strategy to transition to IT and publish a summary.
    - Amend Central Bank Law as needed to enhance independence.
    - Allow ER flexibility while maintaining ER as nominal anchor.
    - Use interest rate policy and FX operations more actively.
    - Publish forecasts of inflation and key variables; activate liquidity forecasting and monitoring units.
    - Utilize de facto floor system and standing liquidity absorption facility; issue LT notes at market-determined rates to sterilize excess liquidity; introduce overnight OMO fine-tuning instruments; adjust reserve requirement ratio upward to become effective.
    - CBA should be sole provider of FX to the market; introduce ER arrangement with horizontal bands and variation limits; develop communication strategy; increase ER transparency by publishing detailed FX auction results.
  - Authorities plan to continue monetary and ER policy TA program with the Fund.

### Financial Stability and Development
- Banking system remains fragile despite improvements:
  - Dollarization, unhedged FX positions, and NPLs are still high.
  - Some banks are undercapitalized or insolvent.
  - IBA has removed bad assets and restructured FX liabilities but lacks a viable business model.
- Staff recommendations on banking sector:
  - Under-capitalized banks should be given strict deadlines to recapitalize or close.
  - Large banks with narrow capital buffers should be required to strengthen them.
  - End supervisory forbearance, enforce regulatory norms, and strengthen banks’ corporate governance.
  - Privatize IBA as soon as possible.
- Financial sector oversight and FIMSA:
  - Strengthen FIMSA’s independence and resources; current charter provides full operational independence on budget and staffing but lacks independence over granting new licenses; closures may require political consent.
  - Recent regulations (including on FX lending) and new methodology for systemically important banks have bolstered oversight.
  - Staff recommended gap analysis against Basel Core Principles to identify supervision improvements and move quickly to resolve uncertainty over possible extensions of blanket deposit insurance guarantee.
  - Authorities requested TA on financial sector regulation and supervision and expressed interest in an FSAP Update.

### Box 2. New NPL Resolution Program
- Program objective: reduce NPLs and compensate individuals whose debt servicing burden increased due to the 2015 devaluations.
- Fiscal and banking support design:
  - Some AzN 650 million has been sent from the state budget to banks.
    - About half retained by banks to pay down overdue retail loans, where applicable.
    - Capital in the banking system is expected to increase by AzN 300 million (7.4 percent of end-2018 system-wide capital).
    - The remaining portion (0.4 percent of GDP) has been sent by banks to individuals (in debit card form) to compensate them for having serviced outstanding loans at the new (depreciated) ER.
  - Banks are required to restructure FX retail loans: redenominated to manat, terms extended, interest rates reduced, and accrued interest and fees written off. The redenomination to manat exacerbates banks’ open currency positions.
  - To mitigate banks’ FX risk:
    - CBA will make loans of some AzN 680 million available to banks at low interest rates and under government guarantees.
    - CBA will make $215 million worth of dollar-denominated bonds available to banks for purchase.
    - By taking a loan from the CBA in manat and using proceeds to buy a dollar-denominated bond, a bank can close its open currency position.

*Source: National authorities and IMF staff calculations, as presented in the source content.*

### 29.      While the new NPL program will improve household balance sheets, it will have

### While the new NPL program will improve household balance sheets, it will have

### Banking sector and NPL program: findings
- The program will boost banks’ liquidity, and the restructuring will reduce loan dollarization.
- The authorities expect that bank solvency will improve in a small number of banks, as positive effects from government transfers outweigh negative effects of accrued interest write-offs.
- Staff and authorities agreed that the program creates moral hazard by undermining incentives for proper risk management of new FX loans and worsens repayment culture.
- NPLs are likely to remain high after the program (12.9 percent), and uncertainty surrounding NPL estimates will persist.
- FIMSA has identified four systemically important banks that have a CAR requirement of 11 percent, compared to ten percent for the rest of the system.

### NPL resolution strategy and supervisory recommendations
- Authorities and banks: FIMSA has been developing an out-of-court settlement system to facilitate NPL resolution.
- Legal and institutional measures underway:
  - FIMSA is drafting legal amendments that would enable the creation of asset management companies.
  - Authorities are assessing possible reforms to the responsible lending law, with an aim toward directing resources to tradable goods sectors.
- Staff recommendations:
  - An independent and transparent asset quality review (AQR) is essential to ascertain likely loan recovery rates; on-site inspections of provisioning practices are not a substitute for AQRs.
  - Impose timetables to resolve NPLs through write-offs or sales and make the process cheaper and quicker.
  - Improve bank governance and roll back regulatory forbearance to prevent weakening in bank balance sheets.
  - Ensure transparent accounting of bad asset management and resolution.

### Debt market development and debt management
- Staff highlighted the importance of a coordinated approach to debt market development.
- Key elements of a capital market development strategy:
  - Develop deeper local currency bond market with longer tenors, more diversified investor base, market-determined pricing, and enhanced secondary market liquidity.
- Better coordination among the Ministry of Finance, CBA, and SOFAZ should ground government borrowing and investment decisions in an integrated asset-liability management framework assessing risk-return trade-offs and macro-financial implications.
- Authorities’ concern: a manat bond market could become concentrated among a few domestic investors and crowd out lending to private sector.

### Financial data, transparency, and market functioning
- Financial data and analysis should be strengthened:
  - While financial institutions are in principle required to publish accurate data, capital and NPL figures in several banks are widely viewed as questionable.
  - This uncertainty discourages banks from participating in interbank transactions.
- FIMSA actions and staff recommendations:
  - Building on recent TA, FIMSA should verify and start publishing financial soundness indicators, more detailed banking system data, and a financial stability report.

### Structural impediments to inclusive and diversified growth
- Persisting structural impediments include:
  - (i) weak governance and institutions; (ii) limited SME access to credit; (iii) inefficient labor markets; (iv) export concentration; (v) limited product and trade market competition; and (vi) sizeable skill gaps.
- Consequences: high informality, limited FDI, weak entrepreneurship and SME development, and low productivity.
- Policy and reform directions:
  - Lower entry barriers, including by applying the Anti-Monopoly Law, to improve market efficiency.
  - Complete WTO membership process to inject competition into domestic markets and foster diversification.
  - Apply the OECD’s Investment Guidelines to attract nonoil FDI and know-how.
  - Expand financial literacy and promote competition in the banking sector to stimulate SMEs and reduce reliance on tax incentives.
  - Prioritize and improve efficiency of public spending on education to address skill mismatches.

### Governance, anti-corruption, and AML/CFT
- Addressing governance, anti-corruption and AML/CFT vulnerabilities would support creation of a private sector-led, inclusive growth model.
- July 2018 IACP monitoring report: recognized progress in raising awareness about corruption and in the functioning of the government’s Commission on Combating Corruption, but limited transparency and engagement hinder assessment and formulation of recommendations.
- Staff urged stepped-up reforms in line with the UNCAC and recommendations received to strengthen anti-corruption strategy and policies, rule of law, and enforcement of the asset declarations regime for public officials.
- Further strengthen the AML/CFT framework, particularly:
  - preventive measures, beneficial ownership, risk-based supervision, and enhancing prosecution and conviction.
- Continued engagement between authorities and key stakeholders would facilitate strengthening anti-corruption and AML/CFT frameworks.

### Staff appraisal: policy priorities and recommendations
- Main policy priority: fostering private sector-led and diversified growth while improving resilience to future shocks.
- Fiscal policy:
  - Continue fiscal consolidation to save an adequate portion of exhaustible oil wealth for future generations.
  - Consolidation should be growth-friendly: mobilize higher non-oil revenues, improve efficiency of public spending, prioritize investments in human capital, restructure SOEs, and better target transfers and subsidies.
  - Reducing the non-oil primary deficit by 1 percentage point of non-oil GDP would help build precautionary buffers and maintain debt sustainability; further adjustment is needed to improve intergenerational equity.
- Fiscal rule and public financial management:
  - Introduction of a fiscal rule in 2019 was a major step forward; 2019 spending packages will challenge compliance.
  - Refine the fiscal rule to ensure it fosters fiscal discipline and is robust, sustainable, and credible.
  - Complement the fiscal rule with stronger public financial management practices, greater fiscal transparency, and better management of fiscal risks.
- Monetary policy and market development:
  - A further monetary easing appears appropriate given still tight financial conditions and remaining spare capacity.
  - Transitioning to inflation targeting and greater ER flexibility would help absorb shocks and promote better risk management.
  - Modernize monetary operations and increase issuance of local currency securities to foster financial market development, facilitate liquidity management, and provide benchmark securities.
  - Resist financial repression, including through interest rate caps.
- Financial supervision and competition:
  - Strengthen financial supervision and increase competition to enable the financial sector to support economic growth.
  - An independent asset quality review is a critical starting point to assess true health of the system.
  - Upgrade and strengthen financial sector supervision to improve confidence and prevent build-up of future vulnerabilities.
- Structural reforms for diversification:
  - Remove structural impediments by opening to international trade and investment, reducing the size of the public sector, and improving financial inclusion and governance.
  - Follow through with effective implementation, monitoring, and assessment of recently announced institutional and regulatory reforms.
  - Improve data and transparency to enhance decision-making and reduce vulnerabilities to corruption.

*REPUBLIC OF AZERBAIJAN  INTERNATIONAL MONETARY FUND*

### 42.      It is recommended that the next Article IV consultation takes place on the standard

### 42.      It is recommended that the next Article IV consultation takes place on the standard 

### Macroeconomic Outcomes (Figure 1)
- Growth (Percent Change): 2008-18 Average and 2018 comparisons shown for Armenia, Azerbaijan, Georgia, Kazakhstan, Kyrgyz Republic, Tajikistan, Turkmenistan, Uzbekistan (chart data presented visually).
- Inflation (Percent Change, Year Average): 2008-18 Average and 2018 comparisons across same countries (chart data presented visually).
- Fiscal Balance (Percent of GDP): 2008-18 Average and 2018 comparisons (chart data presented visually).
- Balance on Current Account (Percent of GDP): 2008-18 Average and 2018 comparisons (chart data presented visually).
- Credit to Private Sector (Percent of GDP): 2008-18 Average and 2018 comparisons (chart data presented visually).
- Unemployment Rate (Percent): 2008-18 Average and 2018 comparisons (chart data presented visually).

### Real Sector Indicators (Figure 2)
- Contributions to Growth (In percent): Oil, Non-Oil, Total, 2002–2018 (time-series chart).
- Real GDP and Non-Oil GDP Growth (In percent): monthly/quarterly series from Jan-12 to May-19 (chart).
- Actual and Potential Non-oil Growth and Output Gap (In percent): series 2000–2024 (chart).
- Headline, Food, Non-Food, and Services Inflation (In percent): monthly series Jan-13 to Apr-19 (chart).
- Labor Productivity, Output per Worker (GDP constant 2011 international $ in PPP): series 2000–2018 showing EM Europe, CCA Oil Importers, CCA Oil Exporters, AZE (chart).
- Azerbaijan: Contribution to Growth, 2010-18 (In percent): Capital, Labor, TFP, GDP growth (chart).

### External Sector (Figure 3)
- Export of Goods: Main Commodities (Percent of Total Export, 2017)
  - Oil 81.8%
  - Oil products 3.6%
  - Natural gas 9.0%
  - Metals 1.6%
  - Vegetable products 0.7%
  - Chemical products 0.6%
  - Machines 0.5%
  - Liquors, wine, and tobacco 0.5%
  - Textiles 0.4%
  - Plastic and rubbers 0.2%
  - Animal hides 0.2%
  - Transportation vehicles 0.2%
  - Other exports 0.6%
  - Non-hydrocarbon 5.6%
- Current Account (Percent of GDP): trade balance, service balance, net income and overall current account series 2004–2018 (chart).
- Non-oil Imports, Exports, and Current Account Balance (In percent of non-oil GDP): series 2004–2018 (chart).
- Capital and Financial Account (Percent of GDP): Other investment net, Portfolio investment net, Direct investment net, Capital and financial account series 2004–2018 (chart).
- Oil Fund Assets and Gross Official Reserves (Billions of U.S. Dollars): series 2004–2018 (chart).

### Exchange Rate (Figure 4)
- CCA Domestic Currency per USD (Jan 2014 = 100): series Jan-14 to Jun-19 for ARM, AZE, GEO, KAZ, RUS, KGZ, UZB, TKM (chart).
- Azerbaijan: Exchange Rate (AzN per USD): series Jan-14 to Jun-19 (chart).
- Azerbaijan: Manat cross exchange rates (Jan 2014 = 100): Euro, Russian Ruble, Turkish Lira, Kazakhstani Tenge, Georgian Lari (series Jan-14 to Jun-19).
- Azerbaijan: Non-oil sector's REER, NEER, Relative Prices (June 2010 = 100): REER (non-oil), NEER (non-oil), Relative prices series Jan-14 to Jun-19.

### Fiscal Sector (Figure 5, Tables 3a/3b)
- Oil and Non-oil Revenues including from VAT and Income Taxes (Percent of GDP): series 2005–2018 (chart).
- Capital and Current Expenditures (Percent of non-oil GDP): series 2005–2018; Oil Price ($ per barrel, RHS) included (chart).
- Oil price, Fiscal Breakeven Oil Price, Non-oil Primary Balance (US$ per barrel, unless otherwise noted): series 2005–2018 (chart).
- Current and Capital Expenditure, 2018 (Percent of GDP): Current Expenditure and Capital Expenditure levels by country (chart).
- General Government Revenues (Percent of GDP): composition (Personal Income, Corporate Income, General Goods and Services, International Trade, Unclassified Taxes, Other income) across countries (chart).
- Quality of Infrastructure and Capital Expenditure, 2018: Quality of infrastructure (score 1-7) vs capital expenditure (percent of GDP) (chart).
- Selected fiscal projections and key figures (Table 1, Table 3a, Table 3b):
  - GDP at constant prices growth: 2017 -0.3; 2018 1.4; 2019 2.7; 2020 2.1; 2021 2.1; 2022 2.2; 2023 2.3; 2024 2.5
  - Consumer price index (period average): 2017 12.8; 2018 2.3; 2019 3.2; 2020 3.3; 2021 3.4; 2022 3.5; 2023 3.5; 2024 3.5
  - Total revenue and grants (Percent of GDP): 2017 34.2; 2018 38.8; 2019 39.1; 2020 37.8; 2021 37.2; 2022 36.0; 2023 34.9; 2024 33.9
  - Total expenditure (Percent of GDP): 2017 35.6; 2018 33.1; 2019 34.7; 2020 34.4; 2021 34.2; 2022 33.8; 2023 33.1; 2024 32.4
  - Overall fiscal balance (Percent of GDP): 2017 -1.4; 2018 5.6; 2019 4.4; 2020 3.4; 2021 3.0; 2022 2.2; 2023 1.7; 2024 1.5
  - Non-oil primary balance (in percent of non-oil GDP): 2017 -30.9; 2018 -32.1; 2019 -31.1; 2020 -30.0; 2021 -29.1; 2022 -28.1; 2023 -27.1; 2024 -26.1
  - General government gross debt (direct borrowing) (Percent of GDP): 2017 22.5; 2018 18.8; 2019 19.7; 2020 18.6; 2021 16.7; 2022 15.1; 2023 13.6; 2024 9.9
  - Oil Fund Assets (in millions of U.S. dollars): 2017 35,807; 2018 38,515; 2019 40,986; 2020 42,421; 2021 43,361; 2022 43,746; 2023 43,883; 2024 43,942
  - Assumed oil price, WEO plus $2 premium (US$ per barrel): 2017 54.87; 2018 70.36; 2019 63.55; 2020 59.95; 2021 58.05; 2022 57.25; 2023 57.25; 2024 57.6
- Consolidated government operations (Table 3a) 2019 projections (millions of manat):
  - Total revenue 31,363
  - Tax revenue 12,680
  - Nontax revenue 18,663 (Of which: Oil Fund revenues 15,940)
  - Total expenditure 27,844
  - Current Expense 18,330
  - Net Acquisition of Nonfinancial Assets 9,515
  - Overall balance 3,519
  - Non-oil primary balance -15,460

### Monetary Sector (Figure 6, Tables 4–5)
- CBA Interest Rate Corridor (Percent): CBA Repo Rate, CBA Refinancing Rate, CBA Reverse Repo Rate, CBA Notes (time series Jan-14 to May-19).
- Money Supply and Deposit Dollarization (Percent, y-o-y): CBA Base Money, Broad money (M3), Manat broad money (M2), Deposit Dollarization (FC D/T D) (series Jan-14 to Jun-19).
- Credit to Private Sector (AzN Billions): Loans to Real Sector (EOP, NSA, Mil.Manat) and Credit to Private Sector (Constant ER) series (Jan-14 to Jun-19).
- Overdue Loans (Percent of total loans): series Jan-14 to May-19 with note that reported NPLs do not fully reflect actual NPLs per 2015 FSAP.
- CBA FX Auctions and AzN/US$ Rate: FX supplied, FX demanded, Official ER (RHS) series Jan-18 to May-19.
- Central Bank summary (Table 4, in millions of manat):
  - Net international reserves of the CBA: 2017 12,019; 2018 11,400; 2019 11,910; 2020 12,420; 2021 12,930; 2022 13,440; 2023 13,950; 2024 14,460
  - Reserve money: 2017 9,873; 2018 10,644; 2019 11,315; 2020 11,998; 2021 12,584; 2022 13,119; 2023 13,709; 2024 14,359
  - Manat reserve money and components provided (series).
- Monetary survey (Table 5, in millions of manat):
  - Net foreign assets: 2017 15,422; 2018 15,314; 2019 15,904; 2020 16,494; 2021 17,084; 2022 17,674; 2023 18,265; 2024 18,857
  - Broad money (M3): 2017 22,772; 2018 25,341; 2019 27,165; 2020 28,805; 2021 30,589; 2022 32,546; 2023 34,695; 2024 37,059
  - Credit to the economy: 2017 11,363; 2018 13,058; 2019 14,507; 2020 15,693; 2021 16,929; 2022 18,290; 2023 19,826; 2024 21,556
  - Credit to private sector (share of non-oil GDP): 2017 25.2; 2018 27.9; 2019 29.2; 2020 29.8; 2021 30.2; 2022 30.7; 2023 31.2; 2024 31.8

### Deposits and Interest Rates (Figure 7)
- Loan-to-Deposit Ratio (Percent): LTD (FX loans/FX deposits), LTD (LC loans/LC deposits), LTD (Total) series Jan-14 to Jun-19.
- Growth of Deposits in Local Currency (Percent, y-o-y): LC Demand Deposits, LC Time Deposits series Jan-14 to Jun-19.
- Growth of Deposits in Foreign Currency (Percent, y-o-y, Constant ER): FX Demand Deposits, FX Time Deposits series Jan-14 to Jun-19.
- Deposit and Lending Interest Rates (Percent, average, end of period): LC Deposit Rate, FX Deposit Rate, LC Lending Rate, FX Lending Rate series Jan-14 to Jun-19.
- Notation of first and second devaluation events marked on charts.

### Business Environment and Governance (Figure 8)
- Doing Business Indicators (Distance to frontier, 100 represents the frontier): Enforcing contracts, Getting credit, Getting electricity, Paying taxes, Registering property, Resolving insolvency, Starting a business, Trading across borders (comparisons AZE, CCA, EM Europe).
- Worldwide Governance Indicators (units of a standard normal distribution ~ -2.5 to 2.5): Voice and Accountability, Political Stability and Absence of Violence/Terrorism, Government Effectiveness, Regulatory Quality, Rule of Law, Control of Corruption (AZE vs CCAEMDE).
- Global Competitiveness Index (Score of 0-100): Institutions, Infrastructure, ICT adoption, Macroeconomic stability, Health, Skills, Product market, Labour market, Financial system, Market size, Business dynamism, Innovation capability (AZE, CCAEM, Europe).
- Trade Restrictions and Prevalence of Trade Barriers (indices and ranks) with caution noted on survey limitations.
- Quality of Infrastructure (Score of 1-7) plotted against GDP per capita (USD).

### Public Sector Debt Sustainability (Figures 9–11; Tables 6)
- Public DSA – Baseline Scenario (As of April 05, 2019) key projections and indicators (in percent of GDP unless otherwise indicated):
  - Nominal gross public debt: 2017 8.6; 2018 22.5; 2019 18.8; 2020 19.7; 2021 18.6; 2022 16.7; 2023 15.1; 2024 13.6; 2024 9.9 (table shows sequence through 2024).
  - Net public debt: 2017 -45.2; 2018 -64.0; 2019 -63.3; 2020 -67.2; 2021 -69.4; 2022 -70.2; 2023 -68.9; 2024 -66.7; 2024 -66.3 (table entries).
  - Real GDP growth (in percent): 2017 3.6; 2018 -0.3; 2019 1.4; 2020 2.7; 2021 2.1; 2022 2.1; 2023 2.2; 2024 2.3; 2024 2.5 (table sequence).
  - Inflation (GDP deflator, in percent): 2017 6.1; 2018 16.7; 2019 12.2; 2020 -1.5; 2021 0.2; 2022 1.2; 2023 1.9; 2024 2.5; 2024 2.7.
  - Effective interest rate (in percent) defined as interest payments divided by debt stock: 2017 2.8; 2018 3.0; 2019 3.4; 2020 3.8; 2021 4.3; 2022 4.9; 2023 4.7; 2024 4.7; 2024 4.1.
  - Change in gross public sector debt (cumulative projections): change values and identified debt-creating flows detailed (table).
- Public DSA — Alternative Scenarios and Composition of Public Debt (Figure 10):
  - Baseline, Historical, Constant Primary Balance, Contingent Liability Shock scenarios with underlying assumptions (Real GDP growth, Inflation, Primary Balance, Effective interest rate) shown for 2019–2024.
  - Composition charts: Net debt (percent of GDP), Gross Nominal Public Debt (percent of GDP), Public Gross Financing Needs (percent of GDP), By Maturity (Short-term vs Medium and long-term), By Currency (Local vs Foreign currency-denominated).
- External Debt Sustainability: Bound Tests (Figure 11; Table 6)
  - Baseline external debt (in percent of GDP): series 2014–2024 with baseline around 42 for projection years.
  - Individual shock tests: Interest rate shock, Real depreciation shock, Growth shock, Non-interest current account shock, Combined shocks, CA shock, Historical scenario.
  - External debt indicators (Table 6): Baseline external debt series 2014 22.0; 2015 37.0; 2016 50.0; 2017 53.3; 2018 47.3; 2019 48.4; 2020 47.7; 2021 46.9; 2022 46.1; 2023 45.0; 2024 41.6
  - Identified external debt-creating flows, current account deficit excluding interest, exports and imports growth rates, gross external financing need (in billions of US dollars and percent of GDP) provided.
  - Key macroeconomic assumptions underlying baseline included (Real GDP growth, GDP deflator in US dollars change, Nominal external interest rate, Growth of exports/imports in US$ terms, Current account balance excluding interest payments, Net non-debt creating capital inflows).

### Balance of Payments and External Projections (Tables 2a/2b)
- Exports and Imports (millions of U.S. dollars, Table 2a):
  - Exports, f.o.b.: 2017 15,152; 2018 20,794; 2019 17,243; 2020 17,217; 2021 16,995; 2022 16,974; 2023 17,168; 2024 17,476
  - Oil and gas sector exports (millions of US$): 2017 13,679; 2018 19,176; 2019 15,589; 2020 15,481; 2021 15,163; 2022 15,043; 2023 15,134; 2024 15,335
  - Imports, f.o.b.: 2017 -9,037; 2018 -10,952; 2019 -8,958; 2020 -8,655; 2021 -8,293; 2022 -8,033; 2023 -7,872; 2024 -7,760
- Current account (millions of US$ and percent of GDP): Current account balance 2017 1,685 (4.1 percent of GDP); 2018 6,051 (12.9); 2019 4,596 (9.7); 2020 4,839 (10.0); 2021 3,856 (7.7); 2022 3,602 (6.9); 2023 3,949 (7.2); 2024 4,422 (7.7)
- Financial account and capital flows: Direct investment, portfolio investment, other investment, financial account net, and overall balance series 2017–2024 provided in Tables 2a/2b.
- Memorandum items: Gross official international reserves (US$ millions) 2017 5,335; 2018 5,626; 2019 5,926; 2020 6,226; 2021 6,526; 2022 6,826; 2023 7,126; 2024 7,426; Oil Fund assets and Public and publicly guaranteed external debt (percent of GDP) also provided.

### Key Statistics and Projections (Table 1 summary)
- Nominal GDP (in millions of manat): 2017 70,338; 2018 79,797; 2019 80,215; 2020 81,981; 2021 84,786; 2022 88,474; 2023 92,949; 2024 97,988
- Nominal GDP (in millions of U.S. dollars): 2017 41,375; 2018 46,940; 2019 47,185; 2020 48,224; 2021 49,874; 2022 52,043; 2023 54,676; 2024 57,640
- Gross investment (percent of GDP): 2017 24.4; 2018 20.1; 2019 21.3; 2020 20.0; 2021 20.4; 2022 20.5; 2023 20.8; 2024 21.2
- Consolidated general government finances and external sector key ratios provided across 2017–2024.

*Source: IMF staff and national authorities as presented in the supplied content.*

### Annex I. External Sector Assessment

### Annex I. External Sector Assessment

### External position and current account (CA)
- The external position improved in 2018 on higher oil prices and lower oil-related services imports.
- The CA continued to strengthen in 2018; the CA and REER tend to move with oil prices.
- After a decade of double-digit CA surpluses, the oil price shock of 2014–15 led to a sharp deterioration in the CA. Recovery in oil prices in 2017–18 and a reduction in oil-related construction and business services led to a rebound of the CA to a surplus of 4.1 and 12.9 percent of GDP in 2017 and 2018 respectively.
- The nonoil CA balance continued to worsen due to a marked increase in nonoil imports and meager growth in nonoil exports.
- Near-term projection: the overall CA surplus is expected to decline to about 10 percent of GDP as oil prices moderate and the impact of the recent appreciation of the REER kicks in.

### Financial account and foreign direct investment (FDI)
- The financial account registered net outflows in 2018.
- Acquisition of foreign assets remained relatively stable while foreign liabilities, particularly FDI and portfolio inflows, declined.
- FDI averaged over 7 percent of GDP in the 2010–17 period but fell to only 2 percent of GDP in 2018.

### Reserve adequacy and liquidity
- CBA’s gross official international reserves increased by 7.5 percent, to $5.8 billion (12.2 percent of GDP, 5.1 months of next year’s imports) by end-2018.
- Oil Fund (SOFAZ) foreign assets were $38.6 billion (82 percent of GDP) at end-2018.
- Together, CBA reserves and SOFAZ assets are equivalent to 39 months of next year’s imports.
- The IMF’s Assessing Reserve Adequacy (ARA) metric shows Azerbaijan scores much better than most EMs on all criteria (yellow diamonds), and remains strong into 2024 given strong CA surpluses, rising reserves, and limited increases in external debt (red diamonds).
- Reserve coverage comparisons: ARA Metric, 3 Months Imports, Broad Money shown; data for EM refer to a sample of 48 emerging markets.

### EBA-Lite assessment, CA and REER gaps, and policy implications
- Despite a sizeable CA surplus, the external position is moderately weaker than implied by fundamentals and desirable policies.
- EBA-Lite regression-based model estimates:
  - Multilaterally-consistent cyclically adjusted CA norm of 13.3 percent of GDP.
  - Actual cyclically-adjusted CA surplus of 11.6 percent of GDP in 2018.
  - Estimated CA gap of -1.7 percent of GDP and a REER gap of 4.9 percent (implying REER should depreciate by 4.9 percent for the CA to be at the norm).
- Main policy changes that would reduce the external gap over the forecast period include:
  - (i) Deeper fiscal consolidation: additional 3.3 pp of nonoil GDP increase in NOPB to -23 percent of nonoil GDP by 2024, mainly through improvements in the efficiency of spending.
  - (ii) Higher public health expenditure: an increase of about 1 pp of GDP to 2.3 percent of GDP by 2024 to get closer to the EM average of 3.5 percent of GDP, accompanied by improvements in the efficiency of healthcare spending.
  - (iii) Financial deepening: bank credit to the private sector to reach the level of 18 percent of GDP, accompanied by improvements in bank supervision and regulation.
- The results imply the CA gap is driven mainly by the fiscal policy gap; the manat has been held constant at about AzN/$ 1.70 since April 2017 while regional trading partners experienced depreciations.

### Sensitivity of assessment to policy assumptions
- No policy change scenario: CA gap -2.4 percent of GDP; REER gap 6.8 percent.
- Fiscal consolidation only: CA gap -2.6 percent of GDP; REER gap 7.3 percent.
- Fiscal consolidation and financial deepening: CA gap -2.4 percent of GDP; REER gap 7.0 percent.
- Fiscal consolidation, financial deepening, and increase in healthcare spending: CA gap -1.7 percent of GDP; REER gap 4.9 percent.
- Footnotes:
  - REER gap estimates based on an elasticity of -0.35.
  - Overall assessment reflects a CA gap range of [-2%, -1%].

### Commodity (consumption-allocation) module results
- Consumption-allocation commodity module (constant real per capita annuity preferred) suggests a CA norm of 14.2 percent of GDP versus the EBA-Lite CA norm of 13.3 percent of GDP.
- The per capita annuity results imply a CA gap of 1.3 percent of GDP in 2018 that widens to 2.5 percent over the medium term.
- Higher CA norm from the commodity module is explained by precautionary savings motives given volatile hydrocarbon revenue flows.

*Source: Annex I. External Sector Assessment (Republic of Azerbaijan), IMF staff calculations and national authorities.*

### 4.      Possible improvements in the rule include:

### 4.      Possible improvements in the rule include:

### i. Spending stability and budget predictability
- Set the target for the non-oil deficit or the expenditure ceiling over the medium term to produce a more stable path for expenditure growth, making it less dependent on current year oil prices.
- The spending ceiling and NOPB path would be revised only every three-four years.
- Graphical indicators in the source illustrate projected paths for:
  - Expenditure Ceiling (AZN, billion)
  - Overall Balance (Percent of GDP)
  - Non-oil Primary Deficit (Percent of nonoil GDP)
  - SOFAZ Assets (USD, billion)

### ii. Flexibility and asymmetric countercyclicality
- The rule is less countercyclical in downturns than upturns; a large fall in oil prices implies a larger upfront adjustment.
- Mitigation options:
  - Place a floor on the ratio of NFA to annual oil revenues.
  - Combine the floor with limits on nonoil real primary expenditures and the NOPB of SOEs, all within a four-year budget plan.
  - If oil revenues rise above the baseline path assumed in the budget, spending can be increased only by maintaining the same ratio of NFA to oil revenue.
  - Any shortfall would be covered in the year of the fall but would need to restore the NFA ratio within five years.
- Objective: allow increasing spending somewhat with higher oil prices, while avoiding immediate fiscal contraction during oil price declines.

### iii. Institutional coverage and quasi-fiscal activity
- Current institutional perimeter of the rule is the CB.
- Risk: entities outside the CB, such as SOEs, can conduct fiscal operations on government’s behalf (e.g., delivering subsidies by selling at prices below cost recovery, creating employment, delivering social programs), which may not be captured if coverage is limited to the CB.
- Extending the perimeter to include SOEs involves a trade-off with the practicality of monitoring SOE financial operations given limited information availability.
- The authorities have established a SOE monitoring commission which is compiling data on the 14 largest SOEs.

### iv. Definitions
- NFA should incorporate only liquid assets and easily recoverable financial liabilities (owed by SOEs to the government) to ensure a realistic calculation of available assets.
- Currently, non-oil expenditure (revenue) is defined to include debt repayments (debt disbursements).
- Inclusion of these financing flows in the above-the-line aggregates could distort the application of the rule.

### v. Defining adequate enforcement and reporting requirements
- Require periodic MOF reporting on fiscal performance compared to the rule.
- Require suggestions for remedial measures in case the rule is not followed.

---

### Annex IV — Fiscal Governance: Fiscal Transparency (key findings and recommendations)
- Progress made in data dissemination: authorities started to publish some data through the National Summary Data Page (NSDP), with links to statistics published by the Ministry of Finance, State Statistical Committee, and the Central Bank of Azerbaijan.
- Authorities are working on enhancing GFS, PSDS, and fiscal reporting with IMF technical assistance under the three-year Central Asia and South Caucasus Fiscal Transparency Project (to align with GFSM 2014 and PSDSG).
- A detailed narrative is published on the annual budget; quarterly and annual budget execution reports are also published.
- Recommended actions to align with the IMF’s Fiscal Transparency Code (FTC):
  - Reporting:
    - Publish fiscal data in line with GFSM 2014 and PSDSG.
    - Expand budget execution reports with disaggregated data by administrative, functional, or economic classification, and reflect outturns compared with projections and previous year outturns.
    - Publish consolidated IPSAS-compliant financial statements.
  - Forecasting and Budgeting:
    - Include details of macroeconomic and fiscal projections for the medium-term and their underlying assumptions in budget documentation.
    - Provide more data on budgetary expenditure by functional and economic classification.
    - Publish details of major investment projects and associated multi-year costs.
  - Risk Analysis and Management:
    - Publish a report on the finances of the SOE sector.
    - Continue to monitor the financial sector for emergent risks.
    - Expand information published on fiscal risks with sensitivity analyses based on macroeconomic assumptions in a comprehensive fiscal risk statement.
  - Resource Revenue Management:
    - Continue to publish self-assessments on application by SOFAZ of Santiago principles.
    - Maintain adherence to EITI standards.
- Open Budget Index (2017) identified areas for improvement: pre-budget statement, citizens budget, and mid-year review.

### Public Procurement (key findings and recommendations)
- The State Procurement Agency was abolished in 2017 and the State Service for Antimonopoly Policy and Consumer Rights' Protection in the Ministry of Economy now oversees the general legal procurement framework, monitoring and auditing of tenders, and resolving complaints and conflicts.
- Procurement system remains highly decentralized with more than 800 procuring entities; each entity oversees its own tender process, bid evaluations, and final selections.
- Proposed new State Procurement Law includes provisions for:
  - e-procurement;
  - an electronic unified register of procurement contracts;
  - mechanisms to limit participation of nonreliable bidders;
  - development of procurement plans;
  - stronger civil servant ethical guidelines;
  - competitive negotiation rules; and
  - complaint procedures.
- Domestic preference rule example: winning domestic producer bids can exceed the lowest cost foreign bid by at least 20 percent.
- Rationale: Implementing the new law and conducting a comprehensive diagnostic assessment of the procurement system would help deliver value for money, suppress opportunities for corruption, and inform an action plan beyond e-procurement.
- Context: Government spending on goods and services and capital projects is about 18 percent of GDP.

---

### Annex V — Inclusive Growth (key findings, indicators, and policy directions)
- Inclusive growth (IG) captures sustainability of the growth model and opportunities for all; with nonoil growth slow since 2015 and oil production faltering, promoting equitable, broad-based, and sustainable growth is macro-critical.
- Azerbaijan performs well relative to CCA peers in income inequality, life expectancy, and access to schooling, but lags in other IG indicators: health and education outcomes, efficiency of social spending, governance and control of corruption, and access to credit by SMEs.
- Social spending and outcomes:
  - Azerbaijan spends the least in percent of GDP on health and education in the CCA, although in per capita terms it is in line with peers.
  - Efficiency concerns: outcomes in education and healthcare fall short of those predicted by public outlays.
  - Recent fiscal adjustments: after a 19 percent jump in 2019, spending on education and health is set to increase by additional 45 percent in 2020.
- Labor income and social protection:
  - Statutory minimum wage is relatively low compared to regional peers and has not kept up with cost of living; the gap between average and minimum wage has been rising.
  - Even with the latest increase in minimum wages, Azerbaijan would still fall below the 0.6 ratio of minimum to average wage recommended by the European Social Charter.
  - Recent steps to raise minimum pensions and minimum wages aim to alleviate poverty and reduce inequality.
- Financial inclusion and SME finance:
  - Low financial inclusion is a key impediment to inclusive growth; Azerbaijan ranks poorly in access to credit compared to peers.
  - Financial inclusion is particularly problematic for youth: only 12 percent having a bank account.
  - Reported top barriers to financial access: lack of trust in banks and high cost of borrowing.
  - Constraints to SME financing: high collateral requirements and insufficient credit bureau coverage.
- Business environment and governance:
  - Private investment has declined precipitously since the Global Financial Crisis.
  - Implementation of laws and regulations to promote competition is weak.
  - Azerbaijan ranks poorly compared to regional and EM averages in controlling corruption; institutional quality and regulatory burden are main obstacles to doing business and contribute to high economic informality.
- Policy directions to promote inclusive growth:
  - Rebalance spending toward education and healthcare and improve efficiency of such spending.
  - Close infrastructure quality gaps through better governance and procurement.
  - Improve targeting of social protection.
  - Create fiscal space through revenue mobilization, improved efficiency of spending, and reduced generalized subsidies (for example, tariffs set below cost recovery on fuel, water, electricity) that disproportionately benefit the rich, to free resources for social spending.

*Source: 1azeea2019001 (PDF chapter/section).*

### 7.      Financial reforms should address the demand and supply impediments to SME

### 7.      Financial reforms should address the demand and supply impediments to SME inclusion

### Key recommended reforms to improve SME access to finance
- Address both demand- and supply-side impediments through:
  - Cleaning up banks’ balance sheets and promoting competition.
  - Increasing credit bureau coverage and lowering collateral requirements.
  - Training entrepreneurs.
  - Developing capital markets.
- Complementary measures:
  - Supporting fair competition.
  - Improving governance.
  - Strengthening property rights.
  - Reducing SOE dominance.
  - Rationalizing business regulations.

### Financial sector context and recent policy actions
- Banking sector measures and outcomes:
  - Presidential Decree of March 2019 provides financing of an NPL resolution program; NPL resolution is considered an important milestone for improving financial stability.
  - As a result of the Decree, banking sector activity, including lending and deposit operations, has increased significantly.
  - The Central Bank of Azerbaijan (CBA) eased monetary policy by reducing the refinancing rate from 15 to 8.25 percent since January 2018.
  - The CBA has activated deposit and note auctions over the past 5 years to focus on base money stability.
- Institutional improvements relevant to SME finance:
  - Establishment of a Credit Guarantee Fund.
  - Establishment of a private Credit Bureau.
  - Establishment of the State Registry for collateral.
  - Amendments to the Civil Code (effective December 28, 2018) to strengthen protection of minority investors by allowing shareholders to hold interested directors liable in unfair related-party transactions.

### Macro-financial environment affecting SMEs
- Growth and inflation:
  - Economic growth has recovered, driven mostly by the non-oil sector.
  - Unemployment rate stands around a record-low level of 5 percent.
  - Inflation was at 2.3 percent on average in 2018, which is 10.5 percentage points below the year before.
- Fiscal framework and social measures:
  - Authorities implemented a new fiscal rule aiming to decrease oil dependence of budget revenues:
    - Under the rule, the year-ahead projected non-oil primary deficit as a percentage of non-oil GDP has to be below the current year’s balance.
    - The fiscal rule requires the nominal spending growth rate for the year ahead not to exceed 3 percent of the current year’s approved expenditures.
  - Two Presidential decrees on social spending in the first half of 2019:
    - Increase in public sector wages of about 40 percent, which amounts to 1 percent of GDP.
    - Increase in minimum wages of 92 percent.
- Monetary policy strategy:
  - CBA declared objective to move toward an inflation targeting regime; primary goal is safeguarding price stability by maintaining inflation at 4 percent (±2 percent).
  - CBA declared move to a floating exchange rate regime in December 2015; transition to de-facto floating is underway and will take time.

### Data, supervision, and structural reforms relevant to SME finance
- Statistical and supervisory improvements:
  - Monetary and financial statistics now in full compliance with the Monetary and Financial Statistics Manual and Compilation Guide (MFSMCG) after TA in 2017 and 2018.
  - Financial Market Supervisory Authority (FIMSA) received technical assistance on financial soundness indicators (FSIs) in 2018; FIMSA is not yet reporting core and encouraged FSIs to STA for posting.
  - CBA compiles BOP statistics broadly in accordance with BPM6; International Investment Position statistics re-initiated in 2015.
  - Significant under-coverage and methodological inconsistencies remain in BOP components such as trade in goods and services, investment income, and some financial account components.
- Institutional and business environment reforms:
  - Implementation of “Strategic Roadmap for 2020” since early 2017 to promote private sector-led growth and ease business procedures.
  - Judicial reforms: random and automatic assignment of cases to judges; electronic case management; e-filing for initial complaints; consolidated law on voluntary mediation.
  - Legal change allowing non-possessory security interests in one category of movable assets without restrictions on the use of inventory, including future assets and proceeds.

### Policy priorities to enhance SME inclusion (actionable items derived from the report)
- Strengthen bank balance sheets and competition to increase lending capacity for SMEs.
- Expand credit bureau coverage to reduce information asymmetries and permit lower collateral requirements.
- Support capacity building for entrepreneurs (training programs).
- Develop capital markets to provide alternative financing channels for SMEs.
- Continue improving governance, property rights, and reducing SOE dominance to level the playing field for private SMEs.
- Rationalize business regulations to lower entry and operating costs for SMEs.
- Ensure progress on statistical, supervisory, and legal reforms to improve monitoring of financial stability and SME finance outcomes.

*Source: STAFF REPORT FOR THE 2019 ARTICLE IV CONSULTATION—INFORMATIONAL ANNEX (Republic of Azerbaijan)*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1azeea2019001.pdf_