Public Information Notice No. 07/59

Public Information Notice: IMF Executive Board Concludes the 2007 Article IV Consultation with the Republic of Azerbaijan

May 30, 2007

On May 9, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Azerbaijan.¹

Background

Azerbaijan's real GDP growth accelerated to 31 percent in 2006, driven by rapidly increasing oil production and transportation. Non-oil real GDP, excluding oil and gas transportation, grew by about 8 percent, as nontradable sectors benefited from ramped up government spending and rapidly growing banking credit. The tradable non-oil sector only grew by about 4 percent in 2006 compared with 10.4 percent in 2005, as labor costs increased and the real effective exchange rate appreciated. The officially reported poverty level continued to decline during 2005-06.

Inflation rose into the double digits by August 2006, and reached 16.4 percent in March 2007. The recent rise in the inflation rate was fueled by a significant relaxation of macroeconomic policies in the context of capacity constraints, as well as by the immediate effect of a large adjustment to utilities and energy prices.

The oil production boom and rising international oil prices have strengthened Azerbaijan's external position. In 2006, the external current account surplus is estimated to have increased to 16 percent of GDP from about 1 percent in 2005. The large current account surplus contributed to a significant increase in gross official reserves (US$2.5 billion, or 5 months of non-oil imports) and government foreign assets (US$1.9 billion), whose sum has considerably exceeded public and publicly guaranteed external debt (US$2.0 billion, or 10 percent of GDP) at end-2006.

The authorities undertook an exceptionally large fiscal relaxation in 2006. Oil revenue increased by 118 percent; and non-oil revenues increased by 4 percent of non-oil GDP owing to the buoyancy of tax bases. Wages, pensions, and other current expenditure increased by about 50 percent and capital expenditure more than tripled, bringing the total expenditure increase to 81 percent in 2006 compared with 2005. As a result, the non-oil primary deficit reached 33 percent of non-oil GDP in 2006 compared with only 13 percent in 2005.

In early 2006, the Azerbaijan National Bank (ANB) shifted from a fixed exchange rate to a de facto crawling peg to the U.S. dollar. With limited instrument independence, it undertook large unsterilized purchases of foreign exchange, in order to limit the annual exchange rate appreciation against the dollar to the targeted 5 percent. These policies led to a 133 percent increase in manat base money in 2006. Broad money increased by 86 percent and credit by 64 percent in 2006, fueling inflation.

The banking system continues to face important challenges. In response to rising credit and foreign exchange risks, the ANB tightened the prudential rules pertaining to these areas and increased the minimum capital requirement. However, at end-December 2006, many banks, including the two state-owned banks, failed to comply with one or more prudential regulations. The banking system remains relatively small (21 percent of GDP in 2006), highly concentrated (one bank controlled 46 percent of assets in 2006), and dominated by the two public banks (accounting for 51 percent of the banking system's assets in 2006).

Progress in other structural reforms has been mixed. The authorities put in place a new system of targeted social assistance in mid-2006, brought utilities tariffs closer to cost-recovery and selected petroleum product prices to world market levels in early 2007, and continued active participation in the Extractive Industry Transparency Initiative. However, some key state-owned enterprises operated without approved budgets in 2006, and there has been limited progress in improving budgetary expenditure management and controls, raising concerns about the quality of the rapidly increasing expenditures. In addition, several international surveys have reported on Azerbaijan's persistent problems with transparency, corruption, and the business climate.

The short-term growth and external outlooks remain exceptionally favorable, but keeping inflation from increasing further represents a major challenge. Driven by further rapid oil production growth, real GDP is projected to expand by about 30 percent, and the current account surplus is expected to increase to 27 percent of GDP in 2007. While rapidly growing capital expenditure would support non-tradable output growth, rising competitiveness pressures would negatively affect the tradable non-oil sector. As a result, non-oil GDP growth (excluding oil and gas transportation) is projected to decelerate to 7 percent in 2007. The continuation of the fiscal expansion would fuel domestic demand and liquidity growth. If monetary policy is not tightened, inflation is expected to increase further in 2007.

Executive Board Assessment

Executive Directors welcomed the strong real GDP growth driven by the temporary oil production boom, which resulted in a strengthening of Azerbaijan's external position, and enabled the authorities to initiate urgently needed investments in infrastructure and the social sectors, with encouraging progress in reducing poverty. Directors agreed that the oil boom presents an opportunity to lay a solid foundation for sustainable non-oil output growth and poverty reduction in the long term. To seize that opportunity, Directors encouraged the authorities to address the acceleration of inflation, the unsustainable pace of expenditure increases, and weaknesses in the business climate and governance, with the objective of further diversifying the economy.

Directors called on the authorities to moderate expenditure increases in the medium term to reduce inflation and ensure fiscal sustainability. Against that background, they welcomed the authorities' intention to start reducing the non-oil primary fiscal deficit to more sustainable levels in the medium term, while recognizing the pressing infrastructure and development needs. They were encouraged by the plans to implement a wide range of supporting fiscal measures, and emphasized the need to move expeditiously in these areas so as to firmly secure long-term fiscal sustainability. They also underscored the importance of improving expenditure management and developing a medium-term fiscal framework consistent with Azerbaijan's long-term oil revenue management strategy. Directors commended the authorities for participating in the Extractive Industries Transparency Initiative.

In the short run, Directors saw room for reining in the fiscal expansion in 2007 in order to contain domestic demand growth. In this respect, they recommended that the non-oil primary fiscal deficit be reduced to below its 2006 level, by curtailing energy subsidies, cutting low-priority current expenditure, and introducing greater selectivity into the choice of, and strengthened control over, investment projects.

Directors called on the ANB to pursue a more pro-active monetary policy, supported by greater exchange rate flexibility and further development of indirect instruments of monetary policy. Directors recommended that monetary conditions be tightened by reducing the ANB's unsterilized foreign exchange purchases, thus facilitating a real exchange rate adjustment via nominal exchange rate appreciation in response to the large increase in budgetary expenditure from oil revenues. In pursuing this strategy, some Directors recommended monitoring closely the impact of manat appreciation on the competitiveness of the non-oil sector and on the banking system. Directors generally recognized the authorities' efforts on the structural side to reduce real appreciation pressures, but believed that such efforts would be effective only in the medium term.

Directors supported the authorities' interest in moving to inflation targeting as part of their efforts to reduce inflation to single digits in the medium term. Key prerequisites for a transition to inflation targeting include enhancing the ANB's independence, eliminating fiscal dominance of monetary policy, developing securities markets, strengthening the banking system, and further improving the Consumer Price Index compilation methodology.

Regarding the financial sector, Directors considered that effective enforcement of prudential regulations would reduce the banking system's vulnerability to exchange rate appreciation, higher interest rates, and credit risks intensified by accelerating credit expansion. Noting the authorities' efforts to revive the privatization of the two state-owned banks, Directors recommended that the privatization terms be such as to attract strategic investors, and that only fit-and-proper investors be allowed to participate in the privatization.

Directors underscored that revitalizing productivity-enhancing structural reforms will be essential for maintaining non-oil sector competitiveness in the face of real exchange rate appreciation. They supported the authorities' plans to improve the business climate by simplifying licensing and registration procedures, and adopting and implementing the new anti-monopoly code, investment law, and anti-money laundering law. They called for steadfast implementation of the anti-corruption program and determined efforts to strengthen governance at the customs and tax administration agencies.

Directors welcomed the authorities' efforts to improve the statistical data base, which are aimed at subscribing to the IMF's Special Data Dissemination Standard.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.