Mission Concluding Statement 

Washington, DC: An International Monetary Fund (IMF) staff team visited Baku and held discussions on the 2023 Article IV consultation November 1 to November 16, 2023. 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: A new post-pandemic normal

1.Following the strong rebound from the pandemic, growth moderated in the first 9 months of 2023. Real GDP increased by 4.6 percent in 2022, driven by a 9.1 percent increase in non-hydrocarbon GDP, with recovery in contact-intensive, construction, and transportation sectors. Hydrocarbon GDP shrank by 2.7 percent, with oil production facing technological challenges only partially offset by rising gas production. Non-hydrocarbon growth appears to be decelerating back to trend in the first 9 months of the year (3 percent, YTD). The estimated output gap remains positive.

2.Inflation has eased significantly. After increasing sharply to 14.4 percent (yoy) in December 2022, inflation declined to 3.9 percent in October 2023, driven by a broad-based decline in food, nonfood, and services prices. Core inflation declined from 14 percent in December 2022 to 3.8 percent (yoy) in October 2023. Inflation has now moved to within the Central Bank of Azerbaijan’s (CBA) target range of 4±2 percent.

3.High oil and gas prices sustained a strong external position. The current account balance improved to a surplus of 29.8 percent of GDP in 2022 (from 15.1 percent in 2021) and remains strong in the first half of 2023. Sustained FX earnings continued to support the de facto peg, with limited demand for FX in official auctions since 2020. Combined CBA and State Oil Fund of Azerbaijan (SOFAZ) reserves reached 44 months of next year’s imports at end-2022.

4.Fiscal consolidation continued in 2022.On the back of higher hydrocarbon revenues, the overall budget surplus increased to over 6 percent of GDP, from 4 percent in 2021. The nonoil primary balance also recorded an improvement of about 1 ½ percent of nonoil GDP in 2022, supported by a 20 percent increase in nonoil revenues (reflecting strong VAT and personal income tax revenue growth) and somewhat lower (16 percent) spending increase. SOFAZ oil revenues rose by a moderate 5 percent, as the impact of higher average oil price was partly offset by lower oil production. With strong nominal GDP growth, public and publicly guaranteed debt declined sharply to 27 percent of GDP by end-2022, from 42 percent in 2021.

5.Following the gradual tightening of the monetary stance, the CBA recently cut interest rates. Between mid-2021 and May 2023, the CBA increased the interest rate by 275 points to 9 percent. With inflation declining and the policy rate positive in real terms, the CBA paused at its July and September 2023 meetings, and reduced the rate by 50 points in November 2023 to 8.5 percent. The CBA has also significantly increased reserve requirements to mop up excess liquidity from the banking sector. Between August 2022 and August 2023, it raised in several steps required reserves in national currency and in foreign currency. The CBA introduced in September 2022 a new monetary policy operational framework to improve monetary policy transmission.

6.The banking sector position continues to improve, but pockets of vulnerabilities remain. Capital buffers are adequate, with capital adequacy ratios at 18.5 percent in September 2023. Credit continues to expand, particularly to households, albeit at a slower pace due to tighter regulatory measures. Nonperforming loans are at a historic low of 3.5 percent. Profitability has also risen, reaching 2.4 percent return on assets and 20.8 percent return on equities. De-dollarization trends continue in deposits and loans, accompanied by declining net open FX positions. The proportion of restructured loans have declined, but remains elevated, and the non-performing loan (NPL) classification still lacks adequate qualitative criteria.

Balanced risks with large uncertainty

7.Growth and inflation are projected to moderate in 2023. Growth will decelerate to around 2.4 percent in 2023 and in the medium term, and the output gap is expected to close in 2024. The external position is expected to remain strong with trade surpluses and continued reserves accumulation. Year-on-year inflation is projected at 4.4 percent by end-2023 (9.4 percent average for 2023) and to remain within the CBA target band in the medium term.

8.Risksto the outlook remain broadly balanced, but external uncertainty is high. An intensification of the war in Ukraine and Gaza, through high hydrocarbon prices and demand, presents upside risks, boosting exports and fiscal revenues, as well as, through high food prices, downside risks for food security and inflation. Commodity price volatility also presents similar upside and downside risks. A global slowdown will negatively impact Azerbaijan’s terms of trade and, along with weakness of trading partner economies, weigh on the outlook. Deeper geoeconomic fragmentation could increase input prices and disrupt payment systems, while also potentially diverting trade flows to Azerbaijan. Domestic risks arise from pro-cyclical fiscal policies, fiscal risks from state-owned enterprises (SOEs), and extreme climate events that would affect agricultural production, food security, and inflation.

Fiscal policy: Staying the course on fiscal consolidation

9.Following two years of fiscal consolidation, the non-oil primary deficit is projected to increase in 2023.The authorities have made significant strides to reduce the non-oil fiscal deficit in recent years, including a large overperformance relative to target in 2022, which contributed to reining in inflation. This overperformance also gave the authorities space to accommodate high-priority capital spending in 2023. As a result, the nonoil primary deficit will increase from 22.4 percent of nonoil GDP in 2022 to around 24.4 percent of nonoil GDP in 2023. The projected increase will create a fiscal impulse, which along with elevated—though declining—wage and income growth, would help sustain strong domestic demand and pose a risk to inflation, which has just returned to the target band. To reduce this risk, staff recommends maintaining prudent budget execution and saving any expenditure shortfall or revenue overperformance.

10.Staff welcomes the authorities’ continued commitment to medium-term fiscal consolidation. For 2024, staff projects a reduction of the nonoil primary deficit by about 2 percent of nonoil GDP, reflecting mainly moderate expenditure growth in line with the 2024 budget. The baseline medium-term projection shows a further deficit decline, assuming: (i) continued moderate growth in current spending and a gradual decline in capital spending in line with the authorities’ medium-term expenditure plan; (ii) expiration of the private nonoil sector PIT exemption by 2026; and (iii) no further erosion of the tax base as a result of new tax holidays and exemptions. Based on these assumptions, the nonoil primary deficit is projected to decline significantly to around 15 percent of nonoil GDP by 2028, while the public debt-to-GDP ratio increases moderately by about 3 percent of GDP to around 21 percent.

11.Sustained fiscal consolidation is necessary to prepare for the projected decline in hydrocarbon production and revenues. Continued annual reduction of the non-oil primary deficit by at least 1.5 percent of non-oil GDP over the medium term remains appropriate to reduce the gap with the permanent income hypothesis (PIH) benchmark estimate of 12.5 percent of GDP, necessary to ensure intragenerational equity. In this context, boosting nonoil revenues while maintaining spending discipline is a priority. Staff welcomes the authorities’ prudent medium-term expenditure plan and encourages the authorities to maintain spending prudence, including continued moderation in the growth of the wage bill, rationalization of subsidies, gradual increase in domestic energy prices, and reduction in capital spending as reconstruction needs decline. However, in the longer term, spending discipline alone will not be sufficient to offset the loss of hydrocarbon revenues, and measures to boost non-hydrocarbon revenues will be required. Staff encourages the authorities to continue their effort to improve tax administration, broaden the tax base, and explore new sources of budgetary revenues. Staff also encourages the authorities to consider further improvements in the design of the fiscal rule in line with international standards, including by reassessing the triggers to changes to the fiscal targets, as well as by further clarifying the operation of correction mechanisms, and to continue efforts to modernize the budget framework.

Monetary policy: Reining in inflation and enhancing the monetary policy framework

12.With actual and projected inflation declining rapidly, the CBA cut the policy rate by 50 basis points in November. This partly reverses the 275 points tightening during mid-2021 and May 2023. The CBA saw the recent decline in inflation as reflecting mainly falling imported inflation: decline in food prices and international transportation costs and the appreciation of the nominal effective exchange rate.

13.While inflation has been falling rapidly, staff counsels caution before reducing rates further. With both current and projected inflation declining rapidly, the CBA’s refinancing rate remains positive in real terms even following the recent cut. [1] In addition, growth is moderating, and the estimated output gap is closing. However, staff recommends caution before continuing to reduce interest rates. External factors that have been the main driving force of falling inflation could be quickly reversed, fiscal policy is budgeted to be expansionary in 2023, and strong (though decelerating) wage and income growth continues to support domestic demand. If disinflation continues, the 2023 fiscal stance turns out to be tighter than budgeted, wage growth continues to decelerate, and adverse food price shocks do not materialize, then further reducing the CBA rates could be considered.

14.The authorities have made progress in modernizing the monetary policy framework, but further work is needed to strengthen the monetary transmission. The authorities continue to de facto peg the currency to the US dollar and view the transition to a hybrid inflation targeting a medium-term undertaking. In 2022, the CBA introduced a new monetary policy operational framework. It launched new standing facilities for liquidity provision and sterilization, expanded the range of open market operations, and took steps to develop the infrastructure for the interbank market. The new framework has already helped to improve the transmission of the policy rate to the interbank rate. The interbank market has become more active, and in September 2023, interbank interest rates have moved inside the interest rate corridor. However, the transmission to bank lending rates has yet to improve. The authorities should continue efforts to modernize monetary policy, including by strengthening the CBA’s analytical and forecasting capacity and enhancing communication.

Financial sector: Monitoring risks and a bigger role for the sector

15.Banking sector financial soundness indicators are strong, but do not fully capture risks. The authorities should remain vigilant to risks stemming from restructured loans, as the level remains at 4.7 percent by end-September 2023, after declining by 18 percent from September 2022. There is also a difference on loan-loss provisions between the official (prudential-based) figures and that under IFRS 9, due to differences in qualitative criteria and the requirement for restructured loans. Although the overall level of prudential-based loan-loss provisions is higher than that based on IFRS by the end of 2022, this is not always the case for some banks. Staff recommends the authorities to continue conducting comprehensive assessments of credit quality, including through stress tests and thematic inspections, and faster progress in NPL resolution.

16.Staff welcomes the CBA’s measures to reign in rapid consumer lending growth, and recommends continued efforts to enhance supervision. The CBA tightened debt-to-income (DTI) ratios and provisioning requirements for riskier consumer loans in 2022, which has increased loan-loss provisions for such loans and slowed consumer lending growth. Staff welcomes plans to transition to risk-based and consolidated supervision, and recommends accelerating this transition.

17. The financial sector should assume a more pivotal role in supporting economic growth and diversification . Despite recent progress in the banking sector, the financial sector, especially non-banks, plays a limited role in supporting the economy compared to peer economies. It remains dominated by a few conglomerates, and financial inclusion is low. In recent years, interest rate spreads have risen, owing to increasing operating costs and profit margins. Deepening the financial markets is however a gradual process that will involve developing and strengthening institutions, market infrastructure, and regulatory frameworks. In this context, staff looks forward to the comprehensive assessment of the financial sector role in the economy that is being conducted by the authorities, including identifying and targeting areas of cost inefficiencies in banks, such as the high level of operating cost, and supports the development of digital financial services such as open banking and fintech to foster competition and expand financial inclusion, especially for SMEs.

Structural policy: Diversify and de-carbonize

18.Azerbaijan’s long-term challenge remains to diversify the economy. The development plan, Azerbaijan 2030 , establishes a roadmap to reduce dependency on hydrocarbons and to promote a more sustainable and diversified economy. The plan recognizes that for the private sector to be an engine of growth and employment, it is necessary to improve the business environment, including by enhancing transparency and combating corruption; raise the efficiency of state-owned enterprises and increase competition; and expand renewable energy sources.

19.Countering corruption and promoting good governance are crucial to attracting private investment. To this end, the authorities have simplified licensing procedures, improved fiscal transparency, enhanced public service delivery through one-stop shop centers, and approved a National Anti-Corruption Action Plan. Staff welcomes legal amendments increasing the independence of the Judicial Legal Council, the forthcoming implementation of the recently approved public procurement law, and approval of new laws related to AML/CFT. Staff nonetheless urges more progress in strengthening the property rights framework, implementing the asset disclosure regime already enacted into law, and further increasing beneficial ownership transparency, particularly in the extractive industry.

20.The large footprint of SOEs in the economy should also be addressed. The authorities have taken steps toward monitoring large SOEs, with the development of a centralized data system and the establishment of key performance indicators. This year, the government also announced plans to attract private sector participation in 8 SOEs. Still, SOE presence remains large, and more progress is needed to increase efficiency and reduce state participation. Staff continues to recommend separating commercial from noncommercial activities in SOEs, with the latter to be financed from the budget; increasing transparency of SOE performance; and facilitating further private sector involvement. Staff looks forward to the results of the OECD-WB assessment of SOE corporate governance applied in SOEs under the management of the Azerbaijan Investment Holding.

21.The diversification strategy dovetails with commitments to tackling climate change. With a commitment to reduce greenhouse gas emissions by 35 percent from 1990 levels by 2030, the authorities have been improving the legislative and institutional environment to promote the renewable sector and initiating renewable energy projects with multilateral and bilateral groups, and the private sector. Still, the cost of implementing all the projects in time to meet these commitments will be significant. Staff will call on the authorities to consider additional policies to reduce the potential fiscal burden, such as gradually withdrawing fossil fuel direct and indirect subsidies and enhancing energy efficiency regulations. This will not only help Azerbaijan reach its climate commitments, but also promote the renewable energy sector as a future driver of economic growth and employment, while remaining fiscally prudent.