IMF Executive Board Concludes the 2008 Article IV Consultation with the Republic of AzerbaijanPublic Information Notice (PIN) No. 08/79
July 1, 2008
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On May 23, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Azerbaijan.1
Azerbaijan's economic growth remained strong, with real GDP expanding by 23 percent in 2007. The oil sector continued to be the main driving force, growing by 37 percent. The non-oil sector also grew rapidly at about 12 percent, propelled mostly by non-tradable activity, particularly construction, commerce, and communications. As a result, per capita GDP is estimated to have exceeded US$3500, and officially reported poverty and unemployment level declined significantly.
However, 12-month inflation accelerated to 19.5 percent at end-2007, reflecting demand pressures from fiscal expansion, rising international food and commodity prices, increases in administered energy and utility prices, and an accommodative monetary policy. Inflation remained high at 21.4 percent in April 2008, despite the fact that the January 2007 adjustment of administered prices had already been absorbed in the base. Widening inflation differentials with Azerbaijan's trading partners resulted in a continuation of real effective exchange rate appreciation, clouding the growth prospect for the non-oil tradable sector.
The oil production boom and rising international oil prices further strengthened Azerbaijan's external position. The current account surplus is estimated to have risen to 29 percent of GDP in 2007, from 18 percent in 2006. Despite very large profit and investment repatriation by foreign oil companies, the government's oil fund assets and international reserves at the Azerbaijan National Bank (ANB) together reached about US$7.3 billion—triple the amount of external public sector debt outstanding at end-2007.
Fiscal policy continues to be expansionary in 2007. Total expenditure grew by 43 percent, with wages and transfers increasing by 46 percent and investment spending rising by 63 percent. As a result, the non-oil primary deficit widened slightly to 32 percent of non-oil GDP, despite a robust performance of non-oil revenues. The consolidated fiscal balance returned to surplus mostly owing to a 60 percent growth in oil revenues, but also reflecting improved tax administration. However, progress to strengthen public expenditure planning, execution, and monitoring was limited.
The monetary policy response to the fiscal-induced overheating was insufficient. In the context of a slowly appreciating crawling peg to the dollar, the ANB undertook large purchases of foreign exchange from the government, leading to a doubling of manat base money in 2007. The policy interest rate was kept negative in real terms.
In March 2008, the ANB introduced a basket peg aimed at stabilizing the nominal effective exchange rate. The manat is now pegged to a dollar/euro currency basket, in which the weight of the euro will gradually increase. The new arrangement and the envisaged weight adjustments are intended to mitigate imported inflation, and as a first step towards more nominal exchange rate flexibility.
Banks' soundness indicators and compliance with prudential regulations improved in 2007, but credit risks intensified amid an extraordinary credit boom. Private banks' share in the banking system surpassed 50 percent during the year. At end-2007, all banks met the requirements on capital adequacy and foreign currency exposure, and the non-performing loan ratios were lower than a year before. Meanwhile, abundant liquidity and increased foreign borrowing by banks boosted credit growth by 97 percent, with increasing exposure to the property sector. In general, the financial sector is still underdeveloped, providing few long-term instruments for savers and investors.
Structural reforms to promote a competitive non-oil sector remained slow. The work to upgrade legislations in line with World Trade Organization (WTO) accession requirements is under way. The one-stop facility for business registration is now operational, facilitating the establishment of new companies. Licensing requirements, though, remain heavy and governance issues—particularly in customs—are perceived as major impediments. Parliamentary approval of important bills to strengthen governance and the business environment (e.g. anti-monopoly, investment and Anti-Money Laundering/Combating the Financing of Terrorism laws) has been pending for more than a year.
The short-term growth and external outlook remains strong, but high inflation is here to stay under the current policy stance. Real GDP is projected to grow by 19 percent on the strength of higher oil production. Non-oil growth—driven by large public expenditure—would moderate to a still high 10 percent. The current account surplus would rise to 36 percent of GDP on higher oil export volumes and prices. Oil fund assets and international reserves are projected to more than triple from the end-2007 level, to reach US$24 billion at end 2008. However, the continuation of the fiscal expansion would fuel domestic demand growth and inflation would stay high in 2008.
Executive Board Assessment
Executive Directors welcomed the impressive growth performance over the past three years, the rapidly improving living standards and declining poverty, and the generally favorable medium-term economic prospects. Directors agreed that the current oil boom holds the promise of modernizing Azerbaijan's economy, but cautioned that sustainable improvements in economic conditions require cautious management. They were concerned about the acceleration of inflation associated with the current expansionary policies, and called on the authorities to adjust promptly macroeconomic policies to prevent high inflation expectations from becoming entrenched.
Directors agreed that fiscal policy should shoulder most of the burden of adjustment to help reverse high inflation expectations and stifle the emerging wage-price spiral. While acknowledging the need for investments in infrastructure and human capital to promote nonoil sector growth and reduce poverty over the medium term, Directors underscored the need to moderate the planned fiscal expansion for 2008 and to embark on fiscal tightening from 2009 to contain aggregate demand, focusing on reducing the pace of expenditure increases. They were concerned that the recent adoption of a sizeable supplementary budget would add to the inflation risk.
Directors emphasized the importance of increasing the effectiveness of public spending. They observed that expenditure moderation would help address the government's concern about the quality and efficiency of public investment. Effective institutional mechanisms need to be established to ensure proper planning, execution, and monitoring of public projects. Directors called on the authorities to adopt a comprehensive medium-term expenditure framework in the context of the 2009 budget that reflects transparently the government's priorities and that evaluates the costs and benefits of projects and their recurrent maintenance costs.
Directors noted the role of monetary and exchange rate policies in preventing inflation from spiraling upward. They welcomed the authorities' intention to move toward a more flexible exchange rate system over time and the recent adoption of the two-currency basket peg—a step that supports the necessary development of the domestic foreign exchange market. Directors encouraged the Azerbaijan National Bank (ANB) to use exchange rate policy more actively to ward off imported inflation, and to allow the manat to appreciate somewhat against the basket.
Directors agreed that the exceptionally fast credit growth observed in the past few years entails substantial risks that may not have yet manifested themselves in the traditional banking soundness indicators. They welcomed the prudential measures recently adopted by the ANB to strengthen banking regulation and supervision, and encouraged it to monitor the situation closely, take additional steps when necessary, and implement the prudential regulations forcefully across the banking system.
Directors underscored the importance of developing further the financial system to facilitate the growth of the non-oil economy. They took note of the renewed initiatives to privatize the state-owned banks, and encouraged the authorities to follow international best practices and complete the process transparently. They recommended consolidating the banking system further, while attracting established foreign banks to promote competition and increase efficiency. Directors encouraged the authorities to develop other sectors of the financial system, including the bond, insurance, and private pension market, to provide additional financing channels, investment vehicles, and savings instruments.
Directors considered a coherent structural reform agenda to be a critical component for supporting non-oil growth over the medium term. They called on the authorities to intensify efforts to strengthen corporate governance of the largest state-owned enterprises, remove obstacles to competition to increase the supply response of the economy, and implement anti-corruption programs. They welcomed the introduction of a one-stop facility for business registration, and called for a reduction in licensing requirements. They encouraged the authorities to proceed with reforming customs legislation and administration in line with WTO rules.