Countries and Regions

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p. 1 of 4 BACK | NEXT I. Current Development Trends and Issues II. Implementation of the Country Strategy and Program III. Portfolio Management Issues IV. Country Performance and Assistance Levels

Country Strategy and Program Update 2003-2005: Azerbaijan

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I. Current Development Trends and Issues

A. Recent Political and Social Developments

1. The political situation in Azerbaijan is generally stable, with the main political uncertainty being the still unsettled Nagorno-Karabakh dispute with Armenia. The Minsk Group, under the auspices of the Organization for Security and Cooperation in Europe (OSCE), stepped up efforts to resolve the dispute in early 2001, but these were put on hold in May 2001 largely because of domestic hostility in both Azerbaijan and Armenia to what was perceived as a compromise deal. Talks recently resumed over a three-day meeting in the Czech Republic in May 2002. The appointment of presidential representatives at the level of deputy foreign ministers to attend the May 2002 meeting was a positive development. Both the Minsk Group and the United States (US) are expected to make further efforts toward negotiation of a settlement.

2. Disagreement over the division of the Caspian Sea's oil resources continues, as apparent in the collapse of the Caspian Summit in Turkmenistan in April 2002. Azerbaijan, Kazakhstan, and the Russian Federation have agreed to divide their parts of the Caspian Sea into national zones for the exploration of the oil-rich seabed based on the "medium-line" principle.¹ However, relations with the Caspian's other two littoral states, Iran and Turkmenistan, remain strained. Turkmenistan has called for dividing up the sea in a manner that is unacceptable to Azerbaijan, as it would lose its largest offshore fields. As for Iran, it demands that the Caspian be divided into five equal shares, a proposal that is unacceptable to the other littoral states given that Iran holds only 11% of the shoreline. Recently, Azerbaijan objected to Iran's decision to award a license to foreign oil companies to conduct seismic surveys in a region that Azerbaijan considers to fall within its territory.

3. On the domestic front, the Government has progressed with its efforts to reform the Government's institutional structure. The first stage of this effort, the restructuring of the line ministries and agencies, was initiated in 2001 and is now completed. The centerpiece of this restructuring was the creation of a new Ministry of Economic Development (MOED), with a very broad mandate to manage overall economic development, including coordination of foreign investment. MOED needs considerable strengthening to fulfill its mandate. The next stage of the institutional reform, the restructuring of the Cabinet of Ministers apparatus, is expected to commence in late 2002.

B. Economic Assessment and Outlook

4. Azerbaijan's economic performance in 2001 remained strong. Although, gross domestic product (GDP) growth slowed to 9.9% compared to 11.1% in 2000, it nonetheless remained robust despite the global economic downturn and the impact of the September 11 attacks. Growth was considerable in services (11%, driven mainly by oil sector developments) and agriculture (8%). The growth in the agriculture sector is mainly attributable to much-improved grain production owing to the expansion of cultivation areas, introduction of new technology, and favorable weather conditions. By contrast, real growth in the industry sector was more modest at only 5%. This reflects a more moderate pace of growth in the oil and gas sector due to capacity constraints and a decrease in manufacturing output outside of the oil and gas sector. Azerbaijan's progress toward the Millennium Development Goals and Targets is shown in Appendix 1, Table A1.1, while detailed economic indicators are provided in Appendix 1, Table A1.2.

5. Macroeconomic stabilization has largely been achieved. The sound anti-inflationary policy of the Azerbaijan National Bank (ANB) combined with a strong Azerbaijan manat and falling commodity prices helped keep inflation subdued at 1.5% by the end of 2001 compared to 1.8% a year earlier. The general government deficit (excluding the state oil fund) narrowed to 2.1% of GDP in 2001 from 2.2% in the previous year, following a strengthened effort to contain general expenditures. The current account balance also improved with the deficit falling from 3.4% of GDP in 2000 to 2.3% in 2001. This was primarily due to the turnaround in balance of trade. After falling sharply, investment has started to grow again, reflecting the investment cycle of the oil sector. Gross domestic investment reached 20.1% of GDP in 2001, up from 19.0% a year earlier. Capital investment is dominated by foreign direct investment (FDI). Gross national savings increased sharply over the past 2 years, but from an extremely low base. External debt levels remained unchanged at a relatively low level of 22% of GDP overall, the debt service ratio is expected to remain at a comfortable level (around 5%). Foreign exchange reserves increased significantly, reaching $744 million in 2001 compared to $680 million in 2000, as a result of oil-related inflows. Real exchange rate stability against the dollar has been successfully achieved. While the manat depreciated slightly in nominal terms, low inflation, ample reserves, and relative political stability have all contributed to public confidence in the currency.

6. Despite the favorable macroeconomic indicators, Azerbaijan continues to have a low level of per capita income (about $700 in 2001) and a high level of unemployment. While registered unemployment is only 1.2%, other estimates put unemployment as high as 25%. This reflects a high level of underemployment, particularly in the agriculture sector, which employs about 40% of the labor force. In addition, the poor performance of labor-intensive sectors such as manufacturing and light industry has further aggravated the unemployment situation in urban areas. As a result, a large number of individuals have given up hope of finding a job and have moved out of the currently active population. This highlights an important dichotomy between oil and non-oil sectors. The strong growth in the oil sector, contributing to overall GDP growth since 1997, has not been accompanied by a reduction in income inequality: 50% of internally displaced persons (IDPs), estimated at about 1 million or 12% of Azerbaijan's total population, are reported to be jobless and living on small government allowances.

7. Overall, the short- to medium-term economic outlook for Azerbaijan is positive. Given the size of its proven oil and gas reserves, Azerbaijan is a resource-rich economy. The full realization of this potential, however, depends upon the development of four major projects: (i) full development of the Azeri-Chirag-Guneshli oil field; (ii) construction of the Baku-Tbilisi-Ceyhan (BTC) pipeline to transport oil from this field to the Mediterranean; (iii) development of the Shah Deniz gas field; and (iv) a gas pipeline from Baku to Turkey parallel to the new oil pipeline. Uncertainties about the timing of these projects exist but best estimates envisage both the Shah Deniz and BTC pipelines coming onstream by about 2005. Until then, growth in the oil sector is likely to slow down because of capacity constraints. Nevertheless, increased levels of FDI, in particular oil-related FDI due to the start of the Azerbaijan International Operating Company (AIOC) phase I expansion program, will ensure continued macroeconomic stability and relatively high growth rates.

8. The Government's current tight macroeconomic policy (or fiscal and monetary policies) is expected to continue in 2002. The draft budget, which was approved by the Parliament in November 2001, targets a budget deficit equivalent to 1.2% of GDP. The challenge for the Government will be to make the much needed increase in social expenditures (especially on education and health care) while keeping the fiscal deficit under control. Azerbaijan's monetary stance is also expected to remain unchanged. The main objective of the ANB is to ensure real exchange rate stability against the dollar, and it appears unwilling to cut interest rates so as to increase credit to the real economy to limit the danger of inflation. On the external front, higher import volumes, owing to large investment in the oil and gas sector, coupled with the slowdown in oil sector growth and lower oil prices, are expected to increase pressure on current account balance. The expected increase in the current account deficit is to be financed by FDI and official lending.

C. Implications for Country Strategy and Program

9. The Country Strategy and Program Update (2001-2004) was based on the interim operational strategy (IOS)² and provides solid justification for ADB assistance in the four strategically selected areas/sectors, i.e., assistance for IDPs, rural development, water supply and sanitation, and roads. These sectors will continue to be the focus of ADB operations for the period 2003-2005. In 2003, a full country strategy and program (CSP) will be prepared in dialogue with the Government, which will review the strategic direction of the IOS. The Government's ongoing work to formulate the national program for poverty reduction will be taken into full account in preparing the CSP.

10. To address poverty and unemployment in a comprehensive fashion, the Government launched, in summer 2001, a national program for poverty reduction emphasizing non-oil sector development. A full poverty reduction strategy is to be completed by September 2002. Following these positive developments, the International Monetary Fund (IMF) and the World Bank re-engaged with the Government to develop a medium-term development strategy. In July 2001, IMF approved a new poverty reduction growth facility (PRGF) program. In March 2002, the World Bank approved a second structural adjustment credit program (SAC-II) in the amount of $60 million to support structural reforms, especially in the area of private sector development in the utility industries. The Government has agreed to a number of reforms as a condition for receiving credits under both programs. These include reform of the customs regime, energy sector reform, and institution-building measures to improve governance. The release of the third tranche of credit under the IMF PRGF program, that was due in May 2002, has been withheld, owing to a failure to agree on a timetable for unifying crude oil and electricity prices with international prices. The Government and IMF are trying to resolve the issue. If both programs are successfully implemented, this should result in significant improvements in the enabling policy environment, both for broad-based private-sector led growth and poverty reduction.

11. The emergence of MOED as the agency primarily responsible for economic development in Azerbaijan is a positive signal that the Government is pushing forward on its reform agenda. In addition, MOED's mandate for coordinating foreign investment, when fully operationalized, should also lead to a more effective flow and use of foreign funds. In the past year, uncertainty in ADB's relationship with the main relevant government agencies has negatively impacted the agreed program. The Government's clarification of this relationship is necessary to ensure the smooth implementation of the ADB's 2003-2005 lending and technical assistance program.

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