Share the article
twitter-iconcopy-link-iconprint-icon
share-icon

Time to seize opportunities

Azerbaijan’s government is intensifying efforts to strengthen the non-oil and regional economies using oil revenues and legislative improvements. But inflation is a growing threat.
Share the article
twitter-iconcopy-link-iconprint-icon
share-icon

The evidence of Azerbaijan’s oil boom extends far beyond gross domestic product (GDP) growth, which was estimated to be about 30% in 2007 – one of the highest rates in the world. The all-day gridlock of 4x4s on the city’s broad boulevards is testimony to a rise in prosperity that has far outstripped the country’s ailing infrastructure, with GDP per capita quadrupling to a forecast $4500 in 2008.

“Baku has almost no bridges, underpasses or underground parking,” says Heydar Babayev, the minister for economic development. The government is investing part of its vast oil revenues to reverse this historical underdevelopment. Even the ministry itself is a building site with a temporary entrance while the offices are modernised.

It is hoped that the spending today will lay the groundwork for non-oil commerce to take up the slack once oil output peaks from about 2010. This is also changing the focus for foreign investment and capital goods imports in the country, which were previously dominated by oil-related machinery and services. Other manufactured products are now growing in importance, and this is benefiting German exporters in particular. There is a historical precedent: German engineering firm Siemens opened a factory in Azerbaijan in the 19th century.

“It is estimated that 45% of used cars in Azerbaijan are German-built Mercedes,” says Marco Graff, who became Commerzbank’s representative in Baku in February 2008, with a brief to cater for the bank’s German clients that have operations in the country.

Avoiding complacency

However, Mr Babayev is also concerned to avoid complacency about what is happening beyond the city limits. “When our friends come here from other countries, they are working in quite a comfortable city, and they can monitor the expensive cars and houses, but they may be forgetting that we are in a difficult situation,” he says.

He points to the disputed region of Nagorno-Karabakh (referred to as Karabakh in Azerbaijan), which has been occupied by the Armenian army since full-scale conflict between the two countries ended in 1994. The Azerbaijani authorities estimate that this constitutes almost 20% of the country’s total land area. The conflict, which flared again early this year, has generated about one million refugees, who are now living in the rest of Azerbaijan (one in every eight citizens), and many of whom are reliant on state benefits. It has also left the exclave region of Nakhichevan effectively under blockade from the surrounding Armenian territory.

A UN resolution earlier in 2008 called on Armenia to withdraw its troops from Karabakh in return for a pledge of far-reaching autonomy from the government in Baku. But three UN Security Council members (France, the US and Russia) voted against the motion, and a settlement looks as distant as ever.

The government is also battling to reverse economic decline in the rural areas of Azerbaijan, where poverty levels are significantly higher. In addition to spending on transport infrastructure, public money is flowing into rural irrigation, sanitation and electricity, and farmers are offered cheap government-backed leasing deals on equipment, as well as subsidised fertilizers and seeds.

Mr Babayev says that there are also indirect initiatives to foster development in these areas. “To keep the population out of the big cities, you have to create more or less the same conditions for them in rural areas, so this means new schools, new hospitals,” he says.

Ziyad Samadzade, the chairman of the parliamentary standing committee on economic policy, believes that these measures are reaping rewards. “In the past five years, 85% of new jobs created were in the rural areas,” he says. However, he emphasises that the government’s massive investment programme is intended to facilitate, rather than supplant, the private sector. “The Soviet-era infrastructure is old and inadequate for the current level of development, and very limited for the development of a free-market economy.”

Commercial potential

The banks anticipate that these efforts will unlock commercial potential in previously underdeveloped rural areas. The state-owned International Bank of Azerbaijan (IBA) is investing in new technology and techniques to raise output in cash-crops, such as cotton and tobacco, that can move the country’s agricultural products up the value chain. It signed a deal with the US Exim Bank to finance exports of irrigation products by US firm Valmont, which IBA executive chairman Jahangir Hajiyev believes could double cotton output.

“We are also financing a couple of companies that can process tobacco, from seeding all the way up to but not including cigarette production,” says Mr Hajiyev. Similarly, he is considering investments in methanol, a key input for the petrochemicals industry, as the country begins to refine more of its crude oil locally instead of re-importing refined products.

Boost for business

Still, there is a flavour of state-directed capitalism, to the extent that even private sector banks are taking their lead from official policy. “The government programme on regional development we take as a basis for our future strategy,” says Azer Movsumov, executive chairman of Azerigazbank. He is also focusing on small and medium-sized enterprise (SME) lending, another of the official priorities.

“Most of the banks have contributed to the programme of regional development,” says Mr Samadzade approvingly.

Part of the difficulty in relying on the private sector to generate and direct investment on its own is that the business environment remains highly challenging. Azerbaijan ranks 150th out of 179 countries in Transparency International’s 2007 corruption perceptions index, and at 96 out of 178 in the World Bank’s 2008 Ease of Doing Business report. Azerbaijan’s scores for business licensing, the tax system and cross-border trading are all significant drags on the overall World Bank rating.

Increasingly, the government is alert to the problem. Mr Samadzade says it has run legal and economic reforms side-by-side, and new budget laws will bring “fully evolved” standards that will “guarantee the transparency of the Azerbaijan budget”.

Mr Babayev – previously one of the country’s leading businessmen – is preparing a packed legislative agenda. “We are always thinking about how to reduce taxes, to limit the interruptions of the state authorities in business, and a few months ago we introduced a new one-stop-shop business registration system in co-operation with the World Bank. So I think we will see a better rating this year in the Doing Business report,” he says. Parliament is already considering a new investment law, and the minister hopes to pass a special export incentive law and regulations establishing free economic zones by September 2008.

However, Mr Babayev rebuts criticism from multilateral and non-governmental organisations (NGOs) on the lack of transparency in government spending or the risk that public tenders are being handed to contractors with political connections. “We have normal legislation for tender procedures and commissions,” he says.

He acknowledges that tendering processes for smaller projects or those run under a tight schedule may be less thorough, but points out that in major deals, the government is increasingly working with trusted international contractors. BNP Paribas was recently hired as a financial consultant on the tendering process for power plant construction.

“I cannot look at every company we work with or see the terms and conditions of every loan agreement, but when we are talking about big projects, waste management or incineration plants for example, we are inviting well-known foreign companies... so this is a normal way of doing business. In general I think we have good control over the management of the budget,” says Mr Babayev.

Tools to tackle inflation

Nonetheless, there is one area where the negative elements of the government’s investment projects are unmistakable: inflation is accelerating. The National Bank of Azerbaijan (NBA) announced inflation of 16.4% for 2007, and independent economists believe the official basket may underestimate the impact of price rises for the average citizen. The NBA has an inflation target of 12% to 13%, and governor Elman Rustamov warns: “The current levels are not comfortable… Inflation is one of the most important macroeconomic problems and it is at the centre of the government’s policy focus.”

There is growing danger that the high inflation rate will lead to real exchange rate appreciation for non-oil goods, pricing Azerbaijan’s products out of both export and local markets. In 2006, according to IMF estimates, GDP growth for tradable non-oil goods was just 4%, compared with more than 10% for non-tradable goods and services that are not vulnerable to real exchange rate rises.

The NBA has hiked its refinancing rate to 13% in the past year, from 9.5%, and is doing its best to sterilise the massive foreign exchange inflows from oil and gas sales with local securities issuance. But Mr Rustamov accepts that underdeveloped financial markets do not make the central bank’s task any easier. An ongoing World Bank technical assistance programme is considering the feasibility of reforms to foster securities market development, to improve the effectiveness of monetary policy instruments.

Flexible exchange rate

The NBA is also increasing the flexibility of its exchange rate regime, moving from a dollar peg to a combined dollar/euro basket, weighted according to the volume of Azerbaijan’s trade in the two currencies. This will reduce the weakening dollar’s drag on the manat, strengthening the NBA’s counter-inflationary drive. It may also give the central bank more room to raise its refinancing rate without putting undue appreciating pressure on the peg itself.

Last year, the central bank began the complete liberalisation of capital outflows, which Mr Rustamov calls “one of the most important measures”. This should ease upward pressure on the manat and the domestic money supply.

In view of the massive scale of public spending, reducing excess private sector liquidity is only part of the equation. Yet Mr Rustamov echoes the ministerial priorities on addressing poverty and infrastructure needs.

“Developing the non-oil sector is difficult without infrastructure, roads and railways for the quality diversification of the economy. Poverty has fallen three times over in the past four years... Naturally, fiscal expansion is leading to some economic overheating, this is perhaps the price of that modernisation and welfare programme,” he says.

It is unconventional to hear a central banker talking about poverty reduction but, reassuringly, politicians are also showing mutual understanding of the NBA’s priorities. “We do not want to get drunk on the oil money,” says Mr Samadzade. And Mr Babayev acknowledges: “We know how dangerous inflation is; we know we are creating the inflation by spending more every year, by inflating the money supply.”

However, the government is reluctant to rein in spending just yet, as Mr Babayev wrestles with what he calls “the contradiction within us” that stems from the country’s urgent development needs.

“How can I or the president explain to the population that we are not going to construct or renovate a school or give Baku citizens a modern hospital because of inflation? They have waited a long time for these things.

“We cannot stop projects we started two years ago,” he argues.

He also attributes a significant portion of inflation to the global rise in food prices – the NBA estimates that this accounted for seven percentage points of the total 2007 inflation rate. Government investment in local agricultural production may help to partially insulate Azerbaijan from this worldwide trend, and Mr Babayev rules out a return to Soviet-style price controls.

Local NGOs warn that there are domestic structural factors at work, too: the prevalence of monopolies in many vital sectors, especially utilities and distribution, gives companies the power to push prices upward ahead of wage growth.

Tackling Azerbaijan’s large and influential business interests will be tough, but Mr Babayev may already have his eye on this issue: he has presented a competition law to parliament for consideration this year.

THE LATEST SOVEREIGN WEALTH FUND

Established in 1999, the State Oil Fund of Azerbaijan (SOFAZ) may be a new player compared with the Singaporean and Gulf state sovereign wealth funds that have been in existence for more than 30 years. And at an estimated $3bn, it is also a baby compared with the $200bn China Investment Corporation or even Russia’s $32bn National Welfare Fund. But with oil already flowing through the Baku-Tbilisi-Ceyhan (BTC) pipeline and a rise in gas exports expected when the Baku-Tbilisi-Erzurum (BTE) route is completed, the country is forecast to accrue hydrocarbon revenues of between $200bn and $400bn in little more than a decade.

Moreover, mindful of rising inflation and an expected peak in oil production in about 2010, the government is planning to rein in transfers from SOFAZ to the current budget, which accounted for almost 25% of government revenues in 2007 according to IMF estimates. “We have studied the experience of oil-producing countries such as Norway and the Gulf states, and world evaluation and experience shows that 10% to 11% is the optimal balance for oil revenues in the budget,” says Ziyad Samadzade, the chairman of the parliamentary standing committee on economic policy.

This is likely to accelerate the growth of SOFAZ itself, increasing the attention on how the fund is invested. At present, most of the fund’s holdings are in low-risk, low-return US Treasuries because that is the currency of oil revenues themselves. However, like so many other sovereign wealth managers, Azerbaijan’s economic development minister, Heydar Babayev, who is a member of the SOFAZ supervisory board, is pondering how to improve returns, given the falling value of the dollar and low US interest rates. “I don’t think it is a good idea to keep putting oil money back into the US economy, into the Federal Reserve, although there are not many choices,” he notes.

He confirms that the SOFAZ board is looking at ways to diversify holdings to “preserve the best interests of Azerbaijan”.

Was this article helpful?

Thank you for your feedback!

Read more about:  Central & Eastern Europe , Azerbaijan