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p. 36 of 68 BACK | NEXT I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia Southeast Asia South Asia Central Asia Azerbaijan Kazakhstan Kyrgyz Republic Tajikistan Turkmenistan Uzbekistan The Pacific III. Competitiveness in Developing Asia Statistical Appendix

Asian Development Outlook 2003 : II. Economic Trends and Prospects in Developing Asia : Central Asia

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Azerbaijan

The economy maintained strong growth momentum in 2002, mainly due to a rebound in FDI inflows into the oil sector. Growth is expected to remain buoyant in 2003-2004, underpinned by a continuing investment boom in that sector, though this oil-driven expansion will have only a limited impact on employment and poverty. The Government needs to maintain sound macroeconomic policies and speed up market-oriented reforms, if broad-based growth and a considerable reduction in poverty are to be achieved.

Macronomic Assessment

GDP growth accelerated slightly to 10.6% in 2002 from 9.9% in 2001, driven by increased FDI in the oil sector. Reflecting the launch of several large-scale investment projects, including the construction of the Baku-Tbilisi-Ceyhan (BTC) oil pipeline, gross FDI inflows into the oil sector surged from $821 million (15% of GDP) in 2001 to $1,521 million (25% of GDP) in 2002. This pushed the ratio of fixed investment to GDP to about 30% and provided a major impetus to the economy (Figure 2.19).

Manufacturing and services related to oil development, such as construction and the production of construction materials, expanded rapidly, although oil production itself increased by a modest 1.8% to 0.3 million barrels a day due to capacity constraints. A bumper grain harvest led to a 6.4% expansion in agricultural production and contributed to GDP growth.

Since output growth resulted primarily from an increase in productivity, wages and salaries rose substantially, while employment increased only marginally. According to official statistics, the average wage rose by 20.3% in nominal terms (17.1% in real terms), while the unemployment rate is reported to have increased from 1.2% at end-2001 to 1.3% at end-2002. However, official statistics considerably underestimate the true unemployment level. Results of recent labor market and household budget surveys suggest that, despite the impressive economic growth of the last 7 years, the actual unemployment rate in Azerbaijan remains well above 10%, while about half the population still lives in poverty.

The general government budget, which does not include the Oil Fund, recorded a deficit of AZM645 billion or 2.2% of GDP in 2002, compared with a 2001 deficit of 2.1% of GDP. Revenue performance improved from 18.0% of GDP in 2001 to 19.2% of GDP in 2002 but this was more than offset by an increase in expenditure. Similarly, while revenues of the Oil Fund continued to grow, the Government started utilizing its assets to finance social and investment projects. As a result, the Oil Fund's surplus fell to 3.5% of GDP in 2002 from 4.0% in the previous year.

Money supply increased by 13.1% during 2002. The level of financial intermediation, as measured by the ratio of broad money to GDP, remained low at about 13% of GDP, and the high degree of dollarization persisted, with foreign currency deposits accounting for about half of broad money. Average annual consumer price inflation accelerated slightly from 1.5% in 2001 to 2.8% in 2002. The nominal exchange rate of the national currency (the manat) depreciated by 4.4% against the dollar, and the real rate depreciated by 1.6%. Azerbaijan has so far avoided the excessive appreciation of the real exchange rate that is often associated with a natural resource boom.

The external current account deficit widened substantially from $73 million (1.3% of GDP) in 2001 to $768 million (12.6%) in 2002, as imports related to oil development increased sharply. This was fully financed by inflows of FDI and other capital flows such that the overall balance of payments recorded a surplus of $230 million. Accordingly, gross official reserves, including Oil Fund assets, grew from $1,194 million at end-2001 to $1,373 million at end-2002. Reflecting the Government's cautious approach to external borrowing, the stock of public and public-guaranteed foreign debt increased by a modest $94 million to $1,356 million (22.3% of GDP), consisting mostly of concessional loans from multilateral and bilateral donors.

Policy Developments

Macroeconomic policies remained fairly tight in 2002. Although the general government deficit increased slightly from 2001, it was much smaller than the deficit of 4.0% of GDP envisaged in the 2002 budget. The refinance rate of the National Bank of Azerbaijan was lowered from 10.0% to 7.0% a year, but remained positive in real terms. However, in a worrisome development, several ad hoc decisions were made regarding the use of Oil Fund assets, including financing the state oil company's equity participation in the BTC pipeline project. Such use of Oil Fund resources threatens to undermine the coherence and consistency of financial policies and entails the risk of destabilizing the macroeconomic situation over the medium term.

On the structural side, the Government took a number of measures to curtail implicit energy subsidies, enhance transparency and accountability of budget management, and improve the business environment. In particular, a program of strengthening financial discipline in the energy sector was adopted, and management of four electricity distribution networks, covering most of Azerbaijan's territory, was transferred to private firms, resulting in a significant improvement in tariff collection rates. In addition, all extrabudgetary funds, with the exception of the Oil Fund and the Social Protection Fund, were integrated into the state budget. In another major step toward greater fiscal transparency, implicit subsidies to the electricity and gas sectors, in the form of unpaid fuel deliveries to these sectors, were included in the 2003 budget. Furthermore, the number of business activities subject to licensing was reduced from 240 to 30 and licensing procedures were streamlined.

However, little progress was made in other areas of structural reform. The implementation of the second privatization program launched in 2001 was slow, and privatization of the International Bank of Azerbaijan, whose dominance of the banking system hinders competition in the financial sector, was delayed. Administrative reform, involving modernization of the Ministry of Taxes and the State Customs Committee as well as separation of regulatory and commercial functions of SOEs in the energy and transport sectors, was in effect stalled. Corruption remains a serious problem and much needs to be done to create an enabling environment for the development of a vibrant private sector in the non-oil economy.

The Government reaffirmed its commitment to foster broad-based and equitable growth, and to reduce poverty in the State Programme on Poverty Reduction and Economic Development for 2003-2005, which was unveiled at a high-level conference in Baku in October 2002. The Programme was prepared in a participatory process involving the donor community and civil society. Reflecting the multidimensional nature of poverty and development, the Programme pursues a broad agenda and includes a wide range of policy measures aimed at reducing poverty and promoting sustainable development. However, it does not properly prioritize nor cost these measures, and neither does it set specific poverty reduction targets.

Outlook for 2003-2004

The economic outlook for 2003-2004 is positive, as the ongoing oil investment boom is expected to continue. GDP is projected to grow by 9.5% in 2003 and by 8.0% in 2004. FDI inflows into the oil sector, which are expected to reach $1.7 billion in 2003 and $1.8 billion in 2004, will remain the engine of growth. Manufacturing and services related to investment in the oil sector will continue to expand rapidly. Growth in oil production will likely accelerate to 3.0% in 2003 and to 8.6% in 2004 as capacity restraints are gradually removed. Growth in agriculture, however, will moderate to 3-3.5% as slow progress in sector reform and continuing deterioration of rural infrastructure impede productivity growth. Since GDP growth will be concentrated in capital-intensive sectors, a major fall in unemployment is unlikely, although wages are expected to continue rising.

Under the base-case assumption that fiscal policy remains sound and monetary policy sufficiently tight to preserve macroeconomic stability, annual consumer price inflation is forecast to remain within the range of 2.5-3.5%. The nominal exchange rate is expected to continue to depreciate moderately at about 3.0% a year, with the real exchange rate staying largely unchanged. Exports of goods and nonfactor services are expected to increase from $2.7 billion in 2002 to $2.9 billion in 2003, due to a combination of higher world oil prices and larger exports volumes, but to decline to $2.8 billion in 2004 as the anticipated fall in world oil prices more than offsets a continuing rise in oil export volumes. At the same time, imports of goods and nonfactor services will increase, from $3.1 billion in 2002 to $3.5 billion in 2003 and to $3.6 billion in 2004, driven by increasing investment in the oil sector. Consequently, the current account deficit will widen further to 15.0% of GDP in 2003 and to 18.0% of GDP in 2004 and continue to be financed by inflows of FDI.

However, there is a risk that the Government will considerably increase budgetary and Oil Fund expenditures ahead of the presidential elections scheduled for autumn 2003. This will lead to a larger budget deficit and higher foreign exchange inflows from the Oil Fund, and will put upward pressure on the nominal exchange rate. With its net domestic credit equivalent to less than 1% of GDP and little room for sterilization of interventions in the foreign exchange market, the National Bank of Azerbaijan will have to make a difficult choice between, on the one hand, letting the nominal exchange rate appreciate and, on the other, absorbing additional foreign exchange inflows, which will increase money supply and fuel inflation. In either case, the real exchange rate will appreciate, which will adversely affect competitiveness of the non-oil traded goods sector. Consequently, output growth will be lower and the current account deficit higher than under the base-case scenario.

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