Azerbaijan Republic and the IMF

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Azerbaijan—Letter of Intent

February 6, 2002

The following item is a Letter of Intent of the government of Azerbaijan, which describes the policies that Azerbaijan intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Azerbaijan, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

Use the free Adobe Acrobat Reader to view the Table (389 kb PDF file)

Mr. Horst Köhler
Managing Director
International Monetary Fund
700 19th Street
Washington, D.C. 20431

Dear Mr. Köhler:

1. On July 2, 2001, the IMF Executive Board endorsed Azerbaijan's three-year economic program, and approved a Poverty Reduction and Growth Facility (PRGF) arrangement in support of that program. We would like to take this opportunity to inform you about our implementation of this program to date and our near term policy intentions consistent with this program, and to propose performance criteria, indicative targets and structural benchmarks for end-March and end-June 2002, as well as quantitative performance criteria and indicative targets for end-September and end-December 2002. We also hereby request, for reasons discussed below, waivers for non-observance of three end-September 2001 structural performance criteria, as well as the continuous performance criterion on the non-accumulation of external arrears. This letter should be read as additional to our original letter of intent and Memorandum of Economic and Financial Policies, dated June 15, 2001.

Macroeconomic Developments

2. All of the program's quantitative performance criteria have been met, with the exception of the prohibition against the accumulation of external arrears. The external arrears, which were accumulated at a time when we were requesting the government of Uzbekistan to consider a revision of the timetable for repayment of the debt, have now been largely paid. The remaining outstanding debt (just over US$500,000) is matched by an equal amount of overdue debt owed by Uzbekistan to Azerbaijan for goods delivered to Uzbekistan by an Azeri state-owned enterprise. Since our agreement with Uzbekistan states that value of the goods is to be applied to the state debt of Azerbaijan to Uzbekistan, the government of Azerbaijan considers these mutual debts to be paid in full. Macroeconomic indicators are consistent with program targets; real GDP growth in the nine months through September was 9.3 percent, in line with a program target for annual GDP growth of 8.5 percent. Consumer price inflation for the year ending September was just over 1 percent, below the 2001 inflation target in the program of 2.5 percent. All indicative quantitative targets for end-September 2001 were met as well, except for the ceiling on non-utility arrears of the state budget, which was exceeded by a modest amount.

3. Monetary developments have been in line with our program objectives, with reserve money and credit growth somewhat slower than programmed and net international reserves of the Azerbaijan National Bank (ANB) well above program targets. Similarly, the fiscal deficit was well within program ceilings, notwithstanding shortfalls in both revenues and financing. While we exceeded the program's indicative ceiling on non-utility arrears of the budget by a modest amount at end-June 2001, by end-September 2001 we had succeeded in eliminating virtually all arrears accumulated in the first half of the year. The current account registered a slight deficit in the first half of 2001, compared with a small programmed surplus, as larger than projected service imports by the oil sector more than offset the better than programmed trade balance.

4. For 2002, we continue to believe that the real growth target spelled out in the program remains achievable, notwithstanding the difficult external environment we now face. However, with regard to inflation, the strong measures we have taken to reduce quasi-fiscal subsidies in the form of previous preferential utility and transport tariffs, as well as the planned increases in the domestic prices of oil products and natural gas, will put upward pressure on the CPI, and thus we believe a target of 3.0 percent annual CPI growth--somewhat above the original targets spelled out in the program--would be appropriate. The proposed quantitative performance criteria and indicative targets for end-March, end-June 2002, end-September and end-December 2002 are detailed in Table 1. Performance relative to these targets and criteria will continue to be measured as detailed in Annex I to our Memorandum of Economic and Financial Policies (June 15, 2001), except that net credit to the consolidated government from the ANB will be defined to exclude any unspent funds transferred to the treasury from the oil fund.

Progress on Structural Reforms

5. Progress on structural reforms has continued in all areas identified in our Memorandum of Economic and Financial Policies (MEFP), albeit in some cases with minor technical delays. We have continued to make significant progress on banking sector reform. We have begun to address the results of the diagnostic studies of commercial banks done earlier in the year, including by revoking the licenses of 5 banks, announcing an increase in the minimum capital requirement, and increasing the limit on foreign ownership of domestic banks from 30 to 50 percent. This limit will be eliminated by end 2002, following consultations with the staffs of the Fund and the World Bank.

6. Working with the staffs of the Legal and Monetary Affairs departments of the Fund, we have made substantial progress on drafting a new Banking Systems Law, which we intend to submit to parliament in early 2002, in accordance with official procedures. The Real Time Gross Settlements system introduced earlier in the year is working well for large-value payments, and we have made progress in designing an improved small-value payments system. We have also completed a study of factors inhibiting competitiveness in the banking system, and in the coming months will work with the Fund staff to develop a time-bound action plan to address these inhibiting factors. We have eliminated all central bank deposits with domestic commercial banks, as called for under the program's structural performance criteria. In 2002, we intend to prepare amendments to the Central Bank Law; among other things, the revised law will prohibit any such deposits in the future. Unfortunately, complications related to closing certain deposits in non-convertible currencies meant that two very small accounts still existed on September 30, 2001 (they were subsequently closed in October), and thus we must request a waiver for this technical violation of the performance criterion. Finally, we have recently completed the process of capitalizing United Universal Bank, through the issuance of manat 30.3 billion in long-term government bonds.

7. With regard to fiscal reforms, we have continued our progress on computerization of the treasury system, and we have adhered to our commitment to publish regular reports on the execution of the state and oil fund budgets, as well as detailed reports on tax and customs revenue collections. We have finalized the regulations--embodied in a presidential decree on the oil fund budget and a memorandum of understanding between the Oil Fund and the Ministry of Finance--to ensure close coordination in the preparation, execution, audit and reporting of the oil fund and state budgets (an end-September 2001 performance criterion). All regulations required for the implementation of the new tax code have been adopted. Parliament has recently approved a revised law on the Chamber of Accounts, giving it authority to audit all government bodies, including all budgetary and extra-budgetary funds. However, it took somewhat longer than we had anticipated to prepare this revised law, and the submission to parliament took place only in the latter half of November 2001 , rather than by end-September as called for in the performance criterion, and thus we request a waiver for the non-observance of this performance criterion. We have also included in the draft 2002 state budget adequate funds to enable the Chamber of Accounts to begin effectively implementing its new, expanded responsibilities. The Ministry of Taxes has made substantial progress recently on tax administration reform. The government recognizes the importance of developing of a solid tax administration system, and therefore we intend to provide the Ministry of Taxes with sufficient funds for tax administration. Finally, we recognize that the temporary accumulation of pension arrears earlier this year was an inappropriate response to revenue and financing shortfalls, and are committed to avoiding any future accumulation of pension arrears.

8. With regard to the Customs Committee, there has been an unavoidable delay in the external evaluation of this body by an internationally reputable company. The initial tender, which was announced in June, closed with only one company bidding to provide this service. As Azerbaijan law requires at least three bids for a tender to be valid, we were forced to rerun the tender, thereby making it impossible to meet the end-September 2001 performance criterion deadline calling for the adoption and initial implementation of a reform program based on the results of this external evaluation. In early October we signed a contract with Price Waterhouse Coopers to conduct this evaluation. They have now completed this work, and based on their findings, we have adopted a Customs Committee reform program, prepared in consultation with the Fund staff.

9. The key elements of this reform program aim at improvements in several areas: (i) better data collection and control through the adoption of an automated data capture system; (ii) revenue enhancement through the use of a bond guarantee program and a bonded warehouse system, the adoption of international standards for import-good valuations, automated information flows between public agencies, and the adoption of modern management and training systems; (iii) trade facilitation through ensuring the customs code adheres to the Revised Kyoto Convention 2000, a gradual switch to an audit-based system for movement control, and the introduction of an automated process for customs documentation for importers; and (iv) greater accountability and efficiency of customs administration through the adoption of a licensed customs broker program, the formation of specialized internal units performing audits, tariff classifications, origin, and customs valuations, and the implementation of a system of targeting and selectivity of transactions and consignments. In light of the fact that the delay was beyond our control, and that we have now adopted a comprehensive reform program for the Customs Committee, we request a waiver of non-observance of this performance criterion.

10. During the course of 2002, we will consider eliminating the ban on exports of scrap metals, in consultation with Fund staff, replacing it with a system of export licenses. These licenses will be automatically granted to any exporter who can demonstrate a legitimate supply source for this scrap metal. Unfortunately, weaknesses in administrative capacity preclude the introduction of a licensing system for scrap metal exports at this time.

11. Working closely with the staffs of the IMF, World Bank and EBRD, the government of Azerbaijan has adopted a comprehensive program designed to strengthen financial discipline in the energy sector (a structural benchmark under the program). Key components of this program include the following: (a) the inclusion of subsidies previously provided by the state oil company (SOCAR) to the electricity and gas utilities into the reports on the consolidated government budget, with SOCAR being granted tax credits for the value of these subsidies; (b) the identification of consumption ceilings for budgetary organizations, with instruction given to the utility companies to disconnect service after the ceiling has been reached; (c) the use of payment cards for utility payments; (d) the provision of adequate compensation in the state budget for needy citizens previously entitled to discounts on utility fees, and the elimination of all preferential tariffs for utility and transport services; (e) measures to increase the efficiency of the electricity plants, and full switch of thermal power plants to the most economical fuel source; (f) the restructuring and privatization of the utility companies; (g) the restructuring of SOCAR; (h) the gradual elimination of the spread between the domestic and export prices for oil and natural gas; and (i) the analysis, and revision as necessary, of tariffs.

12. The subsidies previously provided by SOCAR to the utility companies will be formally incorporated into the 2003 state budget. For 2002, these subsidies will be explicitly recognized, with SOCAR receiving tax credits for any fuel provided to the utility companies but not paid for by them; these subsidies and tax credits will be included in quarterly public reports on the execution of the consolidated government budget. A decree to this effect has recently been issued. To try to control the size of the needed subsidy, the government will place on-site monitors in the utility companies. Several other reforms have already been implemented. Full budgeting for utility consumption by budgetary organizations has been included in the 2002 budget. All preferential tariffs for utilities and transport have been eliminated, and for the most needy in society replaced with explicit subsidies from the state budget. A long-term management contract has been signed for our largest electricity distribution network, and tenders for management contracts announced for the remaining three distribution networks.

13. Some delays ocurred in program implementation. To ensure that no such problems occur in the future, we have established procedures for the careful monitoring of our economic reform efforts. On a monthly basis, representatives of the Ministries of Finance, Economic Development, Taxes, Fuel and Energy, and the National Bank, Customs Committee and Oil Fund will meet to review progress in the implementation of the government's economic reform program, including its policy commitments under its arrangements with the International Monetary Fund and World Bank, and will prepare monthly reports on implementation for consideration by the Prime Minister.

14. We propose the following prior actions for end-March 2002: (i) adoption of a program of reform of the Customs Committee, based on the report of the internationally reputable firm hired to evaluate the Committee, and in consultation with the Fund staff; (ii) submission to parliament of a revised law on the Chamber of Accounts, giving this organization the authority to audit all government bodies, including all budgetary and extrabudgetary funds; and (iii) issuance of a decree indicating that subsidies to Azerenergy and Azerigas will be included in the 2003 state budget, and that in 2002 these subsidies will be included in quarterly public reports on the execution of the consolidated government budget. Structural performance criteria for end-March 2002 include: (i) adoption of a timetable, in consultation with Fund staff, for the unification of domestic and world market prices for oil, oil products and natural gas, as discussed in paragraph 11; (ii) adoption, in consultation with Fund staff, of a timetable for the gradual reduction of the number of specific import tariffs and the weighted average import tariff, consistent with our commitments in our original MEFP; and (iii) adoption of timetables for the full privatization of the International Bank and the preparation of United Universal Joint Stock Bank for privatization. Structural benchmarks for end-March 2002 include (i) submission to parliament of the new Banking System Law, (ii) submission to parliament, in consultation with Fund staff, of a new Budget Systems Law, and (iii) adoption of a concrete timetable for the implementation, in 2002, of all short term elements of the Customs Committee reform program. In addition, throughout 2002, we propose that (i) the quarterly granting to SOCAR of tax credits, not more than 15 days after the end of each quarter, equal to the difference between the value of fuel delivered to Azerenergy and Azerigas and the amount of cash payments received from those companies; (ii) the publication of these subsidy and tax credit decisions; and (iii) the inclusion of these subsidies and tax credits in the quarterly publication on the execution of the consolidated budget, not later than 30 days after the end of each quarter, be structural performance criteria. Structural performance criteria and benchmarks for end-September 2002 will be agreed in the context of the second review of our program. This review will focus in particular on the same issues as the first--progress in banking and energy sector reforms, and the strengthening of governance in the handling of public resources, including in the Ministry of Taxes and the Customs Committee. The second review is intended to be completed on or after April 15, 2002, and the third review on or after October 15, 2002.

15. The government and the ANB believe that the policies discussed above, combined with the policies described in our original MEFP, are adequate to achieve the objectives of the program. We will remain in close consultation with the Fund in accordance with Fund policies on such consultation, will provide the Fund with information it requests for monitoring progress in program implementation, and will have early consultations with Fund staff on policy measures being contemplated which relate to our commitments under the program. The government and the ANB stand ready to take any further measures, in consultation with the Fund staff, which might be necessary to ensure that the objectives of the program can be achieved.

Sincerely yours,

Artur Rasi-zade
Prime Minister
Azerbaijan Republic

Avaz Alekberov
Minister of Finance
Azerbaijan Republic
Elman Rustamov
Chairman, National Bank
Azerbaijan Republic
Farhad Aliev
Minister of Economic Development
Azerbaijan Republic