Mission Concluding Statement 

Republic of Azerbaijan-- Aide Memoire of Staff Visit

May 2, 2012

An International Monetary Fund (IMF) staff mission, headed by Nadeem Ilahi, visited Baku during April 24-May 2, 2012 to discuss recent economic developments, government policies and future prospects for the Azerbaijani economy.¹ The discussions also paved the ground for the 2012 Article IV Consultation mission, tentatively scheduled for October this year. The IMF team met with senior government officials and representatives of the private sector, civil society and the diplomatic community. The mission thanks the authorities for constructive discussions. The following statement reflects the views of the IMF mission.

1. The non-oil economy continued to perform strongly in 2011, and the near-term economic outlook is generally favorable. A 10 percent contraction in oil production in 2011 was almost entirely offset by non-oil growth of 9.4 percent, mainly in construction, and services. Hydrocarbon output is expected to remain unchanged this year, but non-oil GDP could register 6 percent growth and reach its potential level by end 2012, largely supported by public investment spending. Risks to the outlook are largely balanced, and the mission envisages limited direct economic spillovers to Azerbaijan from the Euro Area crisis.

2. Inflation has moderated largely because of a fall in global food prices. Inflation declined sharply from 8 percent in mid-2011 to near 2 percent in March 2012, and is expected to reach 5 percent by the end of the year. While underlying core inflation has broadly stabilized in recent months, increasing government spending and a closing of the non-oil output gap by end-2012 could result in inflationary pressures later in the year. High oil prices have contributed to the current comfortable external position.

3. Prudent fiscal policy would be key in preserving near-term macroeconomic stability. Spending restraint since the middle of 2011 helped contain demand pressures. Going forward, while the approved 2012 budget is expansionary and would result in demand pressures if implemented in full, continued spending restraint would help keep inflation in check. In this regard, the mission recommends keeping the ratio of non-oil fiscal deficit to non-oil GDP at 38 percent, compared to 41 percent in 2011, by moderating the increase in capital spending. The mission welcomes the authorities’ intention of avoiding any supplementary increase in spending this year in response to revenue windfall from a recent and prospective rise in global oil prices.

4. Embarking on fiscal consolidation is key to achieving medium term fiscal sustainability. The flattening of the oil output profile since 2011 is a reminder of the finite amount of Azerbaijan’s hydrocarbon resources, and underscores the need for a path to achieve medium term fiscal sustainability. This would entail reaching a target of 18 percent non-oil deficit to non-oil GDP ratio by 2017. The IMF stands ready to provide technical assistance in this regard, including on pension reforms.

5. Monetary tightening would be warranted if demand pressures emerge, but existing instruments are limited and need strengthening. If fiscal spending is excessive and the non-oil output gap closes sooner than anticipated, then monetary tightening would be needed to keep inflation in check. However, monetary policy, based largely on a de facto stabilized exchange rate, has not been able to dampen inflation volatility. While the authorities agree in principle to allowing greater exchange rate flexibility and moving to an interest rate based monetary policy framework, operational progress has been limited. The mission urges the authorities to redouble efforts to develop a new monetary policy framework, including by deepening debt and capital markets and implementing an effective approach of communicating monetary and exchange rate policies with the public. The IMF stands ready to continue to provide technical assistance for this purpose.

6. Recent government support to the International Bank of Azerbaijan (IBA) has bolstered capital and liquidity for the time being, but a more comprehensive approach is needed to reach a permanent solution. While the government’s recent decision to increase its stake in IBA may have been necessary, it should ensure that this does not run counter to the aim to privatize the bank in an expeditious and transparent manner. CBA’s supervision of the banking system should pay particular attention to IBA as well, and the bank’s external borrowing, which effectively incurs contingent liabilities on the government, should be made consistent with its ability to service its obligations and the government’s overall debt strategy. The mission also believes that to avoid systemic problems and enhance competitiveness in the banking system, IBA should be downsized prior to privatization. A Joint IMF-World Bank Financial Stability Assessment Program (FSAP) update, which will extensively assess the financial system, is expected in the second half of 2012.