Azerbaijan strategy overview

Full strategy  (0.5Mb) Approved 18  Sep 2007

Azərbaycan üzrə strategiya  (1.1Mb)

Summary of public comments  (0.1Mb)

Azerbaijan is committed to and is making progress towards implementation of the principles of Article 1 of the Agreement Establishing the Bank. The economic advancement of the country has been visible and acknowledged while progress in transition to multi-party democracy and pluralistic society has been slow, with many challenges remaining. According to international observers, the presidential elections of October 2003 and the last parliamentary elections, which took place in November 2005, fell short of a number of OSCE commitments, although some progress was noted in comparison with previous elections. The next presidential elections, due in October 2008, will provide an opportunity for demonstrating progress in ensuring freedom of the media and functioning of democratic institutions.

Economic growth

The economy has fundamentally changed since the increase in oil production and opening of the Baku Tbilisi Ceyhan (BTC) pipeline. While the average economic growth was around 10 per cent during 2002-2005, the real GDP grew at more than 26 per cent in 2005 and reached an unprecedented 35 per cent in 2006, making Azerbaijan the fastest growing economy in the world. The dramatic growth has resulted in a more than two fold increase in GDP per capita over the last two years. Increased oil production and exports together with high prices, created an economic structure that is more than ever focused on oil. Currently the oil sector accounts for about 54 per cent of GDP and three quarters of industry. The non-oil sector also grew by about 12 per cent on average in the past two years partly reflecting spill over effects from oil and gas, especially in the machinery, chemical industry, construction, and telecommunication sectors.

Macroeconomic consequences

The high oil revenues have had macroeconomic consequences. The fiscal position of Azerbaijan continued to strengthen in the past two years. Budget revenues increased by two third in 2006, allowing a large increase in public spending, mainly in infrastructure investments. The current account switched from a large deficit of 30 per cent in 2004 to a large surplus of 16 per cent in 2006, due to the dramatic increase in oil exports and a reduction in construction-related imports once the major export pipelines were completed. However, the large increase in oil exports, growth in domestic demand and continued wage increases have exerted upward pressure on monetary growth. The result has been a continued increase in inflation, which reached about 11.4 per cent at the end of 2006 and more than 16 per cent in March 2007 from 5.4 per cent at the end of 2005. The real exchange rate appreciated by about 10 per cent per year during the past two years raising concerns about the loss of competitiveness of the non-oil sector.
There is evidence from around the world that resource wealth makes economic reform more difficult and Azerbaijan is no exception. The progress with structural reforms has been uneven. The government has taken significant steps to raise energy prices toward international levels with the latest major price increase implemented in January 2007. The transparency of resource revenues has improved as Azerbaijan was the first country under the Extractive Industry Transparency Initiative (EITI) to submit an internationally audited progress report. Similarly, the authorities have shown willingness for transparent public procurement procedures in recent infrastructure projects supported by the EBRD. Some initial steps have been taken to improve the business environment including efforts to simplify business registration.

Non-oil and gas sectors

The business environment in the non-oil and gas sectors, however, continues to require significant improvement. The complex tax and customs system, bureaucratic delays and corruption continue to be major obstacles to the development of private enterprises, particularly those in the non-oil sector. Although the anti-corruption law became effective in January 2005, the Anti-corruption Commission has been slow in implementing it. Azerbaijan was ranked 99th out of 175 countries by the World Bank’s Doing Business survey in 2006, an improvement of only one place from 2005. Monopolies continue to hamper competition, while cases of government intervention with investments in the non-oil sector have had a negative impact on investors’ confidence. A new law on investment activity intended to set a level playing field for domestic and external investors has been delayed and is currently under discussion. The level of foreign direct investment in the non-oil sectors of the economy remains low.

Economic diversification

An economy that is so highly dependent on the energy sector is vulnerable to energy shocks. Economic diversification is therefore essential for long term sustainability. The recent large increase in public expenditure of 80 per cent in 2006 and an expected 50 per cent in 2007 raise concerns not only about further inflationary and exchange rate pressures, but also over general absorption capacity and long-term sustainability of public finances given the expected decrease of oil production in the medium term. In the context of substantial oil revenues the government’s major challenge is to maintain macroeconomic stability while efficiently addressing large investment needs and incidence of poverty in the country. This would require designing a long term budget expenditure policy (in terms of size and composition of expenditure), and an effective public investment management program that is aimed at improving the investment climate, increasing competitiveness of the non-oil sector, and establishment of efficient infrastructure.

In 2006, Azerbaijan and EU adopted an Action Plan within the EU’s European Neighbourhood Policy (ENP) framework and signed a memorandum on strategic partnership on energy issues. Both the ENP Action Plan and the country’s ongoing WTO entry negotiations are expected to encourage reforms.

Challenges

Azerbaijan continues to face major challenges which include:

• improving the business environment through sustained anti-corruption measures, strengthening administrative capacity, enhancing the regulatory environment and the rule of law in order to create a level playing field conducive to further development of local private enterprises and attraction of foreign investment.
• developing the non-oil and gas sectors of the economy to ensure poverty alleviation and sustainable development throughout the country including rural areas and cities outside the capital through long-term economic policies and incentive schemes.
• further reforming and strengthening of the financial sector as an effective tool for channelling oil revenues into non-oil sectors and supporting diversification of the economy for sustainable future growth.
• restructuring of the public infrastructure sector and continued investments to improve efficiency and service standards in transport, telecommunications, electricity, gas, water, sewerage, waste treatment, as well as cleaning the heavily polluted environment.
• efficient long-term management of oil and gas revenues and ensuring macroeconomic stability through prudent monetary and fiscal expenditure policy to avoid excessive inflationary pressure and real exchange appreciation.

As of 30 April 2007, the Bank has committed a cumulative amount of €720 million to support 80 country and regional projects covering a wide range of sectors including energy, transport, water, banking, property, agribusiness, and general industry. The net portfolio stands at €461 million. The private sector ratio is 52 per cent of the net portfolio.

Future approach

The Bank’s approach over the next strategy period, taking into account the challenges facing Azerbaijan, will be to support transition towards an open market-oriented economy via economic diversification and creating conditions conducive to long-term sustainable development. The Bank will in particular:

• engage actively in further sector reforms working with both public and private sectors, and continue policy dialogue with the authorities to improve the investment climate.
• support the corporate sector, working with local entrepreneurs, local banks, and foreign investors, with a focus on diversification of the economy into the non-oil and gas sectors including rural development, and improvement of industry standards to an international level.
• continue its leading role in developing the banking sector, enhance further competition, stimulating access to financial services in rural areas, and develop non-bank financial services.
• increase its role in financing key infrastructure projects focusing on transport, energy, and environmental clean-up, supporting capacity building, encouraging private sector participation through sector restructuring, and supporting potential Public-Private Partnerships.

Operational objectives

The Bank’s main operational objectives over the coming strategy period are as follows:

• Enterprise sector – The Bank will contribute to the development of the non-oil sector by making direct debt and equity investments and via support to the financial sector. Particular emphasis will be on SMEs and micro enterprises, fully utilising tailored instruments, resources and programmes including direct equity for local enterprises and non-bank micro-finance institutions, as well as through traditional tools such as credit lines via local banks and the trade facilitation programme. In addition, the Bank will support medium-size enterprises together with local banks through co-financing. The SME sector will be further strengthened through the TurnAround Management (TAM) and Business Advisory Services (BAS) programmes. The Bank will also seek opportunities for larger scale debt and equity investments alongside local and foreign investors, and work as appropriate with the newly established state-owned Azerbaijan Investment Company (AIC) to encourage investments in the non-oil sector. The Bank will promote improved standards of corporate governance, integrity, adequate financial disclosure and transparency of ownership in the corporate sector.
  
  
• Financial sector – The Bank will continue its support to existing and new partner banks in Azerbaijan by providing credit lines, syndicated and subordinated loans, equity investments and trade instruments with the objective of developing larger, more diversified and sustainable banks. A special emphasis will be on provision of financial resources to regions outside Baku through the banks’ expanding branch networks and providing increased support to the agriculture sector. The Bank will continue encouraging competition and consolidation among local banks, and will support foreign investments in the banking sector. Additionally, the EBRD will support the further development of non-bank microfinance institutions as well as leasing and insurance companies. The EBRD investments in the sector will be supplemented by substantial technical assistance for capacity building of local financial institutions.
  
  
• Infrastructure and Energy – Azerbaijan’s infrastructure sector suffers from chronic underinvestment in the past, deferred maintenance and a weak regulatory environment. The current level of basic infrastructure and lack of significant sector restructuring hinders economic recovery, jeopardises the country’s competitiveness and reduces the likelihood of attracting quality foreign investors. Notwithstanding the cheaper and more flexible sources of finance now available to Azerbaijan, the Bank, at the request of the Government, is expected to play an important and bigger role in the large infrastructure investments planned for the medium term, in line with Azerbaijan’s goal to become a transit country between Central Asia and Europe. The Bank is already taking a lead in policy dialogue with the Government particularly in the power sector and will help drive key sector reforms, legislative and regulatory changes, and attraction of the private sector. The key factor for the Bank’s involvement will be its impact in terms of transparent procurement practices, specific technical assistance, implementation capacity building, commercialisation of state-owned enterprises, advice on sector reforms, and experience in the introduction of the private sector. The Bank’s focus in the coming period will be on transport with a particular focus on the east-west and north-south transit corridors (railways, roads, ports, aviation, and transport logistics), energy (power generation and transmission, gas storage and transport, energy efficiency), municipal infrastructure (solid waste collection and disposal), and environmental clean-up (in particular energy related contamination). Given the large increase in public revenues and availability of financial resources from various international sources, the Bank will be selective in the specific sub-sectors on which it will focus in coordination with the Government and multilateral financial institutions. The Bank will work closely with the EU, EIB and the Azerbaijani authorities to co-finance projects, and ensure coordination with other IFIs, noting in particular the Memorandum of Understanding between the European Commission, in liaison with the EIB, and the EBRD signed in December 2006.

The Government’s ability, commitment and willingness to undertake structural reforms are crucial for the successful implementation of the proposed strategy. The Bank will continue and enhance its policy dialogue with the authorities in coordination with the local and foreign business community, other IFIs, EC, and bi-lateral donors. Through this dialogue, the Bank will aim to assist improving the business environment, laying the foundations for long-term economic diversification, channelling growth into rural areas and secondary cities, strengthening the banking sector, and fostering regulatory reforms. In this respect, the Bank will seek from donors to increase its stand-alone technical assistance for advisory support management services (TAM and BAS), legal transition assignments and capacity building for various state agencies.