A remote corner of the former Soviet Union, famed for its oil, celebrated by the Russian communist regime for its wine, is about to be the toast of the Euromarkets. Azerbaijan is issuing a Eurobond in the autumn to announce to the world that its economy is powering ahead, and the markets should stand up and take notice. In the wake of the sovereign issue, markets will also be introduced to Azerbaijan’s banks, the larger of which are planning bond issues over the next year.
Markets will learn for the first time that this little known country that borders the Caspian Sea on one side, Iran on another and Georgia on a third is enjoying an oil bonanza the like of which has not been seen outside the Gulf. Contracts led by BP and other oil majors will ensure that oil and gas are extracted from Azerbaijan’s Caspian Sea fields for a minimum of 15 years. These will put between $140bn and $200bn (depending on estimates of oil production and the oil price) at the disposal of a government whose current gross domestic product stands at $7bn. It is of little surprise that Azerbaijan’s 36% annual GDP growth outpaces that of any other country. GDP per capita has reached $1900.
This bonanza of oil wealth has put a spring in the step of a country that carries two burdensome legacies from its history inside the Soviet Union, and even before this period. The first is a long-running dispute with its neighbour Armenia over land occupied in the west of the country by Armenia in the Nagorno-Karabakh region. A large part of Azerbaijan’s budget is spent on the armed forces in this area. The dispute has made homeless one million people, who have been expelled from the disputed territory, and Azerbaijan spends heavily to support them.
In addition to this dispossessed group, the country has a large number of poor people, largely from the agrarian areas. Between 30% and 40% of the country is believed to live below the poverty line. Finance minister Samir Sharifov says: “We would like to eradicate poverty. This stands at 30% of the population and the number is falling fast.”
New wealth presents many policy dilemmas for the government of President Ilham Aliyev (the successor to Heydar Aliyev) and his ministers. Those managing the budget face pressures from the poor and dispossessed who demand a share of the new wealth, while cautious economists demand long-term investment in productive infrastructure.
Mr Sharifov has responded by greatly increasing his budget for spending on health and education; indeed the amount spent on these has doubled over the past year. The state budget has grown from $1bn in 2004, to $2.2bn in 2005 and is expected to exceed $3bn in 2006. This is a key plank of Mr Sharifov’s economic strategy.
Non-oil economy
The development of a strategy to develop a non-oil economy is a critical plank. Mr Sharifov says: “Fifteen, 20 or 30 years is not a long time in our history. The investments we make now need to have positive impact for many years to come. This is a very dramatic time for the country. We need to make the revenues last long after the oil money has ceased to flow.”
This strategy has a number of poles. First, Azerbaijan needs to manage macro-economic aspects such as inflation, the strength of the currency and money supply. Sharp changes in the oil price present particular challenges. Mr Sharifov argues that the price will stabilise at between $35 and $40 a barrel.
Second, projects on which the oil money is spent must be measured by their capacity to produce economic results over the medium to long term.
Finally, care must be taken to ensure that systems guiding the oil spending are not subverted by waste, graft or disorganisation. If these fail, dissipation of part of the oil revenues will result.
Spirit of freedom
The development of a free market and creation of strong local companies is at the core of the new look and modernised Azerbaijan. The country has come out of a long era of centralised Soviet economic management, when it was largely milked for its oil, exploited for its agriculture and neglected in terms of its infrastructure. Now it wants to build a productive economy where entrepreneurism is encouraged.
Present economic goals are financial stability, low inflation, a strong but independent currency and growing private sector. Mr Sharifov says: “We believe in stimulating private enterprise. The government wants to gradually decrease its interference in the economy. It should regulate but it should not dominate the economy.
“There are still a number of big state companies in the economy, but we believe that gradually we shall corporatise them, and even privatise them.”
Plans are mooted to privatise telecommunications and transport companies. But the country’s oil company, Socar, is regarded as strategic and will be kept in state hands. Azerbaijan does not expect to be able to privatise its national airline, Azerbaijan Airways. Privatisation plans are likely to be hampered by the relatively low level of activity at the Baku Stock Exchange.
The same expression of faith in the free market is made by Rufat Aslanli, executive director at the National Bank of Azerbaijan. “The objective of our strategy of economic reform is to build the national economy based on free-market economic principles. The successful implementation of our oil strategy has provided certain advantages. We must also understand its limitations.
“We realise the danger of being caught in the trap of resource scarcity. The National Bank is pursuing a policy to constantly improve our macro-economic regulation.”
Economic policy at the country’s central bank is appropriately cautious. The risk that oil flows will cause appreciation of the currency on the one hand and inflation on the other needs to be understood and guarded against, says Mr Aslanli. “This framework has already been set up. That is why in the coming years we do not expect any kind of short-term fluctuations or appreciation of the national currency. Inflation price stability is our primary objective but financial stability is also important.
“We need to maintain an optimal balance between these two objectives by maintaining price stability. We intend to keep the inflation rate in single digits. Although the exchange rate is not a formal target, we do keep in mind the importance of financial stability for the banking system.”
Higher inflation and a strengthening currency are “probably inevitable”, says Gregory Jedrzejczak, the country manager for the World Bank. “You [need to keep] the consequences under control. They may be inevitable, but at least at the end you want some products remaining that are useful for the future. You can end up with high inflation, a non-competitive exchange rate and a lost opportunity.”
Infrastructure spending
Economic managers are already concentrating on the period when the oil flows have declined, and the real economy is running under its own steam. The key to long-term prudence is the development of an infrastructure, says the National Bank.
Mr Aslanli says: “The main objective of the strategy governing the long-term use of the oil revenue is to establish the alternative economy. The medium-term expenditure framework is intended to avoid us being caught out when the oil revenues decrease. Thanks to this policy, we have been able to abstain from using oil revenues, despite the tremendous temptation.”
There is no shortage of siren voices and authorities warning the government of the danger of Dutch disease, the term coined to describe the decline of the manufacturing sector in the Netherlands after the discovery of natural gas in the 1960s. Mr Jedrzejczak says: “They have a 15-year window of opportunity to make progress and build the non-oil, non-extraction economy. We want to work with them on the non-oil economy.
“When oil is not the main source of revenues we want to make sure there are other sources of revenues so the country can survive in good shape and grow.
“They need good regulations and property rights and execution through the courts. They also need good physical infrastructure. Finally, they need the capital. The country suffers from poor infrastructure. The electricity supply is very irregular and parts of the country have no access to clean water.” Azerbaijani banks have taken up the challenge of funding infrastructural improvement and the non-oil sector more generally. They have developed credit lines to allow the expansion and modernisation of the country’s long-neglected agricultural sector.
Rainy day fund
Oil dollars received by Azerbaijan are channelled into the Azerbaijan Oil Fund, which is controlled by the president, and invested in treasury bonds or similar securities. The sums accumulated amount to date to no more than “a few billion”, in the words of one observer. Petrodollars have already been spent on funding part of the Baku-Tbilisi-Ceyhan (BTC) pipeline that will take oil from the Caspian Sea to the Mediterranean. A symbolic amount has also been spent on housing persons displaced from Armenia.
Mr Aslanli says the oil fund is managed carefully and scrupulously. “We have been able to devise a well thought through-way of managing the oil revenue. Oil resources are accumulated directly in the state-owned fund. The fund ensures macro-economic stability by keeping the oil resources sterilised from the money circulation.
“The spending of oil revenues is currently very limited. They have been used mainly to improve the lives of refugees and internally displaced people. A very small portion of the oil revenue has also been spent on the necessary infrastructure of oil transportation.
“The oil fund employs sufficiently transparent government procedures. Azerbaijan is one of the first countries joining the UK’s [Extractive Industries Transparency Initiative]. The state oil fund is a pilot institution in this area.”
Mr Jedrzejczak also hails the creation of the oil fund as a triumph: “The establishment of the oil fund by the government has been a major success. It enables us to see data about the oil revenues.”
He warns that spending from the fund should be determined by economic rather than political principles: “We are very sensitive to the point that public expenditure should go through consistent programmes and not be spent on bits and pieces unrelated to each other. If you take the health sector, expenditure should come from a well-established programme. We are working on the government’s expenditures.”
Plant security
The country has dealt with international concerns about the security of the oil funds, says Mr Sharifov. “Azerbaijan has demonstrated its willingness to be transparent through its membership of the Extractive Industries Transparency Initiative. It has shown substantial progress and demonstrated willingness to make revenues transparent, as well as the willingness to make the mechanisms transparent.”
Mr Aslanli continues the theme: “There is a very strong commitment from the government to deal with corruption and transparency. Transparency International does not rate Azerbaijan very highly with regard to corruption. But Azerbaijan is embarking on a number of activities and initiatives. These include the passing of a law fighting corruption, a separate stand-alone state programme to fight corruption, the creation of a special agency to pursue the fight against corruption.
“In short we have started a very intensive fight against corruption. Moreover, a law requiring public servants to declare their income is in the final stages of drafting. Azerbaijan is a member of the committee of the Council of Europe and a member of the Organisation for Economic Co-operation and Development’s anti-corruption network.”
The size of Azerbaijan’s unregulated cash economy also gives concern, but observers in the financial community insist that it is only a matter of time before the modernisation of the banking system (the growing availability of credit cards, for example) and tighter controls on tax collection will reduce the size of the informal economy.
Mr Sharifov says: “We want to create a system where the minister of taxes collects taxes in accord with each tax payers obligation.”
