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Country Strategy and Program Update 2002-2004: Azerbaijan

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I. Development Situation

A. Recent Political and Social Developments

1. The political situation in Azerbaijan is generally stable, with the main political uncertainty being the still-unsettled Nagorny-Karabakh dispute with Armenia. Both parties have been working toward a peaceful solution of this issue under the auspices of the Organization for Security and Cooperation in Europe. The recent peace negotiations held in Key West, Florida, United States, ended without concrete results, and further negotiations, originally scheduled to take place in Geneva in June 2001, have been postponed.

2. The appalling living conditions of the refugees and internally displaced persons (IDPs) residing in refugee camps and other temporary shelters are becoming a growing concern. Close to a million, IDPs and refugees have lived in temporary abodes for 7-8 years and their health and nutrition situation is fast deteriorating. Countrywide, about a fourth of the total households are malnourished with close to a third of the infant population chronically malnourished. Around 41 percent of the nonpregnant women are anemic and about 13 percent of the women IDPs suffer various illnesses.

B. Economic Assessment and Outlook

3. By and large, Azerbaijan faces a favorable environment for economic transition and development. The economic performance in Azerbaijan improved significantly in 2000 amid mild inflation, reduced fiscal and external deficit, comfortable foreign exchange reserves, and a manageable level of external debt. Growth of gross domestic product (GDP) during the last two years has been impressive, at 7.4 percent in 1999 and 11.1 percent in 2000. Detailed economic indicators are given in Appendix 1.

4. Despite vigorous economic growth, the Azeri economy still faces a number of intertwined challenges, including (i) low per capita income levels, (ii) high unemployment rate, (iii) the imbalanced nature of recent economic growth, and (iv) weak governance and institutional capacity. GDP per capita in Azerbaijan is still lower than in many of the Commonwealth of Independent States countries. A major reason for the low incomes is the limited job opportunities. While registered unemployment is 1.2 percent, other estimates peg unemployment (including underemployment) to as high as 25 percent. The slow progress in expanding employment and income opportunities calls for a deepening of structural reforms in order to diversify the economy toward more labor-intensive (i.e., non-oil) sectors. Azerbaijan’s recent growth performance is attributed largely to the revenues generated by its oil-based sector. Increasingly, reliance on this resource-based sector could lead to a Dutch Disease growth path.¹ Such a path would have an adverse effect on the already deep and widespread poverty in Azerbaijan, because it would limit even further employment and income-generation opportunities, while making the economy more vulnerable to external shocks. Finally, weaknesses in the Government’s institutional capacity coupled with insufficient appreciation of the multifaceted dimensions of poverty have constrained effective formulation of the poverty-reduction policies.

5. In recent months, the Government has demonstrated a renewed commitment to economic and institutional reform. A new privatization program has been launched, with the focus on privatizing large-scale state-owned enterprises in key infrastructure sectors such as energy, transportation, and telecommunications. Another recent important development is in the area of institutional reforms. Presidential decrees were recently signed for the creation of Fuel and Energy Ministry, Ministry of Economic Development (MOED), Ministry of Ecology and Natural Resources, along with the merging, streamlining, and abolition of several other ministries and state committees. The International Monetary Fund (IMF) has responded to these new institutional reforms by approving a new Poverty Reduction Growth Facility program. In parallel with the IMF’s program, the World Bank has been preparing a Structural Adjustment Credit to support structural reforms, especially in the area of private sector development in the utility industries.

6. The short-to-medium term economic outlook remains positive, although the annual GDP growth is projected to be slower during 2001-2004 than in 2000 due to an anticipated decline in the world oil price and existing oil export capacity constraints. The positive growth prospect stems primarily from expected higher investment to develop the country’s major oil and gas fields. Since oil revenue is not expected to greatly increase before the year 2005, the higher investment is expected to increase pressure on the current account balance. In the circumstances, the Government should maintain its current tight fiscal and slightly loose monetary policy mix. Inflation in 2001 is targeted at 2.5 percent. The fiscal deficit is estimated at 2.6 percent of GDP for 2001. The monetary and fiscal targets are considered realistic in relation to the heightened growth prospect. However, it remains a challenge for the Government to increase the much-needed social expenditures while keeping the fiscal deficit under control. Increased foreign investment would also place pressure on the exchange rate to appreciate.

C. Implications for the Country Strategy and Program

7. The 2001-2004 country strategy and program (CSP) update ² takes its strategic directions from the interim operational strategy (IOS) of the Asian Development Bank (ADB) for Azerbaijan endorsed by the Board in December 2000. The inequitable nature of continuing economic growth and the urgent need to assist growing numbers of poor, especially the IDPs, were the major underlying concerns in formulating the country strategy. The overarching goal of the IOS is to reduce poverty and raise the people’s living standards in Azerbaijan. This is to be achieved through (i) enhancing human development, (ii) supporting good governance and institutional strengthening, and (iii) promoting sustainable growth. ADB’s assistance in Azerbaijan has been oriented along a two-pronged strategy, where ADB will (i) help the Government strengthen the effective provision of essential public goods and services to those in greatest need, and (ii) provide assistance to help correct for imbalanced growth by strengthening the environment for competitive private investment and job creation. In addressing each prong, ADB’s operations will be policy driven, with a special emphasis on good governance and strengthening institutions.

Recent developments in Azerbaijan have two implications for the formulation and implementation of the CSP. First, with current and projected economic growth and higher budget revenues, counterpart funds for ADB-assisted projects should not be a constraint in the short-term. Second, the Government’s renewed commitment for the reform and privatization processes is a positive signal to the funding community. More specifically, the new developments provide ADB with an opportunity to extend assistance for improvements in governance and strengthening of public institutions in Azerbaijan. However, one risk may slow or even stall the new phase of reforms: the risk that vested interests, deeply entrenched in the status quo, may hinder the institutional reforms.

9. To mitigate the risk, external support is critical to encourage the Government to continue and actively pursue the course of deeper reforms. Given its status as a new partner of the country, ADB needs to quickly disseminate information on its policies and procedures³, and build up its own knowledge base in Azerbaijan in order to assist the Government to pursue the course of deeper reforms. To achieve this, ADB’s economic and sector work program should be employed to selectively review institutional and policy aspects of the Government, focusing on strategically important themes and/or sectoral issues.

10. ADB is a newcomer to Azerbaijan compared to the other multilateral and bilateral agencies operating there, and good collaboration with them is essential to ensure the efficiency and effectiveness of ADB’s assistance. Many of the agencies have similar concerns and share the same broad agenda as ADB in terms of assistance for poverty reduction, governance, and institutional strengthening in Azerbaijan. Going forward, ADB will remain committed to ensuring that its assistance – both lending and nonlending – is strategically focused, carefully framed, and well-positioned.

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