Regions and Countries

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Country Strategy and Program Update 2005-2006: Azerbaijan

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I. Current Development Trends and Issues

A. Recent Political Developments

1. The political situation in Azerbaijan has generally been stable. Presidential elections were held in October 2003. According to official results, Mr. Ilham Aliyev, son of former President Heydar Aliyev, won a landslide victory in the election, defeating seven rival candidates. In the immediate aftermath of the elections, the opposition refused to accept these results and clashes took place between police and opposition supporters. However, since then, there have been no further recurrences of violence and the situation is considered stable. Mr. Ilham Aliyev pledged to continue his father's policies and reappointed most senior government officials to their positions. Mr. Heydar Aliyev died in December 2003.

2. Azerbaijan and Armenia have recently intensified their efforts to find a peaceful solution to their territorial dispute over Nagorno-Karabakh. A series of meetings between the presidents and the ministers of foreign affairs of the two countries have taken place since December 2003, which represents some progress in this area. The Minsk Group of the Organization for Security and Co-operation in Europe has been mediating the negotiations. Progress has also been made in resolving another international dispute involving Azerbaijan-namely, the disagreement over the division of the Caspian Sea. At a 2-day meeting in Baku in March 2004, the working group of deputy foreign ministers of the five littoral states agreed on several more articles of a draft convention on the legal status of the sea. In parallel, Azerbaijan and Turkmenistan resumed bilateral talks on delineating their sections of the seabed, which were suspended about 2 years ago. ¹

B. Economic Assessment and Outlook

3. Azerbaijan's macroeconomic performance remained strong in 2003 and in the first quarter of 2004 (Appendix 1, Table A1.2). Following growth of 11.2% in 2003, real gross domestic product (GDP) grew by 10.6% in January-March 2004, compared with the same period a year earlier. Large inflows of foreign direct investment (FDI) into the oil sector,² which reached $2.8 billion (39.4% of GDP) in 2003, remained the engine of growth. The full development of the Azeri-Chirag-Gunashli oil fields and the construction of the associated Baku-Tbilisi-Ceyhan oil pipeline proceeded apace, despite delayed approval of loans by international creditors. In addition, two new large-scale gas projects-namely, the development of the Shah-Deniz gas field in the Caspian Sea and the construction of the South Caucasus Pipeline, which will deliver gas from Shah-Deniz to Turkey-were launched in early 2003.

4. Notwithstanding large hydrocarbon-related foreign exchange inflows, price stability was maintained and real exchange rate appreciation was avoided. Inflation remained at low single-digit levels, with the consumer price index rising by 2.2% in 2003 and by 3.0% in the 12-month period ended in March 2004. While the nominal exchange rate of the national currency (the manat) against the dollar stayed virtually unchanged in 2003, the real effective exchange rate depreciated by an estimated 13.1%, giving domestic producers a competitive edge.

5. The Government continued pursuing sound macroeconomic policies. In spite of a reduction in a number of taxes, a rise in public sector salaries, and an increase in capital expenditure, the consolidated budget, including the State Oil Fund of Azerbaijan Republic (SOFAZ), recorded a surplus of 0.2% of GDP in 2003. Moreover, part of the revenue windfall arising from higher than anticipated world oil prices was saved as a cushion against possible future declines in oil prices and, consequently, oil-related budgetary revenues. Although broad money continued to grow fast, by 29.8% in 2003 and by 4.9% in the first 3 months of 2004, this reflected the increase in money demand, resulting from rapid GDP growth and continuing remonetization of the economy.

6. The current account deficit widened to 28.3% of GDP in 2003, as imports of capital goods and services for the oil sector increased sharply. The deficit was fully financed by inflows of FDI and other capital inflows such that the overall balance of payments recorded a surplus of $236 million. Consequently, gross official reserves, including SOFAZ assets, increased from $1.4 billion at end-2002 to $1.6 billion at end-2003. The external debt burden remained moderate, with the stock of public and publicly guaranteed debt standing at $1.6 billion (22.0% of GDP) at end-2003 and the ratio of debt servicing to exports of goods and non-factor services amounting to 5.0% in 2003.

7. Progress in structural reform was mixed. While marked headway was made in some areas, such as enhancing transparency and accountability of public finance management and making implicit energy subsidies explicit, progress was limited in other areas, such as privatization of state-owned enterprises, enhancing competition, and demonopolization of the economy. Following his election victory in October 2003, President Ilham Aliyev issued decrees calling for acceleration of structural reform. In February 2004, he approved the State Programme on Socio-Economic Development of the Regions for 2004-2008, which envisages a broad range of policy measures and investment projects aimed at achieving more balanced regional development.

8. The medium-term outlook for Azerbaijan is positive. GDP growth is projected to remain buoyant at least until the end of this decade, driven by large FDI inflows into the oil sector in 2004 and rapid expansion in oil and gas production and exports thereafter. This oil boom, however, represents not only an opportunity, but also a challenge for Azerbaijan. To avoid the "resource curse" experienced by many other oil-rich countries, Azerbaijan needs to (i) maintain macroeconomic stability in the face of large foreign exchange flows related to the exploitation of hydrocarbon resources; (ii) allocate the oil windfall optimally over time and use it efficiently to benefit all segments of the population, especially the poor; and (iii) promote the development of the non-oil sector to create job opportunities and achieve balanced and sustainable growth.

C. Implications for Country Strategy and Program

9. The Country Strategy and Program Update (CSPU) (2004-2006) was based on the interim operational strategy (IOS)³ and continues to provide solid justification for Asian Development Bank (ADB) assistance in the four strategically selected areas or sectors, i.e., assistance for internally displaced persons (IDPs); agriculture and rural development; social infrastructure (primarily water supply, sanitation, and child development); and roads. These sectors or areas are assumed to continue to be the focus of ADB operations until the new country strategy is prepared.

10. In 2005, a full country strategy and program (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 over the last year to implement the national poverty strategy (para. 12) and the new directions provided by the Government's recently approved State Programme on Socio-Economic Development of the Regions will be taken fully into account in preparing the CSP.

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1. Azerbaijan, Kazakhstan, and the Russian Federation have already concluded bilateral agreements to divide their parts of the seabed into national zones based on the medium-line principle.
2. The term "oil sector" refers to the oil and gas sector.
3. ADB. 2000. Economic Report and Interim Operational Strategy for Azerbaijan. Manila.

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