OREANDA-NEWS. On 08 May 2008 was announced, that an IMF mission team visited Azerbaijan to conduct the discussions for the annual Article IV consultation. The mission has reviewed macroeconomic developments over the last year and discussed with the authorities the short- and medium-term economic outlook. Economic growth remains impressive, propelled by the booming oil-sector, but risks to macroeconomic stability have intensified. The key near-term policy challenges are to reign in accelerating inflation, strengthen the quality and efficiency of fast growing public expenditure and maintain a sound banking system in the face of rapid credit expansion. Looking ahead, economic policies will need to meet the challenge of achieving stable non-inflationary growth in the non-oil sector, while using wisely the oil wealth to maintain long-term fiscal sustainability.

I. Economic Developments in 2007

Azerbaijan's exceptionally strong economic growth continued in 2007 resulting in higher per-capita income, job creation and lower poverty. Over the last three years, rising oil production together with very high oil prices has boosted GDP and export growth to unprecedented levels. For the third year in a row, overall growth has been above 20 percent and growth in the non-oil sector is estimated at 11 percent in 2007. The current account surplus rose to 29 percent of GDP and the government's oil fund assets and the international reserves of the Azerbaijan National Bank (ANB) together reached about \\$7.3 billion at end 2007—triple the amount of estimated public external debt. Buoyant oil revenues and strong-performing non-oil revenues accompanied a sizable expansion in public expenditures. The focus of government spending has been to improve living standards and social services and to upgrade and expand critical infrastructure.

But fiscally induced demand pressures triggered an acceleration in inflation. Inflation rose to 19 Ѕ percent at end December—including the effect of the early 2007 bold increase in administered energy prices and the impact of high international food and commodity prices—from 11 Ѕ percent at end 2006. The build up of persistent inflation in 2006 and its acceleration in 2007 indicate, in our view, that the economy is still unable to absorb the large fiscal stimuli inherent in the authorities' plan to pursue an accelerated development agenda. Substantial increases in wages and pensions, very fast growth in spending for goods and services, and a 63 percent increase in public investment fuelled inflation, notwithstanding a major increase in non-oil revenue collection.

The consolidated fiscal balance was positive in 2007, but the non-oil primary deficit increased to 32 percent of non-oil GDP, though it remained below the sustainable level estimated by staff on the basis of the authorities' long-term oil revenue management strategy (LTORMS). In the current environment of high oil prices, the fiscal sustainability constraint is not binding in the short term. Hence, the focus should be shifted to avoiding the build up of pressures that create macroeconomic instability, which will be much more costly to address under less favorable external conditions.

Monetary and exchange rate policies were not used to the extent needed to limit the impact of the fiscal expansion in 2007. Although the ANB established a more coherent structure for the policy interest rates corridor and increased interest rates, these remained negative in real terms. In addition, exchange rate policy—effectively the main instrument at ANB's disposal to control inflation—was far too timid in 2007. As a result, the real appreciation pressures from the exceptionally large terms-of-trade gains of the last few years have disproportionately materialized through inflation.

The high level of monetization of the non-oil fiscal deficit and increasing foreign borrowing by commercial banks resulted in a two-fold increase in credit to the economy. ANB monetization of government's oil revenue and limited sterilization led to a 101 percent increase in manat base money. The expected appreciation of the manat against the US dollar encouraged banks to borrow abroad in dollars, at relatively low interest rates, adding to a rapidly expanding domestic source of credit. Foreign liabilities of domestic banks rose by 138 percent in 2007, but they still only accounted for 11Ѕ percent of their total liabilities. The global liquidity crisis in the latter part of the year and developments in neighboring Kazakhstan have probably reduced access to foreign borrowing and constituted a timely warning for domestic banks and ANB supervisors of the risks from volatile capital flows. Banks prudential indicators generally improved in 2007, but the very rapid credit expansion is likely to generate a lagged deterioration in the quality of banks' portfolios. Efforts to strengthen risk-based supervision at the ANB and actions to improve risk management in banks are positive steps towards enhancing the resilience of the banking system to shocks.

Inadequate macroeconomic policy coordination played a role in the acceleration of inflation and the build up of macroeconomic risks in 2007. Reflecting a moderate pace of budget implementation during the first ten months of the year, the ANB kept a slower pace of manat/dollar appreciation than envisaged in its monetary program. A spike in the implementation of domestically financed government investment in December was much larger than the ANB expected. The ANB converted in December \\$763 million, equivalent to one third of the total annual conversion of oil revenues. Given banks liquidity conditions and the ANB's resistance to a large step appreciation, the resulting base money increase was major and mostly unsterilized and is already feeding into 2008 inflation. The mission believes that better coordination would have led to a sounder macroeconomic policy mix of more moderate fiscal expansion, higher appreciation and smaller money creation, consistent with lower inflation.

Slow implementation of structural reforms has delayed necessary improvements in the business environment. Recent comparative assessments of Azerbaijan business climate concur in their findings that improvements have been minimal and that the environment is not yet conducive to the rapid development of the non-oil sector that the government is targeting. In particular, the use of unfair trade practices and restricted entry into different areas of the economy limit competition. In addition, governance concerns persist. Hence, in the absence of faster and more effective actions to improve the business environment and productivity, the ongoing real appreciation is likely to hurt competitiveness.

II. Prospects for 2008

While the growth and external outlook for 2008 remains strong, the policy challenges to maintain macroeconomic stability have intensified. On the basis of the oil production profile and current macroeconomic policy intentions, the mission expects overall GDP growth of 18 Ѕ percent. Non-oil growth would moderate, though it would remain high at 9 percent, mainly concentrated in the non-tradable sector—the main short-term beneficiary of large fiscal expansion. The current account balance would strengthen substantially, rising to 39 percent of GDP, on account of higher oil export volumes and prices. Oil fund assets and international reserves are projected at \\$25 billion at end 2008, more than three times their level at end-2007. The deterioration of the non-oil primary deficit (projected by the mission at about 7 percentage point of non-oil GDP) would add significantly to inflationary pressures. Even under an envisaged faster appreciation of the manat versus the U.S. dollar, the mission anticipates that the planned fiscal stimulus—together with the projected increases in international food and commodity prices and limited progress in addressing anti-competitive practices in the domestic market—would push 2008 average inflation to about 20 percent, well above the government's objective of 13 percent.

II A. Fiscal policy

In light of macroeconomic developments in 2007 and prospects for 2008 under current policies, the increase in government expenditures planned for 2008 is a matter of concern. The 2008 budget includes significant pension and wage increases and a 48 percent rise in the investment budget to accelerate Azerbaijan economic and social development. Progress in tax administration, which resulted in buoyant non-oil revenue in 2007, is welcome and gives confidence that the ambitious increase in non-oil revenue in the 2008 budget is achievable. The mission understands that the authorities are preparing a supplementary budget. The revised budget is likely to entail higher pensions and increased allocations for the investment program, to reflect rising input and execution costs. As a result the non-oil primary deficit would be 7 percentage points of non-oil GDP higher than the 2007 outcome. In the view of the mission, a full execution of the 2008 budget and the proposed revisions will exacerbate inflationary pressures and further embed inflationary expectations. These are likely to entrench a nascent wage-price spiral that will be difficult to break. The mission is of the view that fiscal restraint remains the most effective lever to control inflation in Azerbaijan and recommends that the authorities avoid a further fiscal stimulus in 2008, by moderating expenditure growth.

The more moderate pace of expenditure execution recommended by the Fund mission could help raise the quality and effectiveness of public investment. The intention of the government to set up the necessary infrastructure to support non-oil sector development and address large social needs are understandable. However, in addition to the limited absorptive capacity of the economy, the institutional framework and the capacity of the administration to implement large investment programs are still inadequate. Difficulties with (i) carrying on cost/benefit analysis; (ii) establishing objective criteria for projects selection; (iii) monitoring the execution of investments; and (iv) assessing the project success in meeting its objectives are serious impediments to effective investment spending. Although efforts are ongoing to strengthen administrative capacity, the risk of substantial waste of public resources is particularly high when public spending increases rapidly. To alleviate these pitfalls, we encourage the authorities to speed up plans to establish a medium-term expenditure framework that is consistent with the macroeconomic stability objective.

More effective government's oversight of the large state-owned enterprises (SOEs) is also critical. SOEs are major players in the economy of Azerbaijan. Their operations are in part driven by public policy objectives and should therefore be subject to closer government and public scrutiny. The adoption of international accounting standards by all SOEs would be a positive step. On account of the macroeconomic impact of the largest SOEs' operations, the mission recommends that the government strengthen the monitoring of SOEs' budgets, both at the preparation and execution stage, and increase their transparency and accountability. OECD indications for best practices in the management of SOEs could form the basis for a reform agenda.

II B. Monetary and exchange rate policy and financial sector issues

The planned move to a basket peg to arrest the nominal effective exchange rate depreciation trend and its impact on inflation is a step forward towards more exchange rate flexibility. The mission welcomes the move towards more flexibility and recommends that the ANB be bold in implementing the new system, focusing on inflation reduction. A preliminary assessment of the mission suggests that as a result of the favorable terms of trade changes the manat is undervalued. Hence, pressures for the manat to appreciate in real terms are to continue, especially as long as the fiscal stance remains expansionary. In these circumstances, the mission supports a stronger manat to contain domestic inflation. A stronger manat would allow the absorption of the fiscal stimulus to occur to a larger extent through higher imports rather than higher domestic prices.

Although monetary expansion is likely to be lower than in 2007, the conversion of government's oil revenue into domestic currency will be large, calling for better coordination between the government and the ANB. Under the ANB preliminary monetary program and the mission's understanding of the 2008 revised budget plans, we estimate the necessary monetization of oil revenue at about \\$3 billion. With limited sterilization, manat base money would grow by close to 70 percent. The mission recommends that the ANB and the ministry of finance establish a system to exchange timely information on planned treasury operations to improve ANB's liquidity management.

In the absence of a more prudent macroeconomic policy stance, credit growth is projected at 55 percent. This expansion, though lower than in 2007, would still create additional demand pressures. The mission expects the de-dollarization of the economy to continue, easing ANB's concerns about the pursuit of faster nominal appreciation. Tighter global liquidity conditions might also help macroeconomic management in Azerbaijan. Reduced availability of foreign loans—despite the pull-in effect from appreciation expectations and positive interest rate differentials—would constrain a potentially large source for further credit expansion.

The ANB is taking action to address the risks created by the rapid increase of credit growth, but continued attention to existing and new risks remains essential. The strengthening of the prudential framework and its strict application are the appropriate responses to ongoing developments. Stress tests indicate that under a standardized stress hypothesis a relatively small number of banks would fall below the 12 percent regulatory capital adequacy ratio and all banks would remain solvent. The focus of supervision on enhancing banks' risk management is appropriate. The mission supports the option of raising the risk weight of mortgages and measures to increase the specific provisions for non performing and doubtful loans. We also recommend that the ANB require the banks to make additional general provisions against future loan losses, to reflect the risks from rapid credit expansion.

II C. Structural reforms

To set the basis for strong non-oil growth over the medium term, the authorities need to intensify the implementation of a coherent structural reform agenda. The legal and regulatory actions recently taken and those under consideration, all point in the right direction, but implementation remains deficient. The mission welcomes the establishment of the one-stop window for the registration of new business and looks forward to the authorities' assessment of its impact. The oligopolistic structure in several sectors of the economy indicates that there might be non-legal constraints to competition. The rapid adoption and forceful implementation of the competition law could help. But in the absence of strong political action to counter the vested interests that support a non-competitive economic structure, it is unlikely that the business climate would improve at the necessary speed.

Ongoing efforts towards WTO accession are conducive to reforms that could strengthen the business environment. In addition to leading towards full integration into global trade, the reforms currently being pursued will also support the establishment in Azerbaijan of a legal and regulatory framework that is comparable to the one existing in more advanced economies. The reform of customs legislation and administrative practices recommended by the WTO would be particularly beneficial since it would help reduce non-tariff barriers to imports and increase the flexibility of supply in sectors currently shielded from competition.

Further steps are necessary to develop the financial markets. The authorities should complete the privatization of Kapital Bank and prepare the privatization of the International Bank of Azerbaijan. Measures to enhance competition by encouraging the merger of smaller banks and allowing foreign banks to enter the market would be welcome. The government should also develop the capital markets, initially by issuing bonds of varying maturities to establish a yield curve as the basis for pricing corporate debt. In the future, corporate debt would provide an alternative to bank finance for companies and an alternative to foreign borrowing for banks wishing to obtain longer term funds to finance lending. Life insurance and potential pension providers need government debt to help provide long term investment instruments for individuals as an alternative to real estate and other real assets.

III. The Medium-term Challenges

A reduction of inflation to moderate levels, buoyant non-oil growth and fiscal sustainability are the main macroeconomic challenges over the medium term. Under a scenario in which the current pace of expenditure increase is maintained, the mission estimates that inflation would remain around 20 percent over the medium term. The government would then start reducing its oil fund reserves by 2013, undermining the plans to accumulate sufficient savings for future generations and achieve long term fiscal sustainability. Though high oil prices have delayed the time when the fiscal sustainability constraint from the LTORMS would become binding, the mission urges the authorities to tighten fiscal policy in 2009 and the medium-term to avoid persistently high inflation. The mission also encourages the authority to reduce implicit energy subsidies by gradually aligning domestic energy prices with international market prices. A prudent fiscal policy would also limit real appreciation pressures and allow for a more effective role of monetary policy in controlling inflation. At the same time, the ANB needs to continue increasing exchange rate flexibility to improve the economy's resilience to external shocks, including possibly adverse terms-of-trade developments.

In the context of a recommended medium-term fiscal tightening, stronger public financial management would help contain the costs of adjustment. The mission thus encourages the government to:

• seek parliamentary approval of a medium-term path for the non-oil primary fiscal deficit—and a coherent medium-term expenditure framework—consistent with fiscal sustainability and stable long-term growth, at the time of the 2009 budget submission;

• establish an action plan to strengthen the design, execution, and monitoring of the investment program, in cooperation with the World Bank and other partners;

• strengthen corporate governance in SOEs' by adopting international best practices to regulate and monitor their activities and financial operations;

• reinforce the capacity of the chamber of accounts to audit budget implementation and SOEs' activities;

• improve the tendering and procurement legislation and its implementation; and

• review non-oil tax policy and administration to widen the tax base and eventually reduce tax rates to encourage non-oil sector development.

1 This represents the views of the mission team, not of the IMF. These views may evolve as the staff prepares its assessment for the staff report for the Article IV consultation with Azerbaijan to be discussed by the IMF Board at a later stage.