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Countries and Regions Country Partnership Strategies Document
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Country Strategy and Program Update 2004-2006: Azerbaijan
I. Current Development Trends and Issues1. The political situation in Azerbaijan is generally stable, however, territorial disputes with Armenia remain a major source of political uncertainty. Despite mediation efforts by the Minsk Group of the Organization for Security and Cooperation in Europe and a series of bilateral meetings between the presidents of Az erbaijan and Armenia, little progress has been made in resolving the dispute. The Minsk Group suspended its mediation in early 2003 until after presidential elections in Azerbaijan and Armenia. 2. In the meantime, some progress has been made in resolving another international dispute involving Azerbaijan — namely, disagreements over the division of the hydrocarbon-rich Caspian Sea. Azerbaijan, Kazakhstan, and the Russian Federation have concluded bilateral agreements to divide their parts of the seabed into national zones using the “medium-line” principle, and Azerbaijan is reportedly close to reaching a similar agreement with Iran. Simultaneously, negotiations have continued to reach a multilateral treaty. Following a 2-day meeting in Baku in February 2003, the working group of deputy foreign ministers of the five littoral states, which is charged with drafting a convention on the legal status of the sea, made a statement saying that it had agreed on several articles of the draft convention. 3. The political competition in Azerbaijan is expected to intensify in the run-up to the presidential election that is scheduled for October 2003. In spite of recent signs of health problems, incumbent President Heydar Aliyev has reaffirmed his intention to run for a third term in office. In addition, his son, Ilham Aliyev, who in August 2003 was appointed Prime Minister, is also a candidate for the presidency. The presidential election will be conducted in accordance with Azerbaijan's new election code, which was enacted in June 2003. The election code governs the conduct of national referendums as well as presidential, parliamentary, and municipal elections in one document and represents another major step in codifying Azerbaijan's legislation. A. Economic Assessment and Outlook4. Amid a global slowdown, Azerbaijan's economy maintained strong growth momentum in 2002. Real gross domestic product (GDP) growth accelerated slightly from 9.9% in 2001 to 10.6% in 2002, driven by increased foreign direct investment (FDI) in the oil and gas sector. Reflecting the launch of several large-scale investment projects, including the construction of the Baku-Tbilisi-Ceyhan oil export pipeline, gross FDI inflows into the sector surged from $821 million (14.4% of GDP) in 2001 to $1,693 million (27.8% of GDP) in 2002. This provided a major impetus to the economy. Construction and manufacturing related to the development of the oil and gas sector, such as metallurgy and production of construction materials, expanded rapidly, although oil production itself increased by a modest 2.8% due to capacity constraints. 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. Notwithstanding large hydrocarbon-related foreign exchange inflows, inflation was kept in check and real exchange rate appreciation was avoided owing to prudent macroeconomic polices. Annual consumer price inflation was 2.8% and the exchange rate of the national currency, the manat, remained fairly stable, depreciating by 4.4% against the US dollar. Most oil-related revenues were sterilized through the Oil Fund, whose assets increased by more than $200 million over the year. The general government budget1 recorded a deficit of AZM646 billion or 2.2% of GDP. This was much smaller than the target deficit of 4.0% of GDP, though slightly greater than the 2001 deficit of 2.1% of GDP. The refinance rate of the National Bank of Azerbaijan was lowered from 10% to 7% per annum in an effort to improve credit availability to the non-oil sector, but remained positive in real terms.6. The external current account deficit widened substantially from $50 million (0.9% of GDP) in 2001 to $769 million (12.6%) in 2002, as imports of capital goods and services for the oil and gas sector 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 $236 million. Accordingly, gross official reserves, including Oil Fund assets, grew from $1,220 million at end-2001 to an estimated $1,417 million at end-2002. Reflecting the Government’s conservative external borrowing policy, 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 funding agencies. The ratio of debt service to exports of goods and non-factor services fell from 4.9% in 2001 to 4.4% in 2002. 7. Considerable progress was made in implementing structural reforms in 2002 and early 2003. Most notably, all extra-budgetary funds, with the exception of the Social Protection Fund and the Oil Fund, were integrated into the state budget; domestic prices of most energy products were raised to estimated long-term export or import parity levels; implicit subsidies that were provided to the electricity and gas sectors in the form of unpaid fuel deliveries to these sectors were included in the budget; the number of business activities subject to licensing was substantially reduced; and licensing procedures were streamlined. In addition, the Government made a commitment to carry out a number of important reform measures during the rest of 2003 and in 2004, including privatization of the two state-owned banks, whose dominance of the banking system has been hindering competition in the financial sector. The Government's economic reform program is supported by the International Monetary Fund (IMF), which completed the second review under its Poverty Reduction and Growth Facility arrangement with Azerbaijan in May 2003, and by the World Bank, which disbursed the second tranche of its Second Structural Adjustment Credit in June 2003. 8. The medium-term economic outlook for Azerbaijan is positive, though it is subject to greater than usual internal and external risks. Provided that the political situation remains stable, that major investment projects in the oil and gas sector are implemented on schedule, and that there are no sharp declines in international oil prices, GDP growth is expected to remain buoyant at least until the end of this decade, driven by large inflows of FDI into the oil and gas sector in 2003–2004 and rapid expansion in oil and gas production and exports thereafter. However, this hydrocarbon-driven growth will only have a limited direct impact on poverty because it will generate little employment, whereas oil and gas rents will mostly accrue to state coffers. Furthermore, growing oil and gas revenues will complicate macroeconomic management, may lead to unproductive public expenditures, and are likely to cause appreciation of the real exchange rate over the medium term, thereby undermining competitiveness of the non-oil sector. In the long term, economic growth driven by the oil and gas sector will be unsustainable because, unless new fields are discovered, the ongoing oil and gas boom in Azerbaijan is expected to be relatively short-lived. Hence, the triple economic challenge faced by Azerbaijan is (i) to preserve macroeconomic stability, (ii) to manage the oil windfall wisely to improve living conditions of all segments of the current population, especially the poor, and (iii) to foster the development of the non-oil sector to create productive job opportunities and achieve balanced and sustainable growth. B. Implications for Country Strategy and Program9. The Country Strategy and Program Update (2003–2005) was based on the interim operational strategy (IOS)2 and provides solid justification for Asian Development Bank (ADB) assistance in the four strategically selected areas/sectors, i.e., assistance for internally displaced persons (IDPs), agriculture and rural development, water supply and sanitation, and roads. These sectors will continue to be the focus of ADB operations for the period 2004–2006. 10. Recent developments in Azerbaijan have two implications for the formulation and implementation of the country strategy and program (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 near-term. Second, the Government’s commitment for reform, as embodied in the recent positive developments in both the IMF and World Bank programs, 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 the strengthening of institutions in Azerbaijan. 11. In 2005, a full CSP will be prepared in dialogue with the Government. The CSP will review the progress made toward achieving the strategic direction of the IOS and, if necessary, propose new strategic directions. The Government’s work last year to prepare the national poverty reduction strategy (see para. 13) and the initial results of the implementation of the strategy will be taken fully into account in preparing the CSP. ____________________
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