Oil Wealth and Sustainable Development:the Case of Azerbaijan

Presentation by Dr. Khagani AbdullayevNational Bank of Azerbaijan

Director of the Department of Monetary PolicyFulbright Scholar at George Washington University

Sponsored by the GWU European Union Research Center

Population: 8.2 million

Territory: 86 th.sq.km.

GDP of Azerbaijan (PPP based) is around 2/3 of total GDP of South Caucasus region

GDP per capita in 2007 2620 USD, forecast for 2008 – 3640 USD

1991 – independence gained after the collapse of USSR, but complica-ted economic and political environment at the early 90’s delayed the transformation process

Economic picture in 1992-1993:

Annual inflation: 1600-1800%

Recession , output loss of 20-30% per year

Military aggression of Armenia – crisis exacerbating factor:

20% of Azerbaijan occupied by Armenia

1 million refuges, thousands of civilians massacred by armenian military in the Nagorni-Karabakh region of Azerbaijan

Plus internal political disputes and civil unrest

1993: Heydar Aliyev coming to power with a huge support of society of a war torn country

1994: ceasefire with Armenia, peace negotiations

Power consolidation, internal political stability

Macroeconomic Stabilization , Economic Reforms:

Standby agreement with IMF followed by EFF and ESAF (1994-99);

and later PRGF (2001-2004)

New Oil Era - signing PSA’s with international oil consortium headed by BP-AMOCO led to emergence of Azerbaijan as the regional economic leader

Average annual growth rate stood at 8.4% during 1996-2003, with the inflation rate at 2.8%, structural reforms started: privatization, liberalization and governance reforms

Oil strategy: Construction of the Baku-Tbilisi-Ceyhan Oil Pipeline leading to large-scale petrodollars inflow to domestic economy

More than 25 bln.USD FDI attracted to the oil industry in 1995 – 2007

Since 1998 until now about 22 bln.USD of FDI was repatriated back by foreign companies

The presence of oil has been known since antiquity

By the 15th century oil for lamps was obtained from surface wells

Modern commercial exploitation started in 1872 – First Oil Boom – first azeri millionaires in tsarist Russia

The Baku oil field was the largest in the world at the beginning of 20th century

World War II – Second )il Boom – Baku becoming the first offshore extracting place in the world

At the early stages of World War II Baku satisfied 70% of the Soviet army and industry demand in oil

Currently – Third Oil Boom

Azerbaijan preparing for oil boom – State Oil Fund of Azerbajan (SOFAZ) established in December 1999

SOFAZ – extra budgetary fund, separate legal entity, part of consolidated budget

SOFAZ objectives:

protection of macroeconomic stability through sterilization of oil revenues

accumulation of reserves for future generations

using part of reserves to stimulate economic growth Sources of oil revenues to the budget: country’s share in exports of crude

oil, bonus payments, asset management income

Azerbaijan preparing for oil boom – Long-Term Oil&Gas Revenue Management Strategy, approved by President, Sep.2004

Covers period from 2005 to 2025, aims at: Accumulation of reserves for future generations

Developing the non-oil economy through financing the public investment programs based on sound macro-fiscal planning

Resolution of other crucial problems of national dimension

Main principle: following a constant real expenditure path (sustainable path) when spending out of oil revenues

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Oil GDP growth and Sustainable Real Expenditure Path

2003 - PRESENT: New Oil Strategy and the Booming Economy: New Oil Strategy and the Booming Economy

2003 - PRESENT: New Oil Strategy and the Booming Economy: New Oil Strategy and the Booming Economy

Money Deman

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Money Deman

d Shock

Conclusion: Keynesian Model of Demand Stimulation Policy was put in place in Azerbaijan following a monetary tightening based stabilization policy conducted in 1994-2002:

Domestic economy saw growing non-oil deficit, excess of demand over supply, some inflationary pressure in 2004-2007 and jumping real estate prices – signs of overheating

Why spent too fast in 2004-2007? Main arguments:

National projects on reconstruction of the water supply and irrigation systems

Partial financing of the Baku-Tbilisi-Ceyhan pipeline

Improving the regional infrastructure – key precondition for investors activity

Urgent need to support 1 million refugees (mostly unemployed) living in tents, etc. Government succeeded to hit its main target: POVERTY reduced from 49% in 2001 to Government succeeded to hit its main target: POVERTY reduced from 49% in 2001 to

currently below 20%*, more than 430 000 new jobs createdcurrently below 20%*, more than 430 000 new jobs created

*(poverty headcount ratio at national poverty line, % of population)*(poverty headcount ratio at national poverty line, % of population)

What is the Appropriate Pace of Spending out of Oil Revenue?

Scenario 1. Fiscal expansion (Worse or High Inflation Scenario)

Assumptions for 2008-2016:

Average annual growth of budget expenditures: 25%

Average non-oil GDP growth rate: 5%

Average non-oil budget deficit/ non-oil GDP ratio: 52%

Oil price/barrel: 60$

US T-bills rate : 4.5%, real rate of return: 3%

Scenario 1. Moderate fiscal policy (Good or Low Inflation Scenario)

Assumptions for 2008-2016:

Average annual growth of budget expenditures: 9%

Average non-oil GDP growth rate: 8%

Average non-oil budget deficit/ non-oil GDP ratio: 15%

Oil price/barrel: 60$

US T-bills rate : 4.5%, real rate of return: 3%

Elasticity relationships:

Every 1% of inflation above 8% causes 0.1% decline in both tradable and non-tradable sectors

1% growth of public expenditure leads to:

0.1% growth in tradable sector

0.25% growth in non-tradable sector

Elasticity relationships:

1% growth of M2 causes 0.3-0.35% rise in CPI

This ratio is supposed to go up in the long-run with increasing GDP monetization

Inflation inertia - 1% of past year inflation creates 0.4-0.45% inflationary effect next year

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Long-term Policy objectives of the Government:

Diversification of economy and prevention of “Dutch disease”

Building democratic market economy

Poverty elimination and building a welfare society

Policy agenda of Government in support of these objectives

Sound medium and long term macroeconomic management

Deepening structural reforms and building sound institutions to enhance productivity

Prevention of “rent seeking”,

improving governance and providng high transparency

Adoption of a Medium-Term Fiscal Framework (MTEF) starting in 2008 supported by World Bank and USAID:

First step: pace of expenditure increase for 2008 was moderated (from 60% to 28%). Investment program includes:

completion of investment projects in basic infrastructure started in previous years

most critical projects in social sectors

Linking annual budget to long-term policies and sustainability objectives – program budgeting

Adoption of a Medium-Term Fiscal Framework (MTEF) starting in 2008 supported by World Bank and USAID:

Integrated medium-term macroeconomic projections

Aggregate fiscal targets, target for the non-oil deficit based on stabilization and sustainability goals (top-down approach in drafting the budget expenditures)

Administrative capacity building – Public Financial Management Systems to ensure the quality of spending

Macroeconomic policy coordination and inflation targeting:

Setting reasonable operational target for non-oil deficit - more exchange rate flexibility through scaling down foreign exchange interventions

Setting achievable monetary policy operational targets (money base) backed by reasonable macro-fiscal framework

National Bank of Azerbaijan (NBA) – has goal and instrument independence by law

Current Sterilization Strategy of NBA:

3-month bonds – limited issuance because it is expensive and may lead to speculative capital inflow

Macroeconomic policy coordination and inflation targeting:

Free capital account (outflow recently liberalized)

Imposing reserve requirements on bank’s foreign liabilities (now 5-6% of GDP ) – lessons from Kazakhstan

Improving prudential regulation to minimize system vulnerabilities against 1) credit-real estate boom and 2) short-term capital inflow

Communication strategy of NBA: Drafting and Publication of Financial

Stability and Inflation Reports

Inflation forecasting capacity: building monetary policy transmission models, measuring the output gap

Adoption of the anticorruption program:

National Strategy on Increasing Transparency and Fighting Corruption adopted

The law on fighting corruption adopted

State commission on fighting corruption established

Other anticorruption laws pending to be passed by Parliament:

Anti-money laundering law

Law on the Code of Conduct of Civil Servants

Law on Preventing the Conflict of Interest of Public Officials

E-government project started recently and supported by the World Bank

Public sector reforms: Strengthening fiscal discipline at

SOE via elimination of subsidies and developing corporate manage-ment standards

Introducing strategic planning in budgetary organizations

Improving governance and tax customs administration

Removing market distortions: Privatization of large enterprises

Privatization of large two state owned banks (president decrees signed recently)

Improving business climate in the non-oil sector

President’s recent decree on simplification of licensing and registration – formalization of starting business through one ministry

New antimonopoly code and investment law pending to be passed by Parliament

Widening access to credit : State Entrepreneurship Fund

financed by budget and allocating credits through agent banks

Regional development : Regional Development Program -

enhancing infrastructure and improving business climate through tax incentives and widening access to credit

SOFAZ has won the 2007 UN Public Service Award in the category of “Improving transparency, accountability and responsiveness in the Public Service” for EITI.

SOFAZ is the first governmental organization winning the award in CIS and Eastern Europe

Full reports and the press-releases related to EITI are disclosed on websites:

SOFAZ : www.oilfund.az

EITI Secretariat www.eitransparency.org

NGOs Coalition website: www.eiti-az.org

Azerbaijan volunteered to become a First country to implement EITI

15 March 2005 – Azerbaijan disclosed First EITI reports in the World (2003 annual report and 2004 semi annual report)

By implementing EITI the government of Azerbaijan achieved full accountability and transparency in oil and gas revenues

THANK YOU!!!