Press Release No. 21/402

IMF Executive Board Concludes 2021 Article IV Consultation with the Republic of Azerbaijan

December 23, 2021

Washington, DC: On July 21, 2021, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with Azerbaijan on a lapse of time basis.

Azerbaijan was severely hit by the COVID-19 pandemic and the decline in oil prices, but a sizable relief package helped to cushion the economic impact of the shock . Real GDP declined by 4.3 percent in 2020, driven by a significant contraction in oil GDP, which fell by 7.2 percent, while nonoil GDP declined by 2.6 percent. With the de jure free floating exchange rate regime, the manat continued to be de facto pegged to the US dollar, and average consumer price inflation remained subdued, at below 3 percent. Oil export revenues fell by 40 percent and the current account balance moved from a 9 percent of GDP surplus in 2019 to a small deficit in 2020. The authorities responded to the crisis with a fiscal package of close to 5 percent of GDP, including emergency health spending, subsistence cash transfers to the unemployed, temporary public jobs, support to microentrepreneurs and deferral of some taxes. The fiscal package was complemented by financial sector measures, including loan guarantees and the temporary relaxation of capital and loan provisioning norms. As a result of increased spending and lower revenues, consolidated fiscal balance turned from a surplus of over 8 percent of GDP in 2019 to a deficit of 6.4 percent of GDP in 2020.

Economic activity is projected to rebound in 2021, as the nonoil economy recovers from the pandemic . Nonoil GDP growth is projected to rise to 3.5 percent in 2021, before settling at 2.5 percent in the medium term. Hydrocarbon output is expected to remain stable as increased natural gas production is expected to offset declining productivity of aging oil fields. Inflation is expected to rise to 4 percent in 2021, remaining at 3 percent on average in the medium term. The current account is projected to return to a surplus of around 2.5 percent of GDP in 2021 as oil prices recover and natural gas exports rise and remain in a small surplus in the medium term.

The outlook is subject to a high degree of uncertainty, with risks broadly balanced . A spread of more dangerous COVID-19 virus strains and/or a slowdown in the rollout of vaccines may delay the re-opening of the economy. Slower-than-expected recovery of global demand would also pose a risk to the oil sector. On the upside, a faster-than-expected global recovery could push oil and gas prices higher, boosting revenues and strengthening fiscal and external balances. With oil resources gradually being exhausted, accelerated structural reforms are needed to diversify the economy and improve productivity of the nonoil sector, strengthening Azerbaijan’s economic prospects.

Executive Board Assessment [2]

In concluding the Article IV consultation with Azerbaijan, Executive Directors endorsed the staff’s appraisal as follows:

Azerbaijan faced an unprecedented challenge in 2020, but timely and appropriate policy response mitigated the impact of the pandemic on the economy. A significant relief package helped cushion the impact of the pandemic and the decline in oil prices. With vaccination progressing and lockdown measures gradually eased, the economy has started to recover. The near-term challenge is to properly calibrate the phasing out of the COVID-19-related stimulus, balancing the need to avoid endangering the recovery while preparing the ground for addressing structural challenges. In the long term, Azerbaijan’s running out of oil in the coming decades poses the fundamental challenge as the economy needs to wean off its dependence on oil revenues.

While fiscal policy has been appropriately eased during the pandemic, a growth-friendly fiscal consolidation needs to start in 2022. The accommodative fiscal stance in 2021 is appropriate and, in the case of adverse shocks, automatic stabilizers should be allowed to operate and additional, targeted on-budget fiscal support should be provided, as necessary, within the available fiscal space. Windfall revenue from higher-than-budgeted oil prices should be saved. Looking ahead, continued expansionary stance would not be compatible with preserving the de facto peg and fiscal sustainability and would also make it more difficult to attain intergenerational equity in the face of a projected exhaustion of oil resources. Thus, consolidation should start in 2022 and be sustained over the long term, to gradually achieve a significant reduction in the nonoil primary deficit. While the authorities see a key role for expenditure consolidation, measures to improve nonoil revenues will eventually have to contribute to adjustment. Consolidation needs to be accompanied by measures to protect the vulnerable and support education and health, with a view to enhancing inclusiveness and productivity. Stepped structural and financial sector reforms are also critical, to mitigate the adverse impact of consolidation on economic growth.

Planned fiscal adjustment should be supported by the revised fiscal rule. In response to the outbreak of the pandemic, the authorities have temporarily suspended the fiscal rule. They intend to revise and re-launch it in 2022, using the nonoil primary balance and debt-to-GDP targets to anchor fiscal policies. Public financial management reforms, including of the medium-term fiscal framework, fiscal risk management and transparency, are needed to support the implementation of the rule and its credibility. Establishing a solid track record of the rule implementation is particularly important given its suspension in 2020 during the pandemic, a year after its introduction.

Further monetary easing could be considered to support the nascent recovery, especially if downside risks were to materialize. Although CBA has reduced its policy rates since the outbreak of the pandemic, financial conditions remain tighter than when the pandemic started. Despite the de facto peg, low financial integration and a large spread over the Fed rates provide room for further rate cuts. In addition, following a recent temporary uptick, inflation is projected to remain close to the mid-point of the CBA target range.

A gradual move to a more flexible ER regime should be considered in the medium term. The de facto peg has been effective in keeping inflation under control, but as Azerbaijan’s main trading partners have more flexible regimes, maintaining competitiveness is challenging under the peg. A more flexible exchange rate would facilitate adjustment to oil price shocks, reduce adjustment burden on fiscal policy, and support diversification of the economy and market development. The current difference between the de jure flexible exchange rate regime and the de facto pegged one and the framing of policy communication in inflation-targeting terms poses risks to policy credibility and needs to be addressed promptly. More broadly, the external position is deemed to be substantially weaker than the level consistent with medium-term fundamentals and desirable policies (Annex III).

Targeted and time-bound plan to phase out exceptional prudential easing introduced in response to the pandemic is needed. The authorities need to balance the risk to bank soundness arising from prematurely phasing out the forbearance measures and the risks from delaying the reversal to credit quality and market discipline. Staff welcomes the recent replacement of a blanket deposit insurance, in place since the previous banking crisis, with a limited guarantee program, a list of regulatory tightening measures that have been already implemented or on the schedule, and the efforts in improving financial stability analysis capacity. In the medium term, strengthening financial oversight of both lenders’ risk-taking activities and borrowers’ credit risk is an important complement that is needed to ensure financial stability and improve access to finance. The authorities should also continue making progress in enhancing the effectiveness of the AML/CFT framework.

Impediments to private sector growth and job creation need to be tackled to support private sector development and diversification of the economy. Weak institutions, limited SME access to credit; inefficient labor, product, and service markets; and sizeable skill gaps result in high informality, discourage nonoil FDI and slow productivity growth. Addressing these weaknesses, including by strengthening the governance and anti-corruption frameworks, attending the scarring impact from the pandemic, and pursuing the green agenda envisaged under the Azerbaijan 2030 Priorities, are needed to achieve inclusive and green growth. The recently released national priorities set ambitious goals for social and economic development and would need to be supported by well-designed and consistently implemented policy reforms.