The preliminary findings of IMF says:

The key challenges in the period ahead are: (i) keeping inflation low, especially if overheating pressures intensify; (ii) preserving financial stability while addressing banking sector issues; and (iii) reorienting the economy away from its heavy dependence on oil-financed public spending, and toward private sector-led growth that is both sustainable and employment generating.

The mission recommends:

Restraining budgetary spending to contain demand pressures that could emerge in the near term, and committing to medium-term fiscal consolidation to allow better sharing of hydrocarbon wealth across generations;
Allowing greater exchange rate flexibility to counter inflation and lower macroeconomic volatility, and strengthening monetary policy over the medium term;
Addressing issues at the International Bank of Azerbaijan (IBA) promptly, strengthening supervision and taking steps to deepen the financial system over the long term;
Improving the business environment and eliminating governance constraints on private sector-led growth, especially for small and medium enterprises (SMEs).

1. An IMF staff mission visited Baku during October 20-November 2, 2011, to conduct the 2011 Article IV consultation discussions. It met with the Prime Minister, Minister of Finance, Chairman of the Central Bank of Azerbaijan (CBA) and other senior officials, representatives of the private sector, civil society and the diplomatic community. The mission thanks the authorities for the open and constructive discussions. The following statement reflects the mission’s findings.

Recent Economic Developments and Outlook

2. The non-hydrocarbon economy continues to grow strongly, and while inflation has moderated recently, it could rise in 2012. Non-oil growth is expected at near 9 percent in 2011, compared to 7½ percent last year, and could reach 6 percent next year, supported by public spending. Oil output dropped sharply in 2011 because of maintenance problems and shortfalls in new well delivery and hydrocarbon output is expected to remain broadly the same next year, and over the next decade, before beginning to decline. Inflation surged in late 2010 and early 2011, reaching 9½ percent in February, but dropped to 7.7 percent in September, mainly reflecting global food price trends. However, inflation is projected to rise to 8 percent by end-2011 as government spending increases and non-hydrocarbon output begins to exceed potential.

3. While the country’s medium-term economic prospects are favorable, they are contingent on the implementation of sound policies. Fiscal consolidation and structural reforms, including those related to business environment and governance, could substantially boost private non-oil investment, including foreign direct investment (FDI), allowing the non-hydrocarbon economy to sustain medium term growth rates of 5-6 percent, with moderate inflation. In the absence of these reforms, however, both high growth and macroeconomic stability would be difficult to maintain.

Achieving Sustained and Inclusive Growth while Preserving Macro-financial Stability

4. Economic diversification requires moving from public spending-driven economic growth to one that is led by the private sector. Recent non-hydrocarbon economic growth, while impressive, has been heavily dependent on public capital expenditures, and largely concentrated in services and construction sectors. A sizable portion of the private non-farm sector is dependent on government contracts. Addressing business environment and governance constraints is critical in allowing the private sector to become a self-sustaining engine of economic growth and generating employment. In this vein, reforms that improve competition and ease trade barriers would be key. Attention is also warranted on improving governance, on which Azerbaijan lags many comparator countries. While recent measures, including the introduction of e-Government, would help, efforts to reduce opportunities for corruption should be sustained.

5. Fiscal consolidation would be necessary in 2012 to preserve macroeconomic stability. Spending planned under the 2012 consolidated budget is high in magnitude, with a large capital expenditure component, and, if fully implemented, could raise the non-hydrocarbon deficit to more than 50 percent of non-hydrocarbon GDP, compared to an average of about 38 percent in 2008-10. With output expected to reach potential in late 2011, the mission believes such a large fiscal expansion could result in overheating pressures. A lower non-hydrocarbon deficit—by about 10 percentage points of non-hydrocarbon GDP—relative to the level envisaged in the draft budget would be consistent with the economy’s absorptive capacity and macroeconomic stability, and would still allow for sizable investment spending.

6. The finiteness of Azerbaijan’s hydrocarbon resources underscores the need for the authorities to make a firm commitment to medium term fiscal consolidation. As the economy has recovered well from the 2008-09 global financial crisis, fiscal sustainability considerations should now take precedence in economic policymaking to ensure the benefits of the hydrocarbon wealth are shared across generations. A permanent-income fiscal rule, whereby the government consumes a constant return on its net wealth—both below and above the ground—could anchor consolidation efforts. This would imply a reduction of the non-hydrocarbon deficit to about 18 percent of non-hydrocarbon GDP in 2017. To help build public support for the fiscal consolidation, the mission recommends employing a medium-term budget framework with indicative annual targets for the non-hydrocarbon fiscal balance.

7. Reforms of government revenues and investment spending could complement medium term fiscal consolidation efforts. Non-hydrocarbon revenues could be boosted, without raising tax rates, by streamlining exemptions, applying the tax and customs procedures more uniformly and enhancing competition in the private sector. The ongoing modernization of tax administration, including the introduction of online submission, will help in this regard. Recent steps to increase budget transparency are also welcome and should be supplemented with improvements in the quality of public spending, particularly in the selection and appraisal of public investment projects.

8. Monetary tightening would be warranted in the near term if demand pressures intensify with rising public spending. Sharp changes in global food prices, combined with ad hoc increases in public spending have complicated CBA’s task of keeping inflation low and stable. If demand pressures emerge as a consequence of high public spending and a closing of the non-oil output gap, later in 2011, then allowing greater exchange rate flexibility, including by introducing a sufficiently wide exchange rate band, would be appropriate. The mission believes that the economy’s competitiveness can be adequately preserved by keeping inflation low and stable and preventing real exchange rate appreciation. The mission’s analysis of the real effective exchange rate suggests that the manat remains broadly aligned with the economy’s medium-term fundamentals.

9. Over the medium term, the authorities would be well served to strengthen monetary policy tools to be able to better control inflation. A move away from the exchange rate as the nominal anchor, and a more active focus on inflation and output volatility—through a greater reliance on interest rates and a flexible exchange rate—would improve macroeconomic stability and help deal with real shocks. But this would require a substantial deepening of the government securities market—even in the absence of the need to finance the government today—developing currency risk mitigation instruments, developing interbank credit market, improving monetary-fiscal coordination, and reducing distortions in interest rates and pricing of government securities.

10. IBA’s soundness needs to be improved without delay, while preserving financial stability. The mission welcomes the appointment of consultants to devise a privatization strategy for IBA. Findings of a recent audit underscore the need to strengthen the bank’s liquidity and capital. To avoid exposing CBA’s balance sheet, liquidity support to IBA should be collateralized. Government recapitalization of the bank should be undertaken in line with implementation of a clear action plan to restore the bank to good health. Future plans should also include ways to reduce IBA’s systemic importance, and privatization undertaken transparently and with a clear timetable. IBA should limit additional financing from abroad because given its poor health, such borrowing imposes contingent liability on sovereign resources.

11. Banking supervision should be strengthened and macro-prudential measures applied more proactively. The recent adoption of a leverage ratio and increase in reserve requirement on foreign exchange deposits should help reduce risks in the financial system. To help prevent a buildup of future risks, the mission encourages the authorities to proactively apply macro-prudential regulations. Enforcement of CBA supervision and prudential regulations should be applied uniformly across all banks. Since the economy has been recovering well following the global shocks of 2008-09, CBA should unwind its directed lending to state enterprises, and limit future financing to a purely “lender of last resort” type operation, with appropriate collateral requirement.

12. Medium-term measures to deepen the financial sector are also necessary. The mission welcomes ongoing efforts to strengthen capital markets—with World Bank support to develop long-term instruments for savers and investors. Financial deepening would also require leveling the playing field across all banks; consolidating private banks into viable and competitive entities; and developing appropriate credit infrastructure—e. g., enforcement of contracts and setting up a credit bureau.

13. Sovereign reserves provide a sizable buffer to mitigate the impact of global or regional shocks. Azerbaijan is less reliant on non-oil exports and remittances than other countries in the region—these inflows account for less than 10 percent of current account receipts. However these links are primarily with CIS countries and the evidence from the 2008-09 global crisis suggests a regional slowdown could spill over to the Azeri economy. Notwithstanding the heavy dependence on oil, the direct effects of a significant but temporary decline in global oil prices can be mitigated by the cushion provided by the oil fund. The mission recommends that if such spillovers do threaten a domestic economic slowdown, then the authorities should provide a temporary fiscal stimulus to the non-oil economy. If large non-financial state enterprises face problems, then support should be provided directly from the budget, rather than through CBA.