Mission Concluding Statement 

Republic of Azerbaijan-- Aide Memoire of Staff Visit

November 20, 2012

An International Monetary Fund (IMF) staff mission, headed by Raja Almarzoqi, visited Baku during November 8-20, 2012 to discuss recent economic developments, government policies and future prospects for the Azerbaijani economy.¹ The discussions also paved the ground for the next Article IV Consultation mission, tentatively scheduled for late February 2013. 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 their hospitality and the constructive discussions. The following statement reflects the views of the IMF mission.

1. The near-term growth prospects are generally favorable. Non-oil growth, already at potential by end–year, could reach 10 percent in 2012 and remain strong at about 8 percent in 2013. Non-oil output primarily driven by the construction and services sectors has become considerably dependent on public spending. Oil output—projected to fall both in 2012 and 2013 due to shortfalls in the delivery of new wells—is likely to increase thereafter as a new platform becomes operational in early 2014. Risks to the global and regional outlook are tilted to the downside and Azerbaijan is not immune to them. Upside risks are not ruled out due to potential disruptions in the world oil supply triggered by the geopolitical situation.

2. Inflation has fallen to record levels but could rise with planned public spending and non-oil output beginning to exceed potential. 12-month inflation has declined sharply since end-2011 mainly driven by a fall in global food prices. Inflation is, however, projected to reach 3 percent by the year-end and 6 percent next year, with relatively high public spending and a possible pass-through of the recent increase in global food prices. Notwithstanding the decline in oil output, the external position will remain comfortable aided with high oil prices.

3. Revising the 2013 budget to embark on a fiscal consolidation path would contain risks to macroeconomic stability and strengthen the policy buffer to face a potential deterioration in the global economy. The 2013 budget bill implies an increase in the non-oil deficit and higher reliance on oil revenue. With output reaching potential, the mission recommends to take a more cautious approach on the oil-financed domestic spending by lowering the 2013 non-oil deficit to about 40 percent of non-oil GDP. This deficit would deliver an adjustment of 3 percentage points, relative to the 43 percent non-oil deficit currently projected in 2012. The adjustment could be supported by giving priority to public investment projects with high impact on the long-term growth of the non-oil export sector and fiscal revenue.

4. Bringing the large non-oil fiscal deficit to more sustainable levels over the medium term will require strengthening the current fiscal policy framework. The temporary deterioration in the non-oil fiscal position—appropriate to mitigate the global crisis in 2009—is not sustainable and raises concerns on intergenerational equity and the efficiency of public spending. Risks from quasi-sovereign entities and the pension system are also emerging. While recognizing good elements in the current framework, the mission encourages the authorities to revamp this framework with a view to improving the management of oil resources. In line with international trends in both advanced and emerging markets, a new framework could delink spending from current oil prices, bringing more predictability and credibility in fiscal policy, key for private sector decisions. The IMF stands ready to provide technical assistance on oil revenue management and pension reforms.

5. The Central Bank would need to tighten monetary policy if demand pressures emerge from government spending and the recent pick up in credit growth. The sharp decline on inflation has been driven by the fall in global food prices and spillovers to domestic inflation. But this trend is likely to reverse in the near term with recent spikes in global food prices and potential second round effects on non-food inflation. Policy tools are limited and thus strengthening the interest rate transmission mechanism while allowing greater exchange flexibility will help better control inflation volatility over the long term.

6. Recent actions by the CBA to strengthen the banking system are welcome steps provided they are supplemented with measures to reduce vulnerabilities. The recent increase of the minimum capital requirements and impetus to develop a private sector credit bureau are steps in the right direction. The mission urges the authorities to strengthen the non-performing loans (NPL) and the loan-loss-provisions (LLP) regulations, before the deadline of the new capital requirement to ensure the correct recording of NPLs, LLPs, and capital levels by banks. Developing a contingency plan to deal with banks failing to increase their capital will be key to ensure an orderly exit of these banks. Prudential measures could help tackle the accelerated pace of credit, particularly on consumer lending, and the high loans to deposits ratio and foreign exchange exposure of unhedged borrowers. Though preparations are still ongoing, the mission regrets further delays in the joint IMF/World Bank FSAP update at this crucial time for the banking system. As agreed with the authorities, the FSAP will take place in early 2014.

7. With the IBA privatization put on hold, the authorities need to adopt measures to improve IBA’s soundness and contain contingent liabilities on sovereign resources. Key actions include developing a sustainable and viable banking model for IBA in the near term and discouraging any additional borrowing until the new business strategy is in place. The mission also encourages the CBA to pay particular attention to IBA as part of the supervision of the banking system.

8. Deep structural reforms will be crucial to develop a competitive private sector led non-oil economy able to foster exports, create jobs, and sustain diversification. Progress in this area has been focused on the introduction of e-Government and one-stop windows in several government entities, with some mixed results in curbing the opportunities for corruption and rent seeking. Enabling the implementation of the new customs code and the finalization of the WTO accession, strengthening the financial infrastructure, including by deepening financial intermediation and developing capital markets, along with improvements in governance, and easing of barriers for competition will be key to opening up new markets and developing a new growth strategy with less dependence from oil.