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p. 4 of 6 BACK | NEXT I. Introduction II. ADB’s Classification Policy III. Key Facts of Azerbaijan IV. Criteria for Classification of Azerbaijan V. Operatinoal Implications VI. Recommendation

The Country Classification of Azerbaijan

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IV. Criteria for Classification of Azerbaijan^d

12. Azerbaijan traditionally has had a relatively diverse economy, with oil, oil equipment, agriculture, manufacturing, and textile as some of the main sectors. The economy went through a protracted and profound contraction during the early years of independence. During 1991- 1996, real gross domestic product (GDP) declined by about 60 percent. In 1996, real GDP grew by 1.3 percent, the first positive growth since the country's independence in 1991. Real GDP continued to grow during 1997 -1999 at an annual average of 7.7 percent, and at 11.4 percent for the whole year of 2000. However, the recent economic growth has been mainly driven by the revived production in the oil and oil-related sectors, which provide 26 percent of GDP. Other sectors have continued to decline or languish. Development of the private sector, especially small and medium enterprises, has been severely constrained due to market distortions. People's living standards are low, and per capita GDP is currently about $500. Unemployment is high (15-20 percent), poverty remains widespread, and social inequality is severe.

13. Using the World Bank Atlas methodology,h Azerbaijan's per capita GNP in 1999 was $550 at current prices, lower than the current IDA operational cutoff of $885. In 1998, IDA adopted the operational cutoff of $925 in 1997 prices. Azerbaijan's GNP for the same period was $440, clearly below the cutoff.

14. External Debt and Debt Services. After independence, no external debts were inherited from the former Soviet Union. By the end of 1996, Azerbaijan's total gross external debts amounted to $445 million (17 percent of GDP). Total external debts were within a reasonable range, at about 14-16 percent of GDP between 1997 and 1998, before rising to 24 percent ($964 million) in 1999. They compare favorably with the average levels of Central Asia republics (55 percent in 1999) and developing countries in general (42 percent in 1999). Of the total amount, 74 percent comprises debts to multilateral creditors, 16 percent is export credits, 6 percent is owed to bilateral creditors and 4 percent to commercial banks. External debt service in terms of exports of goods and services remained just below 1 percent before 1998, except in 1997, when it rose to 7 percent. The debt service ratio rose to 4 percent in 1999.

15. Foreign Exchange Reserves. By 1994, the gross reserves of Azerbaijan's central bank had dwindled to $2 million. Since then its foreign exchange reserve position has improved significantly, to about $676 million by the end of 1999. This amounts to a cover of six months of imports and services excluding oil sector operations. 16. Gross Domestic Savings. The economy's savings rate has been low, and early data are not reliable, with large statistical discrepancies (up to 12.4 percent of GDP). The gross national savings rate was estimated at 3.6 percent of GDP in 1996, and rose to 10.7 percent on average during 1997 -1999. As the economy has yet to recover to its standing prior to the breakup of the Soviet Union, a substantial rise in domestic savings is unlikely in the near future.

17. Export Performance. Export growth has been unstable. This is reflected in a 0.3 percent decline in 1995, followed by a 16 percent increase in 1996. The pattern was repeated during 1997-1999 after 2.4 percent growth in 1997, exports declined by 16.1 percent in 1998 but rebounded to a positive growth of 51.2 percent in 1999. Exports declined from $789 million (25 percent of GDP) in 1996 to $678 million (16 percent of GDP) in 1998, before recovering to $1,025 million (26 percent of GDP) in 1999. Azerbaijan's reliance on oil exports increased to 78 percent of total exports in 1999 from 50 percent in 1996.

18. Current Account Balance and External Financing. The current account deficit has declined from 26 percent of GDP in 1996 to 15 percent in 1999. External financing (net), amounted to $4.2 billion cumulatively during 1994-1996 compared with $3.1 billion during 1997- 1999. Major sources include foreign direct and portfolio investment (85 percent in 1997-1999), official medium and long-term capital flows (9 percent in 1997-1999), and short-term banking capital and trade credits (7 percent in 1997-1999). Increasingly, foreign investment has been limited to oil-related sectors (76 percent in 1997-1999 compared with 54 percent in 1994-1996). More importantly, official medium- and long-term capital has decreased in comparison with short-term banking capital and trade credits (the ratio of medium- and long-term capital to short- term capital and trade credits fell to 1.3 in 1997-1999 from 5.1 in 1994-1996).

19. Official Development Assistance and Eligibility for IDA. By the end of 1999, approved official development assistance to Azerbaijan had amounted to about $2 billion, about 80 percent of which is on concessional terms. Since 1992, the country has been a blend borrower of the International Bank for Reconstruction and Development (IBRD) and IDA. However, so far Azerbaijan has received only IDA credits of $369 million for 14 operations.^j Azerbaijan has not been listed as a heavily indebted poor country (HIPC).

20. Access to the International Capital Market. Azerbaijan has not borrowed from the international capital markets. Neither Moody's nor Standard & Poor's have undertaken a sovereign risk assessment for Azerbaijan. To explore Azerbaijan's access to international capital markets, the Government had Fitch IBCA, Duff & Phelps complete a sovereign risk assessment in July 2000.^k

21. Debt Repayment Capacity. ADB's DMCs are ranked through an econometric model that takes into consideration relevant factors. The DMCs are grouped into three categories pertinent to their debt repayment capacities: A (weak), B1 (limited) and B2 (adequate). Based on this methodology, Azerbaijan's debt repayment capacity is limited. 22. Classification. Through the joint application of the two criteria, per capita GNP and dept repayment capacity, Azerbaijan can be classified within group B1, which allows borrowing from ADF with limited OCR access.

23. Poverty. From the late-1980s to the mid-1990s, Azerbaijan experienced tremendous economic dislocation due to the breakup of the Soviet Union, ethnic conflicts, war and political instability. These combined events caused real output to collapse, inflation to run rampant, real income to plunge, and government financial resources to drop sharply. As a result, poverty had become widespread and deep, particularly among refugees and internally displaced persons (IDPs). Almost 62 percent of the households were below the poverty line. About 20 percent of all households are considered very poor.^l The poverty incidence among the refugee and IDP households is about 75 percent and this group has almost twice as many very poor people as in the general population. In addition, the access of the poor to quality social services has decreased. Poverty has been aggravated by reduced public expenditures, an increased number of closed enterprises that ceased to provide financing for social services, and rising pressure on social and municipal services (due to the nonintegration of refugees and IDPs). Nearly one quarter of the country's children are malnourished and two fifths are suffering from anemia. Waterborne diseases have become widespread in urban areas due to the low capacity to treat water and aging pipe networks. Drinking water is available for only 54 percent of households in the country, and for 17 percent in rural areas and smaller towns which have a large share of refugees and IDPs.

24. Government Revenues. Except for 1998, government revenues have remained at around 20 percent of GDP, which is much lower than that prior to 1995. This is partly a natural consequence of government downsizing during the transition to a market-based economy. However, tax collection has been weak as a result of large tax arrears and evasion of indirect taxes such as excise taxes and custom duties. Another major reason for reduced revenues in 1998 was the decline of oil prices. As the production of oil and natural gas is increasing, the Govemment budget is expected to become more dependent on the oil revenues, which presently account for 30 percent of total current revenues. However, limitations of the drilling infrastructure and lower-than-expected finds of oil suggest that oil and gas production will not increase substantially until 2008.^m Until then, the Government will not be able to receive large revenue inflows from production sharing agreements, and additional spending will be needed to cover the costs of initial investment.

25. Developmental Challenges. After almost a decade of transition, the economy is still facing (i) a low level of development with low per capita income, high unemployment, poor infrastructure, and widespread and deep poverty; (ii) a slow transition toward a democracy and a market-based economy, with few structural reforms; (iii) unexploited rich natural resources, which offer bright development potential but have yet to benefit the population, especially the poor; and (iv) an emerging trend toward greater dependence on oil-related sectors. To sustain economic recovery and growth, the country needs to go beyond stabilization to pursue prudent economic management and deepen structural reforms. Major challenges include (i) promoting development of the non-oil sectors, which provide the majority of jobs to the poor; (ii) improving macroeconomic policies and management to maintaining both domestic and external balances; and (iii) deepening structural reforms to build policy, regulatory, and legal environment appropriate for a market economy.

26. Azerbaijan's current status, its per capita GNP lower than the current IDA cutoff, and its limited debt repayment capacity indicate that the country should be categorized in group B1. Other factors pointing in the same direction include (i) a relatively small economy, (ii) widespread and deep poverty, particularly among refugees and lDPs, (iii) the nonavailability of large oil revenues until 2008, (iv) weak institutional capacity of the public sector, (v) an urgent need for development assistance to policy reforms and development of the non-oil sectors, and (vi) over 80 percent of the $2 billion external assistance to Azerbaijan is on concessional terms.

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