Mission Concluding Statement 

Azerbaijan: Staff Concluding Statement of the 2022 Article IV Mission

July 6, 2022

Washington, DC: An International Monetary Fund (IMF) staff team visited Baku and held discussions on the 2022 Article IV consultation from May 25 to June 7, 2022. The IMF team would like to thank the authorities and other interlocutors in Baku for their frank and open discussions. The views presented here are our preliminary findings based on these discussions.

Context - from pandemic to the war in Ukraine

1. The economy has recovered rapidly from the pandemic, but inflation and the war in Ukraine create new challenges. While Azerbaijan benefits from high oil and gas prices, the war poses new risks from rising food prices, food security, and spillovers from sanctions, and introduces significant uncertainty to the outlook. In the long-term, the main challenges remain fiscal consolidation and diversification of the economy.

2. Growth accelerated briskly in 2021 and early 2022 on the back of high oil prices and strong consumer demand. Real GDP increased by 5.6 percent in 2021. Hydrocarbon GDP increased by 1.8 percent owing to the relaxation of the OPEC+ restrictions and a boost in gas exports. Non-hydrocarbon GDP rose by 7.2 percent, with activity accelerating in contact-intensive industries in response to the easing of social restrictions. The war in Ukraine has so far had a limited impact on the real economy and nonoil growth continued to be strong in January-April 2022.

3. At the same time, though, global inflation has fed into a broad-based increase in the CPI. CPI inflation increased sharply from 2.7 percent (yoy) in December 2020 to 12.0 percent in December 2021 and remained at around 12 percent during January-April 2022. This primarily reflects external factors but also an adjustment in regulated prices and an increase in consumption, as suggested by the strong rebound in the nonoil economy. The initially narrow increase in prices has had important second round effects, with prices rising across the CPI basket. This is having a disproportionate effect on the purchasing power of the most vulnerable and could de-anchor inflation expectations.

4. High oil and gas prices resulted in a sizable improvement in the balance of payments. The current account balance improved to a surplus of 15.2 percent of GDP in 2021 (from a small deficit in 2020). Strong FX earnings continue to support the de facto peg, with limited demand for FX in official auctions since April 2020. [1] The improvement in the current account has also supported a change in our assessment of the external position to stronger than (from substantially weaker than) the level consistent with medium-term fundamentals and desirable policies.

5. Appropriately, hydrocarbon windfalls have been saved. SOFAZ oil revenues jumped by over 60 percent in 2021 and nonoil revenues increased with stronger economic activity. Total budget expenditures increased only moderately, despite the increase in Covid-related spending (from AzN 261 million to over AzN 800 million). This increase was funded by a reallocation of spending. As a result, the overall fiscal balance improved by 10 percent of GDP, reaching a surplus of 4 percent of GDP in 2021. The non-oil primary deficit also improved significantly (by over 7 percent of nonoil GDP). General government and government-guaranteed debt decreased to 41.8 percent of GDP in 2021 , from 54 percent of GDP in 2020.

6. T he CBA started to reverse its monetary easing stance. By end-March 2022, it raised the interest rate by a cumulative 150 points, in 5 consecutive meetings, to 7.75 percent, 25 points above the end-2019 level. However, with inflation in double digits, the policy rate is negative in real terms. The CBA paused tightening at its end-April meeting as inflation and inflation expectations moderated. Monetary transmission to bank lending and deposit rates remains weak. Since the start of the CBA tightening cycle in September 2021, average bank lending rates on new loans fell from 17.8 percent to 16.3 in April 2022, while average deposit rates on new manat deposits remained broadly unchanged (at around 8 ½ percent). This also implies a large decline in real terms since early 2021 when inflation began to accelerate.

7. The banking sector remains resilient. According to the financial soundness indicators (FSIs), the banking sector has adequate capital buffers and nonperforming loans continue to decline. Though the large number of restructured loans may mask a sizable amount of impaired business loans. [2] Bank profitability is supported by high interest margins, with spreads between reference lending and deposit rates remaining high, and rapid balance sheet growth. [3] In April 2022, total loans increased by 22 percent compared to April 2021, with loans to households rising by 34 percent, as the banks search for yields. The increase in bank loans was supported by a 28 percent growth in deposits. The faster increase in manat deposits brought down the deposit dollarization to 50.8 percent, from 54 percent a year ago, with a similar decline in loan dollarization. The CBA has phased out all pandemic-related banking sector support measures . The impact of the war in Ukraine and sanctions on Russia has thus far had only a limited impact on the banking sector. [4]

A positive outlook with large risks on the horizon

8. Growth and inflation are projected to moderate in 2022 and further decline in the medium term . Staff projects a deceleration of growth to 3.8 percent in 2022 (with non-hydrocarbon GDP growing at 5.5 percent based on robust first quarter growth), and further to around 2½ percent in the medium term, as the output gap closes in 2023 and oil and gas production gradually declines. Inflation is projected to remain elevated in 2022 reflecting adverse external factors, including high food and commodity prices and supply chain rigidities, and then decline gradually thereafter. Additional monetary tightening would be needed to support inflation returning to the upper bound of the CBA target band (4±2 percent) by end-2024 and remain around the mid-point thereafter.

9. Azerbaijan’s economy benefits from the higher energy prices resulting from the war in Ukraine. The increase in energy prices and the potential increase in gas exports to Europe are projected to boost exports and fiscal revenues over the medium term, with SOFAZ assets projected to approach 100 percent of GDP in 2025. Still, elevated food price inflation and food security are an immediate concern, as a significant share (17 percent) of Azerbaijan’s imports come from Russia, mostly food. Trade risks are mainly related to agricultural products and the impact on the financial sector has been limited to date.

10. Risks to the outlook have increased due to the war but remain broadly balanced. The negative impact of sanctions or a worsening of the situation in Turkey could weigh on the outlook. Food security has emerged as a new challenge. A prolonged conflict would impede Azerbaijan’s access to its main markets for wheat and other food staples; while limited access to fertilizers and inputs could hinder agricultural production. There also remains uncertainty about the path of the virus post-Omicron. Domestic risks include fiscal risks from SOEs and a deterioration of banks assets’ quality. There could also be pressure to increase expenditure due to higher oil revenues. Higher oil and gas prices resulting from ongoing geopolitical tensions would benefit Azerbaijan.

Fiscal policy - saving the windfall; protecting the poor

11. Sharply higher oil revenues are projected to result in a significant overall budget surplus in 2022. This projection is based on the WEO oil price of $108.5 per barrel, which contrasts with the authorities more conservative budget assumption of $50 per barrel, as well as stronger projected nonoil revenues growth (12.2 percent). [5] Staff’s total spending projection – an increase by about 18 percent - is slightly higher than the authorities’ approved budget, reflecting some provision for the supplementary budget.

12. Staff considers it appropriate to use the existing fiscal space to mitigate the impact of higher food prices and welcomes plans to improve the targeting of social assistance. Given the robust performance of nonoil revenues and spending discipline, the authorities have fiscal space to mitigate the impact of the war in Ukraine and high food prices on the population. The authorities implemented a package of budgetary measures to protect the vulnerable from high food prices, including adjustment to pensions and measures to ensure food security. [6] Staff understands that wheat imports and sales are already exempted from both VAT and custom tariffs. The exemptions are temporary with a clearly set sunset. The increased social spending is supported by projected strong nonoil revenue growth and does not pose a risk to fiscal sustainability. Looking ahead, staff notes the authorities’ plans to further improve the targeting of social assistance, by improving the digitalization of the information of socially vulnerable families. [7]

13. Given the high dependence on oil revenues and projected decline in oil production, a credible long-term fiscal consolidation plan remains a necessity. With the oil price projected to remain high, the medium-term fiscal outlook has improved but remains highly dependent on the oil price. In the baseline scenario with no policy adjustment, large‒though declining‒fiscal surpluses are projected in the medium term, with the nonoil primary deficit remaining broadly constant, at around 24 percent of nonoil GDP. Compared to the long-term Permanent Income Hypothesis (PIH)-consistent NOPB benchmark of 12.5 percent of nonoil GDP, this implies a policy gap of about 11.5 percent of nonoil GDP, [8] underscoring the need for fiscal adjustment as the oil production and oil-related revenues gradually decline. General government debt (inclusive of government guarantees issued to Agrarcredit) is projected to drop to 20 percent of GDP in 2022 and then to increase gradually to 30 percent of GDP by 2027.

14. Staff continues to view as appropriate a reduction in the nonoil primary deficit on average by at least 1.5 percent on nonoil GDP annually in the medium term . This would reduce the gap with the indicative PIH benchmark and create cushions in case of adverse shocks. The adjustment could rely on both revenue and spending measures:

• Revenue measures. To prepare for the decline in oil output in the medium term, the authorities will need to boost nonoil revenues. Possible measures include steps to broaden the tax base by reducing tax holidays, tax exemptions and reduced tax rates for selected sectors and activities, reform of the personal income tax system, and modernizing the property tax system. ^[9]
• Expenditure measures . Currently, the baseline scenario assumes growth of the wage bill and spending on goods and services broadly in line with nominal nonoil GDP growth. However, following a large increase in public sector wages in 2019 and 2021, a more moderate increase in wage bill growth, in line with inflation or less, could be considered. A similar recommendation could be made for spending on goods and services. Also, as recommended previously, further rationalization of generalized subsidies should be considered, by gradually raising domestic fuel and energy prices to improve efficiency, encourage investment, help reduce the use of fossil fuels, and encourage the use of renewable energy, while at the same time protecting the poor.

15. Staff welcomes the re-introduction of a revised fiscal rule and supports the announced targets. The design of the revised fiscal rule, targeting the nonoil primary balance (NOPB) and general government debt, represents an improvement over the previous rule suspended during the pandemic. The medium-term target of reducing the nonoil primary deficit to 20 percent of nonoil GDP by 2025, while keeping the public debt-to-GDP ratio below 20 percent of GDP is appropriately ambitious. To serve as a credible fiscal anchor, the fiscal rule needs to be a transparent and binding tool guiding the formulation of government budgets. This requires a clear accountability for the observation of the fiscal targets and correction of eventual slippages. Moreover, the executive authority appears to have significant discretion in determining the annual and medium-term deficits and debt limits. The authorities should not only specify and publicly announce the NOPB path and the debt anchor, but also clearly formulate the supporting provisions and safeguards to ensure the observance of the fiscal rule over time, including correction mechanisms, escape clauses, and strong fiscal oversight. Finally, staff welcomes the development of a rolling expenditure framework for the pilot sectors—education, agriculture, and environmental protection—for 2022–25 and calls for a continuation of the work to strengthen the medium-term budget framework.

Monetary policy - tackling inflation; strengthening interbank markets

16. In response to increasing inflation, the CBA has appropriately reversed monetary easing and increased interest rates in the second half of 2021 and in early 2022. The increase in inflation reflects mainly external and non-monetary domestic factors, including the increase in imported food prices and the adjustment and liberalization of some regulated fuel and water tariffs in early 2021. Staff agrees with the CBA’s assessment that imported inflation has been an important driver. However, inflation has now become more broad-based, and the risks exists that it will remain elevated in the future. Thus, further monetary tightening would be needed to reduce the risk that inflation and inflation expectations become more entrenched and difficult to reverse. The increase in the CBA’s discount rate has so far been relatively limited compared to the previous episode of higher inflation, and also compared to regional peers (see chart). The CBA must also be ready to keep pace with expected increases in global interest rates. At this unique moment, where tradeoffs are particularly difficult, clear CBA communication becomes even more important.

17. Because of the pandemic-related disruptions, modernization of the monetary policy framework has been delayed. The authorities continue to de facto peg the currency to the US dollar. The de facto peg has been effective in keeping inflation under control in Azerbaijan’s undiversified economic setting where the ER is the main channel for the transmission of inflationary shocks. The authorities have been considering a strategy that puts more emphasis on the interest rates rather than monetary aggregates as the intermediate target, and increased exchange rate flexibility in the long-run. While the pandemic has delayed implementation, work should continue to develop domestic markets to improve the transmission channels of monetary policy, including the expansion of the government securities market and developing active money markets, continued efforts to de-dollarize the economy, strengthening the CBA’s analytical and forecasting capacity, and improving the effectiveness of communication. Staff also understands that the CBA is working on developing a new CBDC strategy and stands ready to support CBA in this effort.

Financial sector - monitoring risks

18. Financial soundness indicators are strong. The banking sectors’ capital adequacy ratio fell to a still relatively high 19.1 percent at end-2021, as risk-weights were reset to their pre-pandemic levels and risk-weighted assets expanded rapidly. ^[10] The NPL ratio declined further, reflecting both improved credit quality and effective financial support measures. Credit flows have picked up, particularly in the consumer loans segment, as banks search for higher yields and seek to meet the demand deferred during the pandemic. De-dollarization trends have broadly continued, with loan dollarization falling to 25.4 percent by March 2022, the lowest level in seven years. Net open FX positions have been generally declining, though there was some increase in Q1 2022 as banks’ FX liabilities increased while FX loans continued to decline.

19. The officially reported FSIs, however, could overstate the health of the banking system, as there are pockets of vulnerability. Uncollateralized business loans and restructured loans remain major credit risks. Restructured loans—mainly in the corporate sector—have increased and may not be adequately provisioned, as current regulations are not based on expected credit loss. Consumer lending is also increasing rapidly in a few banks. Recent stress tests indicate that the NPL ratio would increase by the same magnitude as during the 2015–16 crisis in an adverse scenario. The CBA is mindful of these risks and is closely monitoring risky exposures, in particular consumer loans with high DTI ratios.

20. The effort to strengthen financial supervision and provisioning should continue. Notwithstanding recent improvements in supervision, the CBA should renew the pandemic-delayed effort to move to a risk-based framework and supervise larger banks on a consolidated basis. The CBA should also continue to conduct stress tests and thematic inspections to assess banks’ asset quality. In the medium term, provisioning rules could be modernized and aligned to the IFRS 9 framework to account for expected credit loss rather than actual incurred loan loss. [11]

21. Banking sector’s exposure to Russia is limited but needs to be monitored. The sanctions on Russia have thus far had a limited impact on Azerbaijan’s banking sector. However, as Azerbaijan’s exposure to Russia is non-negligible given Russia’s role as an important trading partner, Azerbaijani banks may turn to alternative systems. The authorities should closely monitor banks’ usage of alternative payment systems or crypto currencies.

22. There appear to be some challenges with correspondent banking. The authorities do not currently see any serious problems with correspondent banks in Russia and they are monitoring the situation closely. However, there appear to be some challenges with the correspondent banks in the United States and Europe, including delays in processing payments. While two thirds of Azerbaijan’s banks have correspondent account in the U.S. and European banks, some banks continue to have problems with accessing correspondent banking services.

Structural policy- diversify and de-carbonize

23. Azerbaijan’s long-term challenge is to diversify and de-carbonize the economy. The long-term development plan, Azerbaijan 2030, establishes a roadmap for the country to reduce dependency on hydrocarbon exports and to promote a more sustainable and diversified economy. The ongoing decline in crude oil production has been offset by gas and there are significant ongoing investments in alternative sources of energy. Part of the additional windfall from hydrocarbon revenues could be invested in productive investment, including green infrastructure that could also support intraregional trade.

24. An important impediment is the large footprint of SOEs in the economy. The number of SOEs is large, and there has been limited progress in implementing the government’s strategy to reduce state participation. However, the recent establishment of Azerbaijan Investment Holding (AIH) provides an opportunity to reinvigorate reforms. The following steps could be considered: (i) separate commercial from noncommercial activities, with the latter to be financed from the budget; (ii) increase SOE transparency and performance monitoring through AIH; (iii) facilitate privatization and financial restructuring where needed; and (iv) introduce measures to mitigate the social impact of SOE reforms. A successful SOE reform would support a transition to a private-sector led growth model and help reduce fiscal risks.

Important governance weaknesses and corruption vulnerabilities remain in a number of areas, including in judicial independence, AML/CFT, public procurement, and transparency in the extractive industry. Addressing effectively these challenges is crucial to supporting private sector growth. Staff welcomes the recently adopted National Anti-Corruption Strategy (NACAP), but some critical areas remain yet to be addressed. To be more effective, the authorities should integrate critical policy measures into an updated anti-corruption strategy, address the remaining gap in the AML/CFT legal framework, and continue to upgrade their anti-corruption framework in line with international standards and strengthen its implementation.