Azerbaijan Republic—Letter of Intent

December 6, 2004

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Mr. Rodrigo de Rato
Managing Director
International Monetary Fund
700 19th Street
Washington, DC 20431

Dear Mr. de Rato:

1. On December 19, 2003, the IMF Executive Board completed the third review under Azerbaijan’s Poverty Reduction and Growth Facility (PRGF) arrangement, which is in support of our economic reform program. We would like to take this opportunity to inform you about our continuing implementation of this program, as well as our policy intentions for 2005, and to request waivers for non-compliance with several structural performance criteria. This letter should be read as additional to our original letter of intent and Memorandum of Economic and Financial Policies, dated June 15, 2001, as well as our letters of February 6, 2002, April 23, 2003 and December 4, 2003.

2. Our performance relative to the quantitative performance criteria and indicative targets for end-2003, as well as end-March, end-June and end-September 2004, and the proposed performance criteria and targets for end-December 2004, and end-March 2005 are presented in Table 1. Performance relative to these targets and criteria should be measured as detailed in Annex I of our April 23, 2003 letter. While the fourth review under our PRGF arrangement was scheduled for completion by May 15, 2004 and the fifth review by August 15, 2004, difficulties discussed below have made adherence to this schedule impossible. Therefore, we would like to request completion of the fourth review under our PRGF arrangement, a rephasing of the fifth review so that it be completed on or after May 15, 2005 based on performance criteria for March 31, 2005. To accommodate this rephasing of reviews, we also request an extension of the program to July 4, 2005, from the current expiration date of March 31, 2005. The delays in completing the fourth review, as well as delays in completing earlier reviews, make completion of the originally planned sixth review impossible within the 4 year maximum life of a PRGF arrangement, and thus we also request cancellation of the sixth review and a corresponding reduction in the size of our PRGF arrangement.

3. Our program policies and objectives described below are fully consistent with our State Program for Poverty Reduction and Economic Development (SPPRED).

Recent Macroeconomic Developments

4. Macroeconomic developments remain generally favorable, with strong real GDP growth, a stable exchange rate, and continued accumulation of foreign assets by the National Bank of Azerbaijan (ANB) and the State Oil Fund of Azerbaijan. Real GDP grew 11.2 percent in 2003 relative to 2002, and by 9.9 percent in the first nine months of 2004 compared to the same period a year earlier, reflecting the positive impact of prudent financial policies and comprehensive structural reforms adopted by the government, high oil prices, and continued strong foreign direct investments in the oil sector. Gross official reserves of ANB increased to US$952 million at end-September 2004, and are now equivalent to almost 4.1 months of non-oil imports. Given that external debt and debt service remain relatively low—with prospective public and publicly-guaranteed external debt about 17.5 percent of GDP, and debt service at 2.3 percent of projected 2004 exports—these foreign assets provide a comfortable cushion against adverse external shocks.

5. Inflation remains moderate. Although there was an acceleration in consumer price inflation late in 2003 that continued in early 2004, 12-month consumer price inflation has recently declined from a peak of 6.8 percent as of end-April 2004, to 4.9 percent at end-September 2004, moderately higher than both the 3.3 percent at end-2003 and the program target for 2004 of 2.5 percent. We believe four factors have contributed to this increase in inflation: the increase in wages and pensions in the second half of 2003; the increase of nearly 20 percent in imported wheat prices; the higher than expected domestic impact of oil-sector FDI; and the significant depreciation of the U.S. dollar vis-à-vis most major currencies in late-2003 which, given our policy of using the manat/U.S. dollar exchange rate as an anchor for monetary policy, has produced a significant real effective depreciation of the manat relative to our trading partners. The acceleration in inflation in October, when monthly inflation reached 4.4 percent, we attribute to a number of one time factors, including increases in advance of the expected upward adjustment in domestic energy product prices and the temporary closure of the border with Russia.

6. We continue our efforts to combat poverty. As detailed in the first annual report on our SPPRED, completed in May 2004, poverty is estimated at 44.7 percent of our total population, while the incidence of extreme poverty is almost 10 percent. While changes in methodology between the two most recent household surveys make comparisons difficult, we believe there has been some reduction in poverty, and are determined to reduce it further in the coming years.

Performance Relative to Program Targets

7. All end-2003, as well as end-March, end-June and end-September 2004 quantitative performance criteria and indicative targets were met with comfortable margins, with two exceptions. The indicative reserve money targets were missed by significant margins, in large part reflecting increased money demand, while the indicative limit on unpaid government bills for end-March, end-June and end-September were exceeded by less than 0.1 percent of GDP, due to modest arrears on pension payments.

8. Our performance relative to our structural commitments under the PRGF program has been mixed. We met most of our structural performance criteria and benchmarks for end-December 2003: we established a single uniform enterprise profit tax; replaced specific import duties with ad valorem duties as programmed; reduced the list of VAT exemptions and required that future changes in such exemptions be done only in the context of the annual budget preparation process; allocated tax credits to SOCAR and subsidies to Azerenergy and Azerigas related to unpaid fuel consumed by the utilities on a quarterly basis in 2003; and continued adherence to the reform program for the State Customs Committee (SCC) through end-2003.

9. However, there were a number of structural reforms that proved more difficult to implement than we had anticipated, with the result that we missed several structural performance criteria under the program. First, given the importance for our economic future of a long term strategy for the use of oil revenues, we have taken time to ensure the development of a strategy that is both well-designed and broadly supported. While we were not able to meet the performance criterion calling for the adoption of such a strategy by end-March 2004, our strategy was formally adopted by a Presidential decree in September, with the resultant path of non-oil deficits presented in the draft presidential decree on the 2005 budget.

10. Second, while we have made serious efforts during 2004 to begin the process of increasing the financial discipline of, and government control over the operations of, large state-owned enterprises, the process has been very difficult. We had committed to approve the 2004 revenue and expenditure plans of Azerchemia, Azerenergy and Azerigas by end-March 2004 (a structural performance criterion), but these companies had difficulty producing plans satisfactory to the government, and thus were only able to complete this approval process in April 2004. In addition, we have found it very hard to monitor and enforce the implementation of these plans. However, these plans were approved, and we are making efforts to strengthen our monitoring of the execution of these plans as discussed below.

11. Similarly, the process of revising the legislative foundation of our banking system has proven more complicated and thus protracted than we anticipated, as we struggled to balance the need for independence of the ANB with the need to ensure the transparency and effective oversight of the ANB. Deciding how to meet both these needs took longer than expected, and as a result we were not able to adopt the Banking System Law (BSL) by end-December 2003, or to submit the National Bank Law (NBL) to parliament by end-December 2003 (both structural performance criteria). However, as a prior action for completing the fourth review we have adopted a BSL, and will adopt an NBL, that are both consistent with all Basle Core Principles (BCPs). Among other important features, the laws provide for a level playing field in the banking sector, strengthen banks’ corporate governance, bolster the central bank’s supervisory control, improve our ability to fight money laundering and financing of terrorism, strengthen ANB’s independence in the formulation and execution of monetary policy, improve the accountability of the ANB, enhance ANB transparency through an inclusion of two independent members in its Board, and establish a clear mechanism for distributing ANB’s profits. On this basis, we request waivers of the relevant performance criteria.

12. Also on the banking sector, the process of privatizing International Bank of Azerbaijan (IBA) has gone slower than we had hoped. We had planned to sell 20 percent of IBA to EBRD, and to then issue a tender for the sale of the government’s remaining 30.1 percent of the bank. While it was a structural performance criterion to issue this tender by end-June 2004, the discussions on the sale to EBRD have not yet been completed, and thus it proved impossible to meet this commitment. Nonetheless, we continue our efforts to privatize IBA (discussed in paragraphs 20 and 21 below), and are taking steps to develop a competitive banking system.

13. Finally, while we recognize the importance of ensuring that domestic energy product prices reflect world market prices, we have reconsidered our plans for how to achieve this objective. We had committed to adopt a mechanism for the automatic adjustment of domestic energy product prices by end-December 2003 (a structural performance criterion). However, we are now concerned that such a process could lead to artificial shortages in advance of what would be effectively pre-announced price changes. Thus, while we remain committed to eventually bringing domestic prices into line with world market prices, we have decided not to adopt such a mechanism at this time. Instead, as of November 1 this year we increased the price of natural gas 127 percent, (bringing the average price to roughly 85 percent average cost), which will be combined with an ambitious program to provide gas meters for all households. We have also increased the price of gasoline, diesel fuel, home heating fuel, kerosene, motor oil, industrial oil, turbine oil, transformer oil, other types of oil, motor fuel, jet fuel, coke, naphtha (primary gasoline), bitumen, and compression gasoline, depending on grade, by 10-12 percent, on average. During the coming year, based on an analysis of the impact of these increases in the first half of 2005, we will consider the next stage in revising these prices.

14. In part to help cushion the most vulnerable in society against these price increases, we increased the minimum wage from 60,000 to 100,000 manat per month on July 1, 2004, and plan further increases in both the minimum wage and minimum pension in 2005. We have also included in the 2005 budget 34 billion manat to compensate vulnerable groups for energy price increases.

15. In addition to these one-time price changes, our intention is to review the domestic prices of energy products at least once per year, in the context of the annual budget preparation process, with the goal of first ensuring all prices at least cover production costs, and then over time ensuring these prices more closely align with world market prices. We have publicly announced this pricing strategy. Given the recently announced price increases, and this long-term pricing strategy, we request a waiver of the performance criterion calling for the adoption of an automatic adjustment mechanism.

Monetary and Exchange Rate Policies and Financial Sector Reforms

16. Our macroeconomic targets and projections for 2005 reflect our continued strong economic growth prospects. High export prices, the anticipated completion of the Baku-Tbilisi-Ceyhan (BTC) oil export pipeline and the first phase of the Azeri-Chirag-Guneshli oil field, as well the continued investments in the Shah Deniz gas field and South Caucasus gas pipeline are expected to produce roughly 25 percent growth in the hydrocarbon sector of our economy in 2005, at the budgeted export price of oil of US$25 per barrel. At the same time, reflecting the continuing broad-based growth of our economy, growth in other sectors—particularly in agriculture, agro-processing, transport and telecommunications—are projected to lead to a fifth consecutive year of over 10 percent growth in the non-hydrocarbon sectors of our economy.

17. We also remain committed to macroeconomic stability, and in particular to keeping inflation under control. While underlying inflation in 2004 is projected to be 5.0 percent, as a result of the increases in energy product prices discussed above, we expect the actual inflation level to be somewhat higher. We are targeting 2005 inflation of 5.0 percent.

18. The ANB has in recent years used the exchange rate of the manat to help anchor the domestic price level; we believe this policy has served us well, as it has contributed to low inflation, increasing international reserves and growing external competitiveness, as reflected in the rapid growth of non-oil exports in recent years. Thus, we will continue to use the nominal exchange rate as an anchor for the nominal variables of the economy. However, we recognize that, as our use of oil revenues increases, appreciation of the real exchange rate will be inevitable. We will ensure that this real appreciation does not come about via higher inflation. In part as a result, we anticipate modest nominal appreciation in 2005. We will monitor inflation trends carefully and, if developments indicate our new inflation target is in jeopardy, we stand ready, in consultation with Fund staff, to tighten the stance of our fiscal and monetary policies, as necessary. To enhance our ability to conduct monetary policy, we have recently introduced Central Bank Bills. In addition, the Ministry of Finance and the ANB will review the issue of the long-term government bonds currently held by the ANB, with the aim of converting them into marketable securities. We aim to have a combined total of 500 billion manat worth of Treasury and Central Bank Bills in circulation or held by the ANB by end-2005, but will revise this plan as necessary based on financial market developments.

19. The ANB will continue to follow carefully the developments in the domestic credit market, to ensure that the recent fast pace of credit growth does not undermine the quality of commercial bank loan portfolios. While in 2003 the stock of outstanding commercial bank loans increased by nearly 40 percent, the stock of nonperforming loans increased only modestly, and the ratio of nonperforming loans net of provisions declined. In the first half of 2004, there was a modest reduction in the stock on nonperforming loans, despite a further 20 percent increase in the outstanding stock of credit. Notwithstanding these encouraging developments, the ANB’s supervisors are paying particular attention during on-site inspections to ensuring that the reported loan portfolio quality does indeed reflect the underlying financial health of banks. In addition, based on the results of the recent FSAP assessment, we intend to improve regulations related to banking supervision, as recommended based on the detailed BCP assessment. We will also adopt a zero-tolerance approach to violations of prudential regulations and impose stricter penalties for such violations.

20. We remain committed to the privatization of IBA. However, as the privatization of IBA has proceeded more slowly than hoped, and as privatization alone will not solve all the problems created by IBA’s effective monopoly of key portions of the financial markets, we are embarking on a comprehensive program to improve corporate governance and enhance competition in the banking sector. On corporate governance, as a prior action for completing the fourth review the ANB—having taken into account possible recapitalization opportunities in the future—has approved a timetable for ensuring that the IBA is in compliance with all prudential requirements. In addition, during 2005 we will review the operation of the IBA’s supervisory board, with a view to restructuring it so as to make it more effective in light of the demands of the market and the new banking system law.

21. To improve competition in the banking sector, consistent with our broader anti-monopoly program, we have announced as a prior action for completing the fourth review that, effective December 1, 2004, all banks have the right to serve as collection points for gas and water bills, and that the respective utilities will cooperate with all participating banks. In addition, following the experience with limited tendering for government financial services in 2004, we have announced that, during January 2005, the government will issue a tender for all financial services purchased by the Treasury.

22. With regard to BUS Bank, the government and the ANB will jointly review, by end-March 2005, the appropriate role for this institution in Azerbaijan’s financial markets. We will also take steps to strengthen the management of this institution and issue a tender for its sale during 2005. While we have recently removed the special credit constraints on this bank, we will closely monitor its actions to ensure the bank does not take on excessive risks.

23. Azerbaijan has accepted the obligations of Article VIII, Sections 2, 3 and 4, effective November 30, 2004, following the removal of a few economically insignificant restrictions that remained in our exchange system.

24. The government and the ANB are in full agreement with the conclusions and recommendations of the recent FSAP exercise. We are committed to implementing these recommendations, which will help remove impediments to financial sector development in Azerbaijan.

Fiscal Policy

25. As noted above, in light of the importance of proper handling of the oil revenue that Azerbaijan is receiving already, and the much greater oil revenues we will receive in coming years, the government has designed a long term strategy for the management of oil revenues; this strategy has been formally adopted through a Presidential Decree. The strategy includes the following important principles: 1) We will seek to ensure constant real expenditures of oil revenues over time, to enable all generations of Azeris to benefit from this exhaustible resource. 2) Fiscal policy will focus on targeting the non-oil deficit (as a share of non-oil GDP) as the best measure of the pace of spending of oil revenues. 3) While the current non-oil deficit is well below the sustainable level of real expenditures of oil wealth, we will gradually move toward that sustainable level, placing an annual ceiling on the maximum change in the non-oil deficit, seeking to ensure continued macroeconomic stability and efficiency of spending. We have ensured that the draft 2005 budget is consistent with these principles. In addition, as a prior action for completion of the fourth review the Cabinet of Ministers has issued an instruction that lays out a path of non-oil deficits through 2008, targeting a 2.4 percent of non-oil GDP increase in the non-oil deficit in 2005, and a one percent increase in subsequent years. This instruction also clearly defines the important concepts of oil revenue, non-oil deficit, and non-oil GDP. The calculations underlying these targets will be revised at least once a year, in the context of the annual budget preparation process, in light of developments in oil prices and volumes, but will always be based on conservative assumptions of oil prices and volumes; the resulting path of non-oil deficits will be included in the annual budget, along with our Medium Term Expenditure Framework (MTEF).

26. The strategy we have adopted thus provides guidance on how much oil revenue we can afford to spend in any given time period. The strategy also provides guidance on how to spend that money. We will focus our expenditures of oil revenue on our goals of reducing poverty, encouraging growth in the non-oil sectors, and enhancing regional development, all of which is consistent with our State Program for Poverty Reduction and Economic Development (SPPRED). Thus, our expenditures will focus on infrastructure development, improvements in health and education, and tax cuts for non-oil enterprises. Now that we have developed this broad strategy, our next task will be to convert these principles into concrete expenditure and tax plans, including through the further development of the MTEF and our Public Investment Program (PIP).

27. To further strengthen our budget preparation process, and the coherence of our fiscal policies, the Ministry of Finance and the Ministry of Economic Development will conduct a joint review of the process of preparing the 2005 budget, and before end-February 2005 will present to the Cabinet of Ministers recommendations for steps to (1) improve the annual budget preparation process, and (2) strengthen the ties between the SPPRED, MTEF, PIP, regional development program, other programs related to fiscal policy and the annual budget.

28. The oil revenue strategy and goals are reflected in the 2005 budget we have submitted to parliament. On the tax side, the major reform in the 2005 budget is a reduction in the Social Protection Fund (SPF) contribution rate from 29 percent (27 percent for employers and 2 percent for employees) to a combined 25 percent (22 and 3 percent, respectively). This lower rate could encourage job creation and will enhance the competitiveness of our businesses. We have also eliminated the temporary VAT exemption for grain effective October 1, 2004, and will not reintroduce such an exemption, and we have reaffirmed our commitment not to introduce VAT exemptions outside the annual budget process. On expenditures, we are sharply increasing domestically financed capital expenditures (by almost 37 percent), with these expenditures focused primarily on infrastructure investments.

29. For stabilization purposes, we have established a special Ministry of Finance account in the ANB, where tax revenues resulting directly from oil prices that are higher than assumed in the budget are deposited, as a cushion against possible declines in oil prices. However, to date there have been no formal rules covering this account. We have prepared such rules and included them in the draft Presidential Decree on the 2005 budget.

30. The 2005 budget also includes a substantial increase in the wage bill, largely reflecting both the full year effect of the increase in the minimum wage to 100,000 manat in July 2004 and the effect of the further increase in the minimum wage to 125,000 manat in January 2005. Even at this new level, the minimum wage—which is paid to roughly one-third of all budgetary employees—will remain very low, at around US$25 per month. Average government wages are also low. Despite these low wages, the wage bill for the government—including the associated SPF contributions—has steadily grown as a share of total expenditures, and stands at over 25 percent of total 2005 expenditures. We recognize that, in order for the government to be able to eventually pay more reasonable wage levels, it will be necessary to reduce the number of civil servants. We intend, during 2005, to design a comprehensive medium-term civil service reform program, aimed at achieving this objective.

31. The main area of reductions in expenditures in 2005 is in subsidies. Improvements in Azerchemia’s financial position means that it no longer requires subsidies from the government budget, while improved collection rates and the increased tariffs for natural gas mean that Azerigas should be able to pay SOCAR in full for its gas consumption, without subsidies. Subsidies to Azerenergy are also being reduced modestly (2.5 percent) in 2005, while the subsidy to Baku Metro has been reduced by 48 percent due to the doubling of metro tariffs as of January 1, 2005. Finally, from April 1, 2005, we will increase tariffs for water supply by 100 percent for households and 30 percent for budget organizations, to enhance the financial position of the water companies and thus reduce their need for subsidies.

32. In 2003, for the first time, SOCAR paid its full legal tax liability, rather than a negotiated tax target. However, SOCAR’s cash payments in 2003 were precisely what had been assumed in the 2003 budget, and we expect the same outturn for 2004, despite the fact that in both years oil prices were higher than assumed in the budget. The additional tax liability was settled by applying more of SOCAR’s tax credits—for fuel delivered to Azerenergy and Azerigas for which SOCAR was not paid by those utilities—to SOCAR’s current tax liability, and less to settling accumulated tax arrears. To ensure that the budget benefits from higher oil prices, we have included in the 2005 budget law a requirement that SOCAR pay its full current legal tax liability in cash, using any tax credits to settle its accumulated tax arrears, and we will require SOCAR to pay these outstanding arrears in full. Once all SOCAR’s tax arrears have been cleared, any future credits will be in a form to be determined, in consultation with Fund staff, before the end of the first quarter of 2005.

33. On a related issue, through 2004 we have continued the practice of setting minimum tax payment levels for large state-owned enterprises, to be imposed in the event tax collections fall short of budget levels. Starting in 2005, these minimums have been eliminated; in the future, all enterprises will be required to pay taxes strictly on the basis of the tax laws.

34. The state-owned airline AZAL has recently contracted to purchase four airplanes from Airbus. In the context of the 2005 budget, the government will provide a capital injection to AZAL to assist in paying for these planes. AZAL will be responsible for the remaining cost of these planes; there will be no further budgetary expenditures to assist in paying for these planes, subject to the provision of a government guarantee for credits to finance the remaining cost as foreseen under the terms of the purchase and sales agreement.

35. The reform of our pension system continues. Increasing efforts are under way to develop an insurance and pension framework based on individual accounts and establishing a direct relationship between contributions and pensions. The Social Protection Fund (SPF) has arranged for ATM cards to be issued to pensioners, to enable them to receive their pensions through electronic systems and ATMs. While in Baku these cards are being issued to pensioners only through IBA, outside Baku we have opened the tendering process to all banks. We have recently publicly clarified, as a prior action for completion of the fourth review, that pensioners throughout the country—including in Baku—are free to choose whichever payment outlet (including private commercial bank) they wish to receive their pensions through, and that the ATM cards issued to pension recipients can be used at any ATM in the country. We are also working to improve SPF revenue collections, notwithstanding the reduction in SPF contribution rates. We believe that we will be successful in this effort, both as a result of rising wages in the economy—including the increase in the minimum wage—as well as improved administration and enforcement. We recognize the risks inherent in budgeting on the basis of administrative improvements in collections, and we will monitor the situation. The planned increase in minimum pensions will only take place after we have monitored SPF revenues in the fourth quarter of 2004 and the first quarter of 2005 and are confident on that basis that the annual revenue targets will be met, and that the SPF has not only had success in clearing outstanding arrears but will be able to avoid future arrears. The government will take any necessary measures to prevent future accumulation of pension arrears.

36. Our external debt levels remain modest, and we continue our policy of paying all acknowledged government and government-guaranteed debts in a timely fashion. We continue to seek a resolution of our debt disputes with Kazakhstan, Turkmenistan and Uzbekistan, and we have recently resolved a debt dispute with a Turkish company. A Law on Public Debt has been prepared, with technical assistance from the Fund, and will be submitted to parliament in 2005.

Other Structural Issues

37. The revenue and expenditure plans for 2004 that we approved for Azerenergy, Azerigas and Azerchemia were consistent with the subsidy allocations to these companies in the 2004 budget. However, the monitoring and enforcement of these plans has proven difficult. The Chamber of Accounts has recently completed, or is in the process of conducting, audits of these companies. Based on the results of these audits, as well as the implementation of their approved revenue and expenditure plans for 2004, the government will take steps to strengthen the financial oversight of these companies. In addition, the Ministry of Finance will, by the end of 2004, prepare reporting forms that these companies, as well as SOCAR, will be required to use in reporting quarterly on the implementation of their approved 2005 revenue and expenditure plans.

38. We recognize the importance of continuing to strengthen governance in Azerbaijan. Parliament approved an anti-corruption law in January 2004. This law requires that government officials annually report their sources of income and total wealth, establishes limits on the value of gifts government officials are allowed to receive, and prohibits public officials from benefiting personally through the execution of their official duties. To effectively implement this law, an anti-corruption committee was formed, and we have adopted a comprehensive anti-corruption strategy that was prepared with the active engagement of the international community and NGOs.

39. Despite the steps we have already taken to improve the business environment, we recognize the importance of continuing these efforts. While protecting the rights of the ANB to inspect banks, the Ministry of Finance to inspect budgetary organizations, and the Ministry of Tax to conduct necessary inspections to ensure compliance with the tax laws, we will continue our efforts to reduce further any unnecessary and intrusive inspections of businesses. We will also continue the process of simplifying business registration, including by reducing the paperwork requirements and considering the establishment of a one-stop registration process. Finally, during 2005 we will submit to parliament a new Investment Law, which has been prepared in close cooperation with the staff of the World Bank.

40. We are increasingly concerned about the artificial monopolization of domestic markets for a large number of goods. We intend to strengthen our fight against monopolies in three ways. First, we will accelerate the preparation of a new Anti-Monopoly Code, and submit it to parliament during the first quarter of 2005, with the aim of strengthening our efforts to create a competitive economy. Second, not awaiting the passage of this new Code, we will review and revise as necessary our procedures for enforcing our anti-monopoly rules and regulations. Finally, we will review developments regarding the apparent monopolization of certain goods on the domestic market.

41. We have started a major reform of the communications sector, aimed at separating the regulatory and commercial functions within the Ministry of Communications and Information Technologies (MCIT), and then privatizing its commercial activities. As a first step, we plan to shift the responsibilities for the regulation of the telecommunications sector to an independent unit (with its own charter) within the MCIT and then later to establish this unit as an wholly independent government agency. We will also shortly begin the process of privatizing the MCIT's participation in joint ventures and hope to complete this process by end-2005. Next year we will also start the process of restructuring our domestic telecommunications network (Aztelekom and Bakutelekom) with the aim of ultimately privatizing it as well. It is hoped that these measures will materially improve the business climate in the telecommunications sector and stimulate both domestic and foreign investment into this industry, including into the regions.

42. We will continue to implement a liberal trade policy. On April 1, 2004, the final stage of the process of replacing specific with ad valorem customs duties was taken; as of this date, only excisable products, cars and a few minor products continue to be subject to specific customs duties, and the weighted average tariff has been reduced to 5.7 percent. The second meeting of Azerbaijan's WTO accession working party met in October 2004 and good progress was made. Work will now focus on issues of market access for goods and services and agriculture. The next meeting of the working party is expected to take place in the second half of 2005.

43. We recognize the necessity of timely and accurate macroeconomic statistics. We will thus continue our efforts to improve our statistical collection, analysis and reporting system. We will review our need for assistance in this effort, and will request appropriate technical assistance including from the Fund. As a result of the progress we have made in this effort, we are now prepared to subscribe to the reporting standards of the Special Data Dissemination Standards (SDDS) system during early 2005.

Program Monitoring

44. Quantitative performance criteria and targets for end-December 2004, as well as end-March, are detailed in Table 1. We propose that Cabinet of Ministers approval of revenue and expenditure plans for Azerchemia, Azerenergy, Azerigas, and SOCAR, consistent with the subsidy allocations in the 2005 budget, be a structural performance criterion for end-December 2004. We also propose the following structural performance criterion for end-March 2005: issuance of tenders for all financial services to be purchased by the Ministry of Finance. We also propose one end-April structural performance criterion: adoption by the Cabinet of Ministers of a plan to improve the annual budget preparation process, and strengthen the connections between the SPPRED, MTEF, PIP and annual budget, based on the review conducted by the Ministry of Finance and the Ministry of Economic Development, with this plan to be implemented during the preparation of the 2006 budget. Finally, we propose the following structural benchmarks for end-March 2005: (1) in accordance with the Law "On Public Service" dated July 21, 2000, to prepare legislation providing for the recruitment of citizens to the civil service on a competitive basis and, based on that legislation, setting a timetable for implementing comprehensive civil service reforms. We remain committed to the phased implementation of this law, which foresees the broader reform of the civil service. (2) Based on a review by the Cabinet of Ministers, in conjunction with the Ministry of Economic Development, Ministry of Finance, Ministry of Energy, and Ministry of Taxes, of the financial performance of Azerchemia, Azerenergy, Azerigas and SOCAR, adoption of decisions to strengthen the financial discipline and oversight of these companies.

45. The fifth review of our PRGF arrangement will focus on three areas: (1) continued progress in energy reforms—particularly enhancing financial discipline of key state-owned enterprises, controlling the subsidies to Azerenergy, and ensuring SOCAR pays its full legal tax liability, consistent with the tax laws and the relevant provisions of the 2005 budget law; (2) enhanced competition in financial markets, including progress toward the privatization of IBA and BUS Bank; and (3) progress on strengthening the MTEF and PIP, as well as the links between the MTEF, PIP, SPPRED, and the annual consolidated budget.

46. The government and the ANB believe that the policies discussed above, combined with the policies described in our previous letters and MEFP, are adequate to achieve the objectives of the program, but we will take any further measures that may become appropriate for the purpose. Azerbaijan will consult the Fund on the adoption of these measures, and in advance of revisions to the policies discussed above, in accordance with Fund policies on such consultation.