Mission Concluding Statement 

Republic of Azerbaijan — Concluding Statement of the 2013 Article IV Consultation Mission

March 12, 2013

Thanks to the use of oil wealth, Azerbaijan has become one of the world’s fastest growing economies over the last 10 years. But with a relatively short oil production horizon, the authorities need to accelerate efforts on several fronts to achieve the government’s 2020 goal of a highly competitive economy, with sustainable and broad-based growth led by the private sector. The current high oil price presents an opportune environment, with the efforts aimed at creating: (i) strong frameworks for conducting fiscal, monetary, and financial sector policies, with careful management of the macroeconomic policy mix; (ii) a deep and efficient financial sector; and (iii) a favorable environment for private sector activity.

Specifically, the mission recommends:

• Embarking on an up-front fiscal consolidation to pursue a sustainable non-oil fiscal position and provide room for private sector activity. This would require sustained efforts to reduce public spending, especially on investment, while improving its efficiency.

• Shifting to a more neutral monetary policy stance, ending the CBA’s role in direct lending to the real sector, and preparing, in coordination with other government agencies, for greater exchange rate flexibility over the long term.

• Capitalizing the banking system while strengthening supervisory safeguards, with a focus on restructuring the operations of IBA in line with international best practice.

• Promoting diversification by easing the entry and exit of companies in the non-oil sector, reducing corruption, improving access to finance, enacting the code of competition, and completing the WTO accession.
Recent Economic Developments and Outlook

1. Economic activity continues to grow strongly.¹ With growth of 9.6 percent, the non-oil output reached its potential last year. Non-oil growth is expected to remain near 9 percent in 2013, supported by public spending. Oil output is projected to drop in 2013 for a third year in a row, albeit at a slower pace, but should increase slightly next year with new well deliveries. Overall, we project GDP growth of 4½ percent in 2013.

2. With the non-oil economy hitting capacity constraints, inflation is set to rise in 2013. Inflation dropped sharply to 1.1 percent in 2012, mainly reflecting the impact of global and domestic food price trends. But, unless action is taken, inflation is projected reach 7 percent by end-year, above the CBA’s 5-6 percent target range, for an annual average of 3½ percent as government spending increases and non-oil output begins to exceed potential.

3. If current policies are continued, the economy will become more vulnerable to shocks and private investment will not take off. Oil dependence and fiscal vulnerabilities are rapidly increasing as evidenced by the rising break-even oil price and oil fund transfers to the budget. Moreover, the planned large public investment program, including in the 2013 budget, would maintain the non-oil primary deficit in percent of non-oil GDP more than 10 points above the sustainable of 35 percent level, and lead to a substantial drawdown of buffers against external shocks. This would undermine the credibility of the government’s goal of achieving fiscal sustainability by 2018. The spending plans would also heighten concerns over resource waste, in the absence of improvements in public investment management, and would create disincentives for self-sustaining private investment. A fall in oil prices, triggered by trade spillovers resulting from an intensification of the recession in the euro area, is a key risk and would expose the non-sustainability of the fiscal position.

4. Ensuring a more sustainable and private-sector-led medium-term outlook requires a change in course of economic policies. In fiscal policy, we recommend a gradual reduction in the non-oil deficit, primarily by scaling down investment plans but also by rationalizing current spending. This would need to be accompanied by structural reforms, notably in governance, the business environment, efficiency of government spending, and trade policy. With these reforms, growth in the medium term—especially in the non-oil sector—would exceed that under the current policies.
Paving the way for a diversified and private-sector led economy

5. A gradual tightening of the fiscal position would reduce vulnerabilities and create room for a self-sustaining expansion of private-sector activity. We advise an upfront fiscal consolidation of 4 percent of non-oil GDP over 2013–14 (or 2 percent of GDP) relative to the estimated 2012 non-oil deficit outturn of 45 percent, and urge the authorities to resist spending pressures that could lead to an increase of off-budget spending or the approval of a mid-year supplementary budget if the oil price increase further this year. The consolidation efforts could be underpinned by scaling down public spending, in particular, public investment, to levels consistent with macro stability, absorptive capacity constraints, and support for sustainable growth. Improving the selection and appraisal of projects in line with international best practice and establishing clear links to the 2020 strategy would be crucial in this regard. Strengthening tax revenue administration should also be a priority to ensure that recent amendments to the tax code do not further weaken the non-oil fiscal position through increased evasion. The mission welcomes the government’s intention to reform the pension system as this would make the system financially sustainable while providing a sufficient degree of income replacement in retirement. The IMF stands ready to follow up on its recent technical assistance in this area.

6. With high oil prices allowing the authorities to work from a position of strength, this would be an opportune moment to cement principles of sound oil revenue management in a new policy framework. Continuing with the scaled-up public spending is not appropriate for Azerbaijan, given the weak non-oil fiscal position, the increasing overheating risks, and insufficient assurances of efficiency in public investment. Committing to a fiscal rule and strong institutional arrangements, in line with recent IMF policy advice for resource-rich countries, would promote fiscal discipline. The fiscal rule could provide deficit benchmarks to smooth the spending consolidation path and foster reforms to strengthen non-oil revenue and rationalize public spending. Priorities include: (i) streamlining exemptions and applying tax procedures uniformly; (ii) improving the management of public investment and redirecting some resources from a fuel subsidy reform to better targeted transfers; and (iii) strengthening the public financial management system, along with fiscal discipline and transparency, to ensure high standards of fiscal control. The Fund stands ready to support the government's efforts in these areas with technical assistance, in cooperation with the World Bank.

7. Turning to monetary policy, the CBA could shift to a more neutral stance in the near term and undertake monetary tightening if signs of demand pressures intensify. We also recommend that the CBA should not have any role in future direct lending to the real economy. Steps should also be taken to improve the monetary policy transmission channel. Implementing the planned prudential measures would cool down the acceleration in consumer loans while also helping preserve financial sector stability.

8. The authorities should collaborate to prepare the ground for greater exchange rate flexibility over the longer term. A more flexible exchange rate gives the authorities an additional tool to reduce output and inflation volatility and improve the economy’s ability to absorb shocks, particularly over the long term as non-oil exports become more diversified. In Azerbaijan’s circumstances, the introduction of greater flexibility needs to be gradual and should follow the implementation of pre-conditions and reforms in foreign exchange management and the monetary policy framework, as stressed in the recent IMF technical assistance advice. Near-term priorities include deepening the capital market, developing currency risk mitigation instruments, and improving monetary-fiscal policy coordination. At a later stage, a clearly articulated CBA foreign exchange market intervention policy could guide market participants before allowing foreign exchange trades within a progressively wider band. Over the longer term, plans should be put in place to abandon the official exchange rate as the nominal anchor, including by introducing a target band with an explicit intervention strategy. This would pave the way for introducing inflation targeting as the main anchor for conducting monetary policy.

9. The ongoing capitalization process and ensuing consolidation should be used to create a more viable and competitive banking sector and promote diversification. The financial sector should be strengthened to support economic diversification as it is not sufficiently deep and efficient. Ongoing CBA initiatives to strengthen corporate governance regulations, risk management practices (requiring certified risk managers), and prudential regulations to contain consumer lending are well placed. Such initiatives should be supplemented with strengthened supervisory safeguards in line with international best practice to ensure the accurate classification of non-performing loans, with proper loan-loss provisioning. Approving a time-bound action plan to guide, in particular, the processes of capitalization, recording of NPLs, and potential merger and acquisitions will be crucial to contain risks in the system.

10. The largest bank, IBA, has an unviable business model and needs major restructuring to be able to support the real sector. IBA faces heavy risks ranging from large projects under construction to agricultural development that are not properly assessed and cannot be funded by short-term deposits. An unreformed IBA would undermine the stability and efficiency of the banking system and result in high costs for the shareholders, including the government. The restructuring of the IBA operations and its governance structure should follow internationally accepted principles to pave the way for the downsizing and transparent privatization of the bank in due course. Therefore, a diagnostic assessment of IBA should be undertaken by a reputable international institution or company, and external borrowing by this bank should be contained until a viable business model is in place.

11. Efforts to strengthen capital markets with the support of the World Bank will facilitate the financing of companies in the non-oil sector. We welcome plans to develop the legal framework, infrastructure, and instruments for savers and investors. Though the recent expansion of the corporate bond market could help deepen the capital market, the authorities need to strengthen the consolidated supervision of banks and its brokerage subsidiaries, and develop an appropriate credit infrastructure—in particular through enforcement of contracts, effective recovery of collateral, and a private credit bureau. The recent change in the Commercial Secrets Law, discouraging the disclosure of shareholders of companies, including banks, should be reversed and the law brought into line with international disclosure principles.

12. The IMF stands ready to continue supporting the authorities’ efforts to strengthen the financial sector through the upcoming update of the Financial Sector Assessment Program (FSAP) to be undertaken jointly by the IMF and the World Bank in early 2014.
Advancing the Reform Agenda to Achieve Diversification

13. The government’s 2020 strategy could provide the platform for decisive reforms in the business environment that could promote non-oil exports. The “easy service center” initiative (ASAN) has reduced the costs and delivery time of government services and should be expanded while phasing out more traditional and inefficient government services. The implementation of e-government initiatives has the potential to reduce opportunities for corruption at the Ministry of Taxes and Customs. But this needs to be supplemented with the legalization of e-signature and actions to improve Azerbaijan’s position in overall governance and rule of law world indicators, critical areas for fostering non-oil FDI and private sector-led growth.

14. Ambitious reforms aimed at reducing informal and formal barriers to trade and competition will be crucial to promote a diversified and competitive economy. An independent international agency should provide a public evaluation of the draft competition code ahead of its enactment. Also, accelerating plans for WTO accession and the completion of regulations needed for the full implementation of the new customs code would encourage private sector investment and speed up integration with global markets. Substantial streamlining of government inspections, licenses, and permits—including for SMEs—could help sharply reduce non-oil companies’ costs and opportunities for corruption.

15. Enhanced coordination and sharing of core information among government agencies is crucial to ensure efficient policy making, and could to be formalized and guided by a memorandum of understanding.

16. The mission thanks the authorities for open and constructive discussions.

¹ Azerbaijan also has significant gas reserves, and the gas wealth is about 1/3 of oil wealth. For brevity, in this note oil refers to both oil and gas, except when discussing the oil production horizon, which only pertains to the oil sector.