Mission Concluding Statement 

Republic of Azerbaijan -- IMF Staff Visit Concluding Statement

September 6, 2006

An IMF staff team, led by Vitali Kramarenko from the Middle East and Central Asia Department, visited Baku during August 30-September 6, 2006 to discuss (i) macroeconomic policies for the remainder of 2006; and (ii) the draft 2007 budget and the underlying macroeconomic framework.

The mission would like to thank the authorities for their excellent cooperation and warm hospitality.

The implementation of the authorities' current strategy of speeding up economic modernization and poverty reduction is facing a number of challenges. Exceptionally high increases in public sector spending out of oil revenues have intensified real exchange rate appreciation pressures. Since the pace of nominal exchange rate appreciation has been slow, these pressures have mainly been reflected in higher inflation. Given the authorities' intention to continue to increase expenditure at a rapid pace, it is preferable that further real appreciation occurs through nominal appreciation rather than through higher inflation because of the medium-term negative effects of double-digit inflation on non-oil growth, financial system development, and poverty reduction. There is also a need to moderate the fiscal expansion in both 2006 and 2007 as it would be increasingly difficult to contain liquidity and domestic demand growth with monetary policy instruments alone. The authorities' concern about competitiveness should be addressed through a stepped-up implementation of structural reforms and enhanced capital expenditure management to ensure that the selected projects result in significant productivity increases.

Recent developments

Azerbaijan's growth and external position is exceptionally strong, but inflationary pressures have intensified in recent months. Real GDP grew by 36.2 percent year-on-year in the first half of the year (predominantly driven by the hydrocarbon sector) while non-oil GDP grew by 8.5 percent. The external position is improving significantly as oil export volumes and prices increase. However, fueled by expansionary policies, the 12-month CPI inflation rate increased to 10.2 percent in August 2006 from 5.5 percent in December 2005. In the first half of 2006, total expenditures increased by about 70 percent over the same period of 2005. Moreover, the revised 2006 budget approved in June targets a nominal expenditure increase of about 96 percent, ¹ consistent with a non-oil primary deficit of about 36 percent of non-oil GDP (or 25 percentage points higher than in 2005). At the same time, monetary policy remains accommodating: since January 2006 the ANB has made large mainly unsterilized purchases of foreign exchange, resulting in rapid growth of manat base money, and the manat has appreciated by only 4 percent vis-à-vis the dollar.

The macroeconomic outlook for 2006 and 2007

The growth and external outlook is expected to remain very favorable. Real GDP is set to expand by about 25 percent in 2006 and 2007, mainly due to a further large increase in oil production. This, together with higher oil prices, will lead to a significant widening in the external current account surplus. The non-oil real GDP growth rate is projected to decline from about 9.5 percent in 2006 to 7 percent in 2007, in part because of the completion of the oil-related construction boom.

Mounting inflationary pressures represent the major short-term risk that needs to be tackled without delay. Absent a timely policy adjustment, including greater exchange rate flexibility and a moderation of the fiscal expansion, inflation would continue to increase and inflationary expectations would become entrenched during 2006 and beyond. Given the policy implementation so far in 2006, maintaining inflation in single digits is becoming an increasingly unrealistic near-term objective. Therefore, the remainder of this statement presents the mission's recommended policy mix that could help maintain inflation close to single digits during 2006-07.

Fiscal policy

Fiscal prudence is key to macroeconomic stability and long-term fiscal sustainability. Short-term demand management considerations call for a significant moderation of the fiscal expansion from the intended pace in both 2006 and 2007. The mission recommends reducing the non-oil primary fiscal deficit to about 25 percent of non-oil GDP from the budgeted 36 percent in 2006, and then maintaining this ratio at 25 percent in 2007 compared with the current government's intent to further increase it to 40 percent. The recommended deficit level would leave enough room for a 65 percent increase in expenditure in 2006 and a further 20-25 percent increase in 2007. A tighter fiscal stance for 2006-07 would have been preferable to ensure that inflation stops rising and reverts to single digits quickly, but the mission acknowledges the authorities' desire to speed up the economic and social development and the existence of a large number of unfinished projects. From a longer-term sustainability perspective, the authorities' intended non-oil primary deficits for 2006 and 2007 and implicit energy subsidies, estimated at 25 percent of non-oil GDP in 2006, are clearly unsustainable in the long term.

The mission supports the authorities' intention to implement important fiscal measures. On the revenue side, the authorities' plans to strengthen governance at customs and the ministry of taxes are welcome, and they need to be supported by strong political will to change the culture of tax evasion. This being said, it is not advisable to budget significant gains from improved tax administration before they materialize. On the expenditure side, the mission welcomes the authorities' intent to (i) move utility prices closer to cost recovery; (ii) raise domestic petroleum product prices with a view to gradually aligning them with world market prices; (iii) review staffing levels in budgetary organizations; and (iv) reduce the budget funding of subsidized credits to the private sector. These measures would leave more space for productive spending. Moreover, the mission advises the authorities to ensure full compliance with procurement legislation and to tighten the project selection and evaluation procedures.

The draft 2007 budget should be designed within a sound medium-term framework. This involves (i) following through with the current commitment to present a consolidated central government budget for 2007 and 2008-09 with an emphasis on the non-oil primary deficit; (ii) operationalizing the long-term oil revenue management strategy approved by the President in 2004 by presenting to parliament official estimates of oil wealth and a medium-term path for the non-oil primary deficit; (iii) transferring all upstream oil revenues to the oil fund; and (iv) linking the annual public investment program to a medium-term expenditure framework with a clear definition of national priorities.

Monetary policy

A tighter monetary policy stance is needed to keep core inflation close to single digits. In particular, this would require: (i) a faster pace of nominal exchange rate appreciation than observed so far in 2006; and (ii) higher interest rates and increased sterilization within a modified framework of monetary policy instruments (see below). These measures would help contain manat base money growth at 85 percent in 2006 and about 30 percent in 2007. Continuing to improve the enforcement of prudential regulations, particularly regarding banks' open positions in foreign currency, would reduce constraints on exchange rate flexibility. If the authorities are not prepared to further increase exchange and interest rate flexibility and moderate fiscal expansion, it is recommended adopting a realistic inflation target for 2007 and committing to a reduction in inflation to single digits in the medium term.

The ANB would need to continue to improve the monetary policy operating framework. In particular, the mission recommends implementing the recent Monetary and Financial System Department (MFD) technical assistance recommendations on (i) the establishment of an interest rate corridor using standing overnight deposit and credit facilities; (ii) the introduction of weekly operations with seven-day repos and reverse repos; and (iii) the abolition of the fixed-rate six-month refinancing facility. For this framework to become effective, the outstanding stock of ANB notes and treasury bills would need to be increased and a faster procedure for collateral registration would need to be adopted. The ANB would also need to further intensify its communication with the banking community and the public at large on current monetary policy issues and short-term risks to the inflation outlook through (i) press conferences following each monthly Board meeting; and (ii) forward-looking analysis in its monthly inflation reports.

Maintaining the ANB's strong financial position is essential for its credibility. The recent decline in the ANB's net worth mainly reflects the revaluation losses associated with nominal exchange rate appreciation, driven by increased spending out of oil revenues, rather than balance-sheet weaknesses. In accordance with the ANB law, the government would need to recapitalize the ANB to bring its charter capital to its initial value of AZN 10 million. This should be undertaken by issuing dated marketable securities bearing market interest rates.

¹ Expenditure growth rates presented in this statement exclude energy-related subsidies of the State Oil Company of the Republic of Azerbaijan (SOCAR).