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The World Bank

Report No:ICR0000155

IMPLEMENTATION COMPLETION AND RESULTS REPORT (IDA-40610)

ON A

POVERTY REDUCTION SUPPORT CREDIT

IN THE AMOUNT OF SDR 13.1 MILLION

(US$ 20.0 MILLION EQUIVALENT)

TO THE

REPUBLIC OF AZERBAIJAN

March 30, 2007

POVERTY REDUCTION AND ECONOMIC MANAGEMENT SOUTH CAUCASUS COUNTRY UNIT EUROPE AND CENTRAL ASIA

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CURRENCY EQUIVALENTS

(Exchange Rate Effective March 21, 2007)

Currency Unit = New Azeri Manat AZN 1.00 = US$ 1.1526 US$ 1.00 = AZN 0.8676

FISCAL YEAR

January 1 – December 31

ABBREVIATIONS AND ACRONYMS

AAA Analytical Advisory Activities ACG Azerbaijan-Chirag-Guneshi ADB Asian Development Bank AIOC Azerbaijan International Operating Company ANB Azerbaijan National Bank APL Adaptable Program Lending BEEPS Business Environment and Enterprise

Performance Survey BIS Bank of International Settlements BOT Build-Operate-and Transfer BTC Baku-Tbilisi-Ceyhan pipeline CAS Country Assistance Strategy CFAA Country Financial Accountability Assessment CIS Commonwealth of Independent States COM Cabinet of Ministers CPAR Country Procurement Assessment Report CPIA Country Performance Indicator Assessment CPS Country Partnership Strategy EBRD European Bank for Reconstruction and

Development EITI Extractive Industries Transparency Initiative ESMAP Energy Sector Management Assistance Program EU European Union FDI Foreign Direct Investment FIAS Foreign Investment Advisory Services FID Foreign Investment Department FSU Former Soviet Union GATS General Agreement on Trade and Services GBWSP Greater Baku Water Supply Rehabilitation

Project GDP Gross Domestic Product GFS Government Finance Statistics GTZ Gesellschaft furt Technische Zusammenarbeit HIPC Heavily Indebted and Poor Countries IAS International Accounting Standards IBA International Bank of Azerbaijan IBTA Institution Building Technical Assistance ICR Implementation Completion and Results Report IDA International Development Association IDPs Internally Displaced Populations IFC International Finance Corporation IFI International Finance Institutions IFRS International Financial Reporting Standards IMF International Monetary Fund INOTIS Integrated Non-oil Trade and Investment

Strategy I-PRSP Interim Poverty Reduction Strategy Paper IPSAS Investment Public Sector C Standards ISA International Standards on Auditing LDP Letter of Development Policy LIL Leaning and Innovation LPG Liquid Petroleum Gas LTORMS Long Term Oil Revenue Management Strategy M&E Monitoring and Evaluation MDGS Millennium Development Goals MED Ministry of Economic Development MEP Main Export Pipeline MIS Management Information System MoF Ministry of Finance MOFE Ministry of Fuel and Energy MoH Ministry of Health MOLSPP Ministry of Labor and Social Protection MTEF Medium-Term Expenditure Framework NAS National Accounting Standards NBA National Bank of Azerbaijan NBS National Budget Survey NGO Non-Governmental Organization O&M Operations and Maintenance OSCE Organization for Security and Co-operation in

Europe PAD Project Appraisal Document PAR Poverty Assessment Report PES Public Employment Services PHC Primary Health Care PIP Public Investment Program PPF Project Preparation Facility PPIAF Public-Private Infrastructure Advisory Facility PRGF Poverty Reduction and Growth Facility PRSC Poverty Reduction Support Credit PRSP Poverty Reduction Strategy Paper PSA Production Sharing Agreement QAG Quality Assurance Group REER Real Effective Exchange Rate RFP Request for Proposal RTGS Real Time Gross Settlement System SAC Structural Adjustment Credit SDR Special Drawing Rights, SDR 1= US$1.5126 SME Small and Medium Enterprise SOCAR State Oil Company of Azerbaijan Republic

SOE State-owned Enterprise SPPRED State Pogramme for Poverty Reduction and

Economic Development SSA State Statistical Agency SSPF State Social and Pension Fund TA Technical Assistance

UNDP United Nations Development Programme USAID United States Agency for International

Development VAT Value-Added Tax VDS Voluntary Departure Schemes WTO World Trade Organization

Vice President: Shigeo Katsu Country Director: Donna Dowsett-Coirolo Sector Manager: Carlos Felipe Jaramillio Project Team Leader: Christos Kostopoulos ICR Team Leader: Christos Kostopoulos

Azerbaijan Poverty Reduction Support Credit (PRSC)

CONTENTS

Data Sheet A. Basic Information B. Key Dates C. Ratings Summary D. Sector and Theme Codes E. Bank Staff F. Results Framework Analysis G. Ratings of Program Performance in ISRs H. Restructuring

1. Program Context, Development Objectives and Design ............................................ 1 2. Key Factors Affecting Implementation and Outcomes .............................................. 4 3. Assessment of Outcomes ............................................................................................ 8 4. Assessment of Risk to Development Outcome......................................................... 28 5. Assessment of Bank and Borrower Performance ..................................................... 29 6. Lessons Learned........................................................................................................ 31 7. Comments on Issues Raised by Borrower/Implementing Agencies/Partners........... 33 Annex 1 Bank Lending and Implementation Support/Supervision Processes.............. 34 Annex 2. PRSC Policy Reform and Results Matrix ..................................................... 37 Annex 3. Summary of Borrower's ICR and/or Comments on Draft ICR ..................... 52 Annex 4. Comments of Cofinanciers and Other Partners/Stakeholders ....................... 53 Annex 5. List of Supporting Documents ...................................................................... 54 MAP.............................................................................................................................. 55

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A. Basic Information Country: Azerbaijan Program Name:

Poverty Reduction Support Credit (PRSC)

Program ID: P074938 L/C/TF Number(s): IDA-40610 ICR Date: 04/02/2007 ICR Type: Core ICR

Lending Instrument: PRC Borrower: GOVERNMENT OF AZERBAIJAN

Original Total Commitment:

XDR 13.1M Disbursed Amount: XDR 13.1M

Implementing Agencies: Ministry of Finance Cofinanciers and Other External Partners: B. Key Dates

Process Date Process Original Date Revised / Actual Date(s)

Concept Review: 02/18/2004 Effectiveness: 01/13/2006 01/13/2006 Appraisal: 06/01/2004 Restructuring(s): Approval: 05/17/2005 Mid-term Review: Closing: 06/30/2006 06/30/2006 C. Ratings Summary C.1 Performance Rating by ICR Outcomes: Moderately Satisfactory Risk to Development Outcome: Substantial Bank Performance: Moderately Satisfactory Borrower Performance: Moderately Satisfactory

C.2 Detailed Ratings of Bank and Borrower Performance (by ICR) Bank Ratings Borrower Ratings

Quality at Entry: Moderately Satisfactory Government: Moderately Satisfactory

Quality of Supervision: Moderately Satisfactory Implementing Agency/Agencies: Moderately Satisfactory

Overall Bank Performance: Moderately Satisfactory Overall Borrower

Performance: Moderately Satisfactory

C.3 Quality at Entry and Implementation Performance Indicators

Implementation Performance Indicators QAG Assessments

(if any) Rating:

Potential Problem Program at any time

Yes Quality at Entry (QEA):

None

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(Yes/No): Problem Program at any time (Yes/No):

No Quality of Supervision (QSA):

None

DO rating before Closing/Inactive status:

Satisfactory

D. Sector and Theme Codes

Original Actual Sector Code (as % of total Bank financing) General education sector 10 10 General energy sector 15 15 General industry and trade sector 25 25 General public administration sector 40 40 Health 10 10

Theme Code (Primary/Secondary) Legal institutions for a market economy Primary Primary Macroeconomic management Secondary Secondary Other financial and private sector development Secondary Secondary Public expenditure, financial management and procurement

Primary Primary

Regulation and competition policy Primary Primary E. Bank Staff

Positions At ICR At Approval Vice President: Shigeo Katsu Shigeo Katsu Country Director: D-M Dowsett-Coirolo D-M Dowsett-Coirolo Sector Manager: Carlos Felipe Jaramillo Samuel K. E. Otoo Program Team Leader: Christos Kostopoulos Christian E. Petersen ICR Team Leader: Christos Kostopoulos ICR Primary Author: Mansour Farsad F. Results Framework Analysis Program Development Objectives (from Project Appraisal Document) The objective of the proposed PRSC is to support the Government#s policies and structural reforms that are consistent with and supportive of the poverty reduction and economic strategy as highlighted in the SPPRED. More specifically, the credit aims to enhance the Government's ability to manage Azerbaijan's natural resource boom

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efficiently, and to stimulate balanced economic growth and job creation, which are fundamental to poverty reduction. Revised Program Development Objectives (if any, as approved by original approving authority) None (a) PDO Indicator(s)

Indicator Baseline Value

Original Target Values (from

approval documents)

Formally Revised Target Values

Actual Value Achieved at

Completion or Target Years

Indicator 1 : Contain inflation.

Value (quantitative or Qualitative)

2004: 10.4 Year end inflation

Single digit inflation

2005: 5.5% Year-end inflation 2006: 11.4% Year-end inflation

Date achieved 12/31/2004 12/31/2005 03/23/2007 Comments (incl. % achievement)

The target was almost achieved in 2004, achieved in 2005, and missed in 2006.

Indicator 2 : Diversification of economy and growth of non-oil GDP.


2004: 13.5 Non-oil GDP gr. 2004: 18% Non-oil Exp/Tot Exp

Diversification of non-oil economy; non-oil exports grow by more than 10% a year. WB estimates that the target is surpassed.

2005: 8% Non-oil GDP gr. 2005: 10% N-O Exp/Tot Exp 2005: 50% Non-oil Exp gr. 2006: 12% N-O GDP gr. 2006: 7% N-O Exp/Tot Exp 2005: 23% Non-oil Exp gr.


The target was achieved in all years since the beginning of the operation (N-O refers to "non-oil").

Indicator 3 : Public and publicly guaranteed external debt Value (quantitative or Qualitative)

2004: 18.5% of GDP Range of 20-25 percent of GDP

2005: 13.1% of GDP 2006: 9.2% of GDP

Date achieved 12/31/2004 12/31/2005 03/23/2007 Comments The target was achieved in all years since the beginning of the operation.

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(incl. % achievement)

(b) Intermediate Outcome Indicator(s)

Indicator Baseline Value

Original Target Values (from

approval documents)

Formally Revised

Target Values

Actual Value Achieved at

Completion or Target Years

Indicator 1 : Sustainable fiscal deficit (non-oil primary balance rel to non-oil GDP reported)


2004: -13%

Consistent with Long Term Oil Revenue Management Strategy (LTORMS)

2005: -13% 2006: -32%


The target largely achieved in all years, despite large spending increase in 2006. The LTORMS allows for accelerated spending in the early years of the oil boom but contains no specific expenditure targets. Macro concerns raised.

Indicator 2 : Strengthening of institutions for non-oil growth, financial services (FS), and accounting standards (AS).


FS: payment systems strategy prepared AS: Accounting Law prepared

FS: payment systems strategy adopted AS: Accounting Law enacted

FS: payment systems strategy adopted AS: Accounting Law enacted


Achieved fully.

G. Ratings of Program Performance in ISRs

No. Date ISR Archived DO IP

Actual Disbursements (USD millions)

1 06/28/2006 Satisfactory Satisfactory 18.77 H. Restructuring (if any) Not Applicable

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This Implementation Completion and Results report is being undertaken as part of the Bank’s internal requirement for evaluation of competed programmatic development policy loans. Usually, these reports are undertaken after the full series of loans is completed, and the accompanying reform programs have been implemented. In the case Azerbaijan’s PRSC, the ICR is being prepared about halfway through the reform program which is currently under implementation, because Azerbaijan has decided that it will not be necessary to borrow for additional PRSCs, given the absence of financing needs. Still, Azerbaijan’s reform program is being implemented with the support of the Country Partnership Strategy for FY07-FY10. Accordingly, this ICR reviews the PRSC operation through 2005, and assesses the progress being made towards the achievement of the medium term program objectives. The ICR proposes that additional reviews of the PRSC’s contributions to the medium term reform program is conducted alongside the interim and final completion reviews of the Country Partnership Strategy.

1. Program Context, Development Objectives and Design (this section is descriptive, taken from other documents, e.g., Program Document/ISR, not evaluative)

1.1 Context at Appraisal (brief summary of country macroeconomic and structural/sector background, rationale for Bank assistance) 1. The PRSC was part of the World Bank’s continuous structural reform dialogue with Azerbaijan which dates to the early years of adjustment in the latter half of the 1990s. The period prior to appraisal, which was initiated in May 2004, was marked by macroeconomic stability and progress in structural reforms. During 2000-2004, the economy grew at an average annual rate of about 12 percent, in contrast to the dramatic output drop the country experienced in the early part of the 1990s (accumulated to 60 percent), after independence. Between 2000 and 2004, output in agriculture and industry doubled, while output in key service sectors (e.g., transport, communications, and the social sectors) more than tripled. Foreign direct investment (FDI), which primarily supported the oil sector but had a trickle-down effect on the rest of the economy, was a large contributor to the economic expansion. FDI flows peaked at 32 percent of GDP in 2003; they supported the oil sector with deep water wells and construction of the Baku-Tbilisi-Ceyhan (BTC) pipeline. Overall, during the 2000-2004 period, Azerbaijan succeeded in maintaining macroeconomic stability despite the high FDI inflows by relying on generally sound fiscal and monetary polices, and in achieving low fiscal deficits (2.8 percent of GDP per annum), low inflation (2.6 percent per annum), and high non-oil growth (13.0 percent per annum).

2. Azerbaijan’s structural reform program was supported by the second Structural Adjustment Credit (SAC-II) in the period 2000-2003, a two-tranche operation. The first tranche was disbursed in March 2002 (upon effectiveness), and the second tranche was disbursed successfully in May 2003. While the preparation of the operation was lengthy, the operation closed successfully in December 2003. The SAC-II aimed to enhance the Government's ability to manage the country’s forthcoming natural resource boom efficiently, and to stimulate balanced economic growth, job creation and poverty reduction. In particular, the SAC-II (i) improved transparency in public finances, and the

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strategic priority setting of public expenditure to accelerate poverty reduction and economic growth; (ii) enhanced conditions for private enterprise and foreign investment, especially in the non-oil part of the economy; and (iii) supported reforms in the utility sector to improve access to reliable electricity, heating, and clean water for the population. At the strategic level, the SAC-II achieved three important outcomes for Azerbaijan’s future: (i) it led to the establishment of the governance framework of the Oil Fund and helped secure more than US$13 billion in FDI for the oil and gas sector; (ii) it led to the amendment of the Budget Systems Law beyond the credit’s conditionality, integrating Oil Fund spending into the Consolidated Budget; and (iii) it set in motion the preparation of the country’s poverty reduction strategy.

3. In 2003, the Government, in collaboration with civil society, prepared a poverty reduction strategy entitled the State Program for Poverty Reduction and Economic Development (SPPRED, Report No. 25593-AZ). The SPPRED aimed at maintaining economic stability, improving infrastructure, increasing access to basic social services, and increasing the income-generating opportunities for the poor. The first SPPRED progress report and its joint Bank/Fund assessment was presented to the Board in September 2004, and the second one in August 2005. In 2003, Azerbaijan also saw a defining political development which, among other things, had an impact on the preparation of the next adjustment operation (PRSC). The prolonged illness and death of President Heydar Aliyev late in the year; both had a temporary dampening impact on the pace of reform in the country. By November 2003, Ilham Aliyev had been elected President and Presidential Decrees had been issued in November 2003 and in April 2004, aiming to assure continuity in the reform program. Nevertheless, the transition in leadership had an understandable effect on the pace of reforms. While the appraisal of the PRSC was initiated in May 2004, it was completed in February 2005.

4. Rationale for Bank Assistance. At the request of the Government, the IDA prepared an SDR 13.1 million (US$20 million equivalent) Poverty Reduction Support Credit (PRSC) as the first operation in a three-year reform program to assist Azerbaijan in implementing the SPPRED (the country’s PRSP). The Operations Committee reviewed the PRSC and raised the issue of the appropriateness of adjustment lending to resource rich countries, including Azerbaijan. The Committee concluded that in the case of Azerbaijan adjustment operations in general (or combined with TA operations) were important instruments for supporting reforms and encouraging growth in the non-oil sector. While the lending amounts were relatively small, the operations themselves were thought to contribute to creating a forum for continuous policy dialogue on key issues and had proved effective in Azerbaijan (as in the case of the SAC-II) in advancing the reform agenda. Beyond the financial support, the role of the Bank was considered critical in reducing the non-income dimensions of poverty by improving the quality of education and health services, as well as supporting access to basic infrastructure, clean water and sanitation.

5. The PRSC, discussed by the Board in May 2005, was the first of two single tranche adjustment operations planned for the FY03-05 Country Assistance Strategy (CAS, Report No. 2579-AZ, dated April 29, 2003). The first PRSC comprised the base case scenario and was planned for FY05. The second PRSC –which did not materialize owing to lack of financing need– defined the high case scenario of the FY03-05 CAS.

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The PRSC operations were designed to successively support core structural reforms included in SPPRED. They followed on the reforms supported by the SAC-II and were accompanied by the second Institution Building Technical Assistance project (IBTA-II). The PRSC supported reforms, being a continuation of the reforms initiated by the SAC-II, were seen as an umbrella for supporting other Bank operations in Azerbaijan.

1.2 Original Program Development Objectives (PDO) and Key Indicators (as approved) 6. The objective of the three-year PRSC program was to support the Government’s SPPRED. The program aimed to enhance the Government's ability to manage the country’s natural resource boom efficiently, and to stimulate balanced economic growth and job creation, which were fundamental to poverty reduction.

7. The key indicators for the PDO are broad and are included in strategic goals 1 and 2 of the policy matrix. They include the growth of the non-oil economy, non-oil trade, indebtedness, inflation, institutional milestones in the efficiency and effectiveness of public resource use, and measures of development for the institutional development of the private sector. (Individual statistics are included in the Results Framework Matrix of the ICR.)

1.3 Revised PDO (as approved by original approving authority) and Key Indicators, and Reasons/Justification 8. The PRSC objectives and components remained unchanged throughout the operation’s implementation. However, the Government has decided that it would not need to borrow for additional budgetary support after 2006 given dramatic increases in oil prices in the current year, and the projected high prices in the medium term. The PRSC lending program was therefore suspended. However, the PRSC policy reform program continues to be supported by the new Country Partnership Strategy (presented to the Board, December 7, 2006), under a variety of analytical, technical assistance, and investment lending tasks (see Section 7.4, below). Given that the present ICR is being drafted as the ongoing medium term policy reform program continues to develop, it focuses on the actions taken prior to the Board presentation of the first operation and the subsequent progress in the reform agenda. The report assesses the likelihood that the medium term program objectives could be reached within a reasonable time frame.

1.4 Original Policy Areas Supported by the Program (as approved) 9. The components of the PRSC program covered the following policy areas consistent with the overall development objectives described above:

1. Managing the oil boom, with the objective of maintaining macroeconomic stability, avoiding “Dutch Disease” and facilitating non-oil growth, employment and pro-poor expenditures.

2. Generating jobs and sustainable non-oil growth, with the objectives of improving the business environment and the access to financial services, building SME support infrastructure, and stimulating agriculture.

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3. Improving access to services and infrastructure, with the objective of reversing the decline in social services, social assistance, and infrastructure.

4. Realizing the oil and gas potential, with the objective of addressing issues of transparency in the use of oil resources. This component complemented actions under component 1.

5. Implementing the SPPRED, with the objectives of supporting institutional capacity building to monitor SPPRED outcomes, and ensuring that the sustainability of the reforms remains in the forefront.

1.5 Revised Policy Areas (if applicable) 10. The policy areas under the PRSC were not revised.

1.6 Other significant changes (in design, scope and scale, implementation arrangements and schedule, and funding allocations) 11. No significant changes were made to the operation.

2. Key Factors Affecting Implementation and Outcomes

2.1 Program Performance (supported by a table derived from a policy matrix) 12. The PRSC was the first operation in a three series program. The planned disbursement date was May 31, 2005, but actual disbursement took place on January 13, 2006 given the lack of financing needs until late 2005, as a result of the unexpectedly high oil prices during that year. Declaration of effectiveness, which requires immediate disbursal, was timed to need financing needs.

First Operation in a Programmatic Series List conditions from Legal Agreement/ Program Document Status 1. The Borrower has maintained a satisfactory macroeconomic framework. Met 2. The Law on Investment has been submitted to the Parliament for its consideration. Met

3. The Borrower has adopted a national strategy for the development of payment systems for FY 2004-2006. Met

4. The Law on Accounting has been enacted. Met 5. The Borrower has made satisfactory progress in its implementation of an action program for the restructuring of SOCAR, which includes, inter alia: (a) adoption of international financial reporting standards; and (b) financial and corporate restructuring of SOCAR.

Met

6. The Borrower has developed for the utility sector: (a) a medium-term tariff policy; and (b) a regulatory framework which envisages, inter alia, the establishment of an independent regulatory agency.

Met

7. The Borrower has made satisfactory progress in implementing its Budget Systems Law, including: (a) approval of implementing regulations; (b) implementation of a training program for those involved in budget formulation and execution of the budget systems in the Ministry of Finance of the Borrower; and (c) preparation of a budget process manual based on the Budget

Met

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Systems Law 8. The Borrower has: (a) ensured that all the expenditures of SOFAR have been included in the consolidated budget, the MTEF and the PIP for FY 2004; and (b) published the account of SOFAR for FY 2003, which was audited in accordance with international standards of accounting.

Met

9. The Borrower has submitted the MTEF to the Parliament and prepared the PIP for FY 2005-2007. Met

10. The Borrower has: (a) transferred regulatory functions from the Caspian Shipping Company to the Ministry of Transport of the Borrower; and (b) published that a similar process will be undertaken in other transport sectors.

Met

11. The draft law on targeted social assistance has been submitted to the Parliament. Met

12. The Borrower has adopted a legal framework for public sector accounting in accordance with the international standards. Met

2.2 Major Factors Affecting Implementation: 13. The first PRSC was not restructured, nor was it ever at risk. There were also no major changes in its design. However, the second and third PRSCs were cancelled. The MoF and MED provided an effective oversight and coordinated activities of the other implementing agencies. Other major factors that contributed to the successful implementation of the PRSC included the following:

• Ownership and commitment of the Government to the reform agenda. The Government had committed itself to a comprehensive program through a balanced approach to economic reform as outlined in the SPPRED. The SPPRED presented a credible poverty reduction strategy consistent with the multi-dimensional nature of poverty reduction in Azerbaijan and the need for developing the non-oil sector. The Government initiated the preparation and implementation of this reform agenda with the strong backing of the President and Parliament (see Section 8.1 for details).

• Soundness of the background analysis was a major contributing factor in the identification and implementation of policy measures under the PRSC program. Key inputs for the preparation of this operation were provided through a variety of economic and sector analytical work. The Bank completed the Integrated Non-Oil Trade and Investment Strategy (INOTIS) in November 2003, the Public Expenditure Review in December 2002, the Poverty Assessment in June 2003, the Country Procurement Assessment Report (CPAR) in July 2003, and the Country Financial Accountability Assessment (CFAA) in September 2003. The PRSC also benefited from a PSIA on the impact of increases in electricity tariffs on the poor, completed in December 2004, and a comprehensive Energy Sector Report for Azerbaijan, completed in February 2005. Significant analytical work also continued through the implementation of the program and helped shape the course of the reform program. At the level of project lending, operations such as the Second Structural Adjustment Credit (SAC-II, completed in June 2003), and the Second Institution Building and Technical Assistance (IBTA-II) also contributed to the design and implementation of the PRSC, as did several sectoral investment projects (see Section 7.3).

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• Intensity of the policy dialogue and focus of the policy measures. A high level policy dialogue has been maintained during the preparation and implementation of the operation. The purpose of the dialogue was to maintain encouragement, cohesion and focus in the sectoral discussions of the entire policy matrix. The policy measures under each component also benefited from extensive consultation with the other donors and feedback from civil society organizations.

• Relevance of risks identified. The President’s Report adequately recognized the

risks relevant to the operation. These risks comprised: (i) the risk that non-reformers could delay key program elements; (ii) the financial management risk (the risk of spending pressures from high oil revenues); (iii) an implementation risk (lack of coordination of sectoral ministries of the Government’s agenda); (iv) a resource flow risk (risk of delays in oil production); and (v) a political and security risk (stemming from the need to share resources quickly). Unforeseen were the high oil prices of 2005 and 2006, as well as the delays in program implementation that were associated with the gradual process of consolidation of power by the country’s new President.

• Cancellation of PRSCs II and III, and operation under CPS. With the

cancellation of the second and third PRSCs, the Policy matrix was adjusted slightly to fit the format of a Results matrix for the CPS. As discusses in section 2.4 below, the team adjusted its mode of operation, from focusing on conditionality, to focusing on advising the Government through investment operations and through AAA tasks.

2.3 Monitoring and Evaluation (M&E) Design, Implementation and Utilization: 14. Monitoring and evaluation design arrangements were sound and helped to moderately strengthen the existing system and the capacity for implementation. The PRSC Policy Matrix and the Letter of Development Policy were the main reference documents for monitoring and evaluating the performance of the operation and the country’s structural reform program. The Policy Matrix defined the three-year outcomes of the operation and identified indicators for monitoring progress toward the development objectives.

15. The monitoring and evaluation of the PRSC Policy Matrix components was carried out in several ways:

• The IMF monitored the implementation of macroeconomic policy measures on a regular basis and through the Poverty Reduction and Growth Facility (PRGF). The Bank also used other relevant macro data to monitor and evaluate macroeconomic developments, resource allocation and use.

• The monitoring and evaluation of the operations of the Oil Fund was done through its annual audited accounts.

• Monitoring the implementation of the Budget Systems Law and the efforts to improve the public expenditures management process was undertaken through advisory work with both the Ministry of Finance (MoF) and the Ministry of

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Economic Development (MED) on the Medium Term Expenditure Framework (MTEF) and the Public Investment Program (PIP). A related area was Treasury modernization, which was monitored through the IBTA-II

• Monitoring and evaluating fiduciary responsibilities and progress in building the relevant capacities were carried out through the IBTA-II and other technical assistance (TA) (e.g., E-procurement).

• Sectoral reforms were monitored through regular Bank operations in Azerbaijan that had policy links to the PRSC program (e.g., Education Reform APL; Health Reform LIL; Pension and Social Assistance Project; and Financial Sector Assistance Program). Separate studies, and an expenditure tracking survey were also carried out to evaluate the trend and efficiency of health and education expenditures.

• Monitoring of the progress to be achieved toward the overall goals of poverty reduction and the MDG targets was carried out through the Household Budget Survey at the national level. A new Household Survey was carried out in 2004, during project preparation, establishing a new poverty benchmark which provided more reliable poverty figures and helped to identify a more realistic set of poverty indicators. Further evaluation of annual poverty trends was also carried out through a programmatic poverty assessment in 2006.

2.4 Expected Next Phase/Follow-up Operation (if any): 16. Despite the lack of financing need, the Government of Azerbaijan has indicated its desire for and commitment to implementing the medium term reform program supported by the PRSC (Letter of Development Policy [LDP] of April 1, 2005) in the new Country Partnership Strategy (CPS) (ref. Letter from the Prime Minister to the Country Director, dated February 13, 2006). The CPS supports continued implementation of the PRSC policy agenda through a host of complementary investment and capacity building TA projects (see Table 7 of the CPS), as well as programmatic TA and AAA tasks (see Table 6 of the CPS). The CPS will monitor the implementation of the reform agenda with a list of key progress indicators linked to the CPIA (see Table 8 of the CPS) and a results matrix (see Annex 1 of the CPS) which specifies in good detail the intended outcomes and implementation milestones for the CPS, in much the same way as the PRSC Policy Matrix. However, the conduct of policy dialogue under the CPS is qualitatively different that the policy dialogue under the PRSC. While under the PRSC policy dialogue was driven by conditionality, under the CPS, self-standing policy dialogue is undertaken with a two pronged approach: policy changes are embedded in the investment/TA projects, and in non-lending activities such as workshops, AAA. Both require the Bank to “prove every day” that it can provide top quality and timely know-how, and neither for the two approaches provide the “closure” that a fulfilled condition could bring policy-based lending. However reform ownership is expected to be even stronger under the CPS.

17. The CPS will follow up on four broad policy areas, as is discussed below. The policy support under each area mirrors the policy measures envisaged under the planned second and third PRSC operations (albeit with some adjustments in the timing, making

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up for the originally ambitious nature of the operation). The policy areas have been agreed following extensive consultations with the Government.

1. Improving the Quality and Transparency of Public Sector Governance. Continued macroeconomic stability will remain the top priority in this area. Since the IMF-supported PRGF came to its conclusion in 2005, the Bank has become more actively involved in monitoring and supporting the macroeconomic management policies of the Government in the medium term. Indicators on macroeconomic developments are monitored quarterly.

2. Supporting the Sustainable Growth of the Non-oil Economy. There is now

expanded access to financial services, and further reduction in the barriers to doing business in Azerbaijan. The next phase of the operation following PRSC1 would support: the development of rural infrastructure and services, an improved transit corridor and transit policy, improved coverage of the water supply system, improved reliability of the electricity and gas supply, and improved financial viability of the utility services.

3. Improving the Quality of and Access to Social Services. In this area the follow-

up operations would aim at: improving the quality and coverage of healthcare services, modernizing the education system, expanding the efficiency and coverage of the social protection system, and improving living conditions and economic opportunities for internally displaced people.

4. Improving Environmental Management. The follow-up operations would

support the clean-up of oil spills, as well as the better management of natural resources within the context of rural development and the conservation of ecosystems.

3. Assessment of Outcomes

3.1 Relevance of Objectives, Design and Implementation (to current country and global priorities, and Bank assistance strategy)

Relevance of Objectives

18. The PRSC program was prepared at a time when the country had established its credibility for sound macroeconomic management, was anticipating the advent of high oil revenues and had prepared the first line of institutional defenses for foreign currency inflows (the Oil Fund and the Budget Systems Law) under the SAC-II. The next policy objectives, which the PRSC program identified and addressed were: (i) managing the oil boom; (ii) Generating jobs and sustainable non-oil growth; (iii) improving access to services and infrastructure; (iv) improving Realizing the oil and gas potential , and (v) implementing the SPPRED.

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Relevance of Design and Implementation

19. The PRSC design was sound for the following reasons:

• It supported the poverty reduction strategy: The PRSC included a broad range of policy measures dealing with key structural problems which were of high priority and critical to the success of the SPPRED (e.g., improving social and infrastructure services).

• It was closely related to the CAS: The PRSC operation (and the dialogue surrounding it) was the pivotal forum around which the policy context for the CAS’s investment operations was determined.

• Its scope was comprehensive: It covered most of the important reform areas of the SPPRED, thus providing maximum support to reform initiatives.

• It provided additional sound features: Other positive aspects of the design included strong ownership, prior analytical work, a rich policy dialogue, and the identification of risks and their mitigation (see Section 7.2).

20. The PRSC design was optimistic on the timing of the reforms, for the first operation and for subsequent operations. While the first operation took almost a year longer to appraise than originally expected (completed April 2005 compared to a planned date of July 2004), in good part because political consensus had to be built in a new political environment following the illness and passing of Heydar Aliyev, the second year reforms were exceptionally heavy and their timing was unrealistic given the actual reform achievements in April 2005. Some examples of reforms that took longer than anticipated in the Policy Matrix are as follows: (i) the MTEF process was not implemented to its full potential, mainly because of weak institutional capacities at the central government level; (ii) the separation of commercial and regulatory functions of state-owned entities in the transportation sub-sector has been delayed; and (iii) auditing capabilities in the Chamber of Accounts are still generally weak.

21. The scope of the operation was broad. The operation aimed to be at the same time both strategic and opportune: on the one hand, substantial structural reforms remained to be achieved at the time of preparation, and still do, and, on the other hand, the advent of new oil was expected to allow only a very small window of opportunity. The three-year PRSC program did have a large number of conditions (a combined 134 conditions, triggers, and benchmarks for the three PRSCs, including 38 conditions for the first PRSC, of which 13 were core). In retrospect, experience with the implementation of the new CPS (that is based on the PRSC) suggests that the Government remains committed to the broad reform program (as discussed below), and thus it may not have been necessary to secure it in the broad PRSC matrix. It may have been more appropriate from the beginning (see discussion in Section 8.2) to have spaced out the reforms over a five-year period, instead of a three-year period, and to be more specific regarding some critical reforms, such as macro and budgeting, and the business environment (especially entry and exit).

3.2 Achievement of Program Development Objectives (including brief discussion of causal linkages between policy actions supported by operations and outcomes)

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22. The Government reform program supported by the PRSC, and its components, are discussed in detail in the Program Document (No.31978-AZ). Drawing on that document, the major accomplishments under each of the first year PRSC components, and the extent to which they contributed to the expected output/outcomes, are discussed below.

Strategic Goal 1. Managing the Oil Boom

23. The Government’s medium term program aims to: (i) avoid Dutch Disease and (ii) improve the efficiency and effectiveness of public resources. The implementation of these policy objectives (goals) is expected to allow the Government to achieve the following outcomes (results) by the end of the three-year PRSC program period: (i) maintain macro stability with low levels of inflation; (ii) continue to manage the oil revenues in a transparent and efficient manner; (iii) formulate the budget based on a medium term public expenditure framework and a PIP, through a more participatory process and through the adoption of program budgeting; (iv) increase transparency and accountability in the management of public resources by achieving greater transparency in financial reporting, accounting, and auditing; and (v) show improvement in the impact of expenditures on the welfare of the population, especially in health care and education.

Progress under the First PRSC toward Expected Program Output/Outcomes.

24. Azerbaijan was successful in maintaining macroeconomic stability in 2004 and 2005, a key element of the economic environment conducive to growth and poverty reduction. To a large extent, that has been due to the policy dialogue during the preparation of the PRSC. The country’s institutional architecture for managing profits from oil through the Oil Fund, with the assistance of the Budget Systems Law established under SAC-II, was largely successful. The country has also successfully handled large-scale FDI which flowed into the oil sector (oil FDI at the unprecedented level of US$4.0-4.6 billion in 2003-06 were equivalent to between around 20 and 50 percent of GDP). At the same time, with the increase in oil-related revenues in 2004 (including taxes from oil accruing directly to the budget, not the Oil Fund), public spending on the part of state-owned enterprises and the Government rose. Given the effectively pegged exchange rate, money supply growth accelerated causing double digit inflation in 2004. However, concerted actions of the National Bank of Azerbaijan and Government in early 2005, including introducing more flexibility to the exchange rate, brought down the inflation rate back into a single digit (5.4 percent) by end-2005. The economic growth in 2004 and 2005 was strong: overall GDP and non-oil GDP growth rates averaged 18.3 percent and 11.0 percent, respectively, for the two-year period. The non-oil growth was broad-based (as discussed in the next section). The real effective exchange rate (REER) depreciated in 2003 and 2004, and appreciated in 2005. Overall in 2005, it had not appreciated relative to 2002, and had appreciated 14 percent relative to 2003 (according to NBA estimates). The Manat has appreciated less than other currencies in the region since 2000. Azerbaijan’s non-oil trade grew at 24 percent a year in both 2004 and 2005, and is expected to have grown at 40 percent in 2006; non oil merchandise exports grew at 50 percent in 2005, and had grown at about 30 percent a year in the third quarter of 2006 (year in year). External debt has remained very low. Azerbaijan’s performance under the IMF program (PRGF) ended satisfactorily in May 2005. The country successfully ended

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the 2004-2005 period with a 20.6 percentage point reduction in the poverty rate, which is representative of the gains made in urban and in rural regions (see Table 3).

Table 1: Key Macroeconomic Outcomes Compared to PRSC Projections, 2003-2006

PRSC ICR March 2007 PRSC MoP May 2005 2003 2004 2005 2006 2003 2004 2005 2006

Real GDP growth 11.2 10.2 26.4 34.5 11.2 10.9 14.8 20.5Real Non-oil GDP gr. 14.9 13.6 8.3 12.1 15.5 13.4 10.3 8.0Inflation (CPI, eop) 3.6 10.4 5.4 11.4 2.2 6.7 7.6 5.0Gross Inv., %GDP 53.2 58.0 40.7 27.7 51.0 63.0 41.0 34.0Resource Bal, %GDP -23.5 -23.9 10.0 29.3 -24.0 -24.4 -4.4 13.0Cons Fiscal Bal, % GDP -0.8 1.0 2.6 0.1 4.4 5.1 6.2 6.9Cons Fiscal Bal ex OF, %GDP -4.2 -2.5 -2.2 -5.4 -2.9 -0.9 -1.6 -3.2M2, %GDP 7.3 8.0 6.4 12.1 14.5 17.9 17.7 14.6External Debt, % GDP 24.0 22.8 14.2 10.1 23.5 18.1 14.9 11.8Oil Price 28.9 37.7 53.4 64.3 28.9 37.7 54.0 56.0 Memo items Cons Gov Expend, %N-O GDP 40.8 37.7 40.8 63.4 .. .. .. ..Ext CAB, % GDP -27.8 -29.8 1.3 18.7 .. .. .. ..M2, gr, rate 28.0 31.9 16.5 168.3 .. .. .. ..Exchange rate, REER (NBA) -13.0 -1.2 15.3 4.0 .. .. .. ..Exchange rate, AzN/USD (eop) 0.985 0.981 0.918 0.871 .. .. .. ..Note: Differences between “May 2005” and “March 2007” for 2003 and 2004 reflect revisions to the data. The years 2005 and 2006 were forecasts in May 2005. Source: World Bank (PRSC Program Document); Azerbaijan authorities; Bank staff estimates.

25. In the medium term, the prospects for macroeconomic stability and poverty reduction are good, although the Government needs to recognize increasing risks. In 2006, the Government effectively initiated an aggressive medium term effort to repair and rebuild dilapidated infrastructure that is proving a hindrance to non-oil growth and to poverty reduction, financed by rising oil profits to the Oil Fund, and oil-related taxes to budget. Consolidated government expenditures increased by 81 percent in nominal terms in 2006 compared to 2005; increases in 2007 and beyond are expected to be significant, although less pronounced. The priority in the 2006 budget, as it was in the budgets of the previous two years, has been investments in the energy sector and in human development (absorbing about 50 percent and 25 percent of investments respectively). The priorities are reasonable, given the comparatively low levels of services. However, the rapid pace of the increase in public spending has been responsible for the inflationary pressures building up by late 2006 and in early 2007. The concern is that these pressures may cause much higher rates of inflation in the medium term, because of lags in the effects of monetary policy and because inflationary expectations will be built into the economic agents’ decisions. To date, partially owing to de-dollarization (due to the issuance of the New Manat and the greater confidence in the currency), high rates of inflation have been avoided. The ability of Azerbaijan to control inflation in the short term will depend on the pace of the oil-financed public spending and the rate of nominal exchange rate appreciation which the Government will choose to maintain. The expenditure incidents in 2004 and in 2006 raise questions as to the effectiveness of existing budgetary institutions

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to monitor economic developments and to pace public spending increases in a manner consistent with the absorptive capacity of the economy. The country’s ability to ameliorate Dutch Disease also depends on the quality and type of public expenditures and the pace of the entire structural reform program: should public expenditures (and structural reform policies) succeed in raising productivity, to overcome the inevitable appreciation of the real effective exchange rate that comes from increases in aggregated demand which manifest themselves in resource rich economies, then Dutch Disease will be avoided or its impact mitigated.

26. The results of Azerbaijan’s growth on poverty reduction have been impressive. Poverty dropped at unprecedented rates (see Table 2) from 2002 (the earliest comparable measures) to 2005. Results from the programmatic poverty assessment suggest that poverty dropped by 16 percentage points between 2003 and 2005.

Table 2: Estimated Number of People Living in Poverty in Azerbaijan, 2003–05 (percent)

Total Baku Non-Baku Urban Rural poor very poor poor very poor poor very poor poor very poor 2003 39.7 22.1 34.8 19.3 46.0 27.9 38.4 20.0 2004 28.5 13.4 18.6 8.0 35.4 19.0 29.6 13.0 2005 24.0 9.2 14.7 6.6 27.2 11.9 26.9 8.9

2004-05 -4.6 -4.3 -3.9 -1.4 -8.2 -7.1 -2.7 -4.1 2002-05 -20.6 -17.7 -26.8 -19.1 -21.5 -19.6 -16.8 -15.7

Sources: Household Budget Survey and staff estimates. 27. Oil revenue management has been transparent and efficient. Azerbaijan has been managing its oil wealth largely in line with the Long Term Oil Revenue Management Strategy (LTORMS), which states that the oil wealth will be managed to assure constant real spending from oil resources, although, during the early years, spending may be higher in order to establish the foundations for future growth (the LTORMS does not contain discrete expenditure targets). The Government’s higher spending levels in the 2005 and 2006 budgets reflect the higher spending indicated in the LTORMS, although, again, the magnitude of the 2006 spending increases may not have been anticipated under the LTORMS. Azerbaijan’s Oil Fund has been managed in a highly transparent manner and has received international recognition. The Oil Fund published quarterly reports on the internet (www.oilfund.az), and its annual financial statements have been audited by a reputable international auditor for 2003 (as part of the PRSC conditionality), and also of 2004 and 2005. Azerbaijan is also a leading proponent of the Extractive Industries Transparency Initiative (EITI), being the only country that has already published four EITI reports. The report “Eye on EITI” published by the NGOs Publish What You Pay and the Revenue Watch Institute showed that, out of the 21 countries endorsing EITI, Azerbaijan is one of only two countries that have taken the most essential EITI steps and have published fully audited and reconciled EITI reports. In Oslo, in October 2006, Azerbaijan became a board member of the multi-stakeholder board established to manage EITI at the international level and to oversee the future operation of EITI. The country’s membership on the IAB Board of EITI bodes well for the future sustainability of sound Oil Fund management in Azerbaijan. Azerbaijan could

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next move to establish similar quality in the transparency into the resource flows of SOCAR.

28. Improvements in budget management have been too slow, compared to the accelerated pace of public spending. On the budget management side, the Government made steady progress in 2004 and 2005: in 2004 it included the Oil Fund expenditures as part of the consolidated budget for 2004; in 2005, it submitted an indicative MTEF for the 2005 budget and prepared the PIP for 2005-2007 as part of the PRSC conditionality, and also approved the Long Term Strategy for the Management of Oil and Gas Revenues. The Government also adopted a new budget classification system within the framework of GFS Manual and trained the Ministry of Finance staff in the budget formulation and execution. Government also adopted new regulations for the implementation of the Budget Systems Law in 2005. In subsequent years (2006 and 2007 budgets) the consolidated budget has been maintained, as has preparation a nominal MTEF, and a PIP, although the PIP lagged in timeliness. In 2006, Ministry of Economic Development took significant steps in restructuring the Ministry and adding a position of Deputy Minister for Macroeconomic Policy, and in strengthening the Ministry’s Center for Economic Research. The new structure is aimed at strengthening capacity in macroeconomic management. Notwithstanding these important institutional changes, further steps are needed to improve the preparation of the MTEF, including preparation of the macro framework at the Government level (involving the Ministry of Finance, the Ministry of Economic Development, the Oil Fund, and the National Bank on an advisory basis) --these have lagged thus far. In 2005, the Government prepared an early draft of the Budget Process Manual, and a draft Public Investment Manual was prepared in 2006; but the manuals need to be finalized during 2007, in preparation for the 2008 budget cycle and to include more advanced steps in program budgeting.

29. The Government has made moderate progress in financial management. Since the financial accountability framework required substantial strengthening to ensure transparency and improved governance, the Government embarked on a program to strengthen the auditing capacities in the Chamber of Accounts. It also adopted a legal framework for the introduction of public sector accounting based on international public sector accounting standards (IPSAS). Despite the recent advances, however, progress has been slower than anticipated in increasing the scope of activities of the Chamber. Procurement practices also need to be strengthened, despite the progess made with e-procurement to date. In the area of budget management, line ministries do not as yet participate fully in the MTEF process. Problems also remain with respect to reporting and expenditure control, which requires developing a strong internal audit function with the enforcement of implementation. Experience in other countries has shown that these reforms usually take time to implement. In Azerbaijan, there is a greater urgency than in most countries, as natural resource flows are expected to increase in the immediate future. Nevertheless, reforming institutions and training human resources cannot be easily leapfrogged. The impact of public spending on the welfare of the population is generally considered to be positive, although, at this stage, it is mostly due to the pro-cyclical nature of public spending, which is responsible for some of the jobs created, and to the targeted social assistance scheme, rather than to expenditures on health and education, where reform dialogue is picking up in early 2007. It must be noted, however, that

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within the education sector, the Government’s free text book policy is considered successful in that textbooks have reached schools in all parts of the country.

Strategic Goal 2. Generating Jobs and Sustainable Non-oil Growth

30. To foster non-oil sector growth and job opportunities, the Government with the support of the PRSC focused on: (i) improving the environment for increased non-oil trade, private sector development and investment; and (ii) improving financial intermediation and enhanced governance in the financial and corporate sectors. It was anticipated that with the implementation of these polices the Government could achieve the following outcomes by the end of the three-year PRSC program period: (i) rapid and broad-based economic growth with employment generation; (ii) more developed non-oil exports based on WTO compliant legislation; (iii) increased competition in the banking sector and increased access to credit and financial services; (iv) improvement in the quality of audited financial statements from the corporate and financial sectors; and (v) lessening reliance on collateral-based lending.

Progress under the First PRSC on Expected Program Output/Outcomes.

31. Azerbaijan’s non-oil sector has been showing robust growth while employment has been increasing, despite the upward adjustment of wages from the low historical base. Real non-oil sector growth averaged 12.5 percent a year during 2002-2006; in 2005 and 2006, the rate of growth of the non-oil sector excluding oil-related transportation (which has become important only since 2006), was approximately 8 percent for each year. Non-oil merchandise exports relative to non-oil GDP increased from 6.0 percent in 2002 to 10.2 percent in 2006, while non-oil merchandise imports increased from 34.6 percent of non-oil GDP to 38.2 percent in the same time period. According to official statistics, between October 2003 and April 2006, 381,000 new jobs were created in the formal sector, and net employment is estimated to have increased by more than 100,000 during the period. The main non-oil growth areas for 2003-2006 are presented in Table 3: the service sectors and construction show the largest growth rates, while agricultural growth shows the lowest in 2006. Agriculture employed 40 percent of the population in 2003; while employment in the sector has been growing, its share of total employment fell to 39 percent in 2005. At the same time, the economy-wide minimum wage rose by almost 40 percent between 2003 and 2006, while the average nominal wage grew by about 80 percent from 2003; by end 2006, the minimum wage stood at about US$40/month while the average wage stood at about US$162/month. Azerbaijan’s wages are higher than some of its neighbors, but lower than Ukraine, Kazakhstan and Russia. Azerbaijan’s real effective exchange rate (REER) has also appreciated less since 2003 than in Kazakhstan Georgia, Ukraine and Russia. In all, the prospects for Azerbaijan’s non-oil sector remain strong, although caution needs to be exercised in two areas: (i) a very close eye needs to be kept on productivity in the short to medium term, so that it offsets the erosion to competitiveness that may stem from the appreciation of the real effective exchange rate; and (ii) domestic markets will have to open up (ref. the business environment discussion), so the boost to aggregate demand originating in the oil sector and in oil-financed public expenditures gradually is substituted by the non-oil economy.

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Table 3: Non-oil GDP Growth Rates, 2003-2006

2003 2004 2005 2006 Non-oil GDP 14.9 13.6 8.3 12.1 Non-oil industry 22.2 9.9 14.8 4.1 Agriculture 5.6 4.6 7.5 0.9 Constructions 61.0 41.9 2.0 8.5 Services 8.0 8.9 9.6 18.2 Transport (incl oil transport) 7.4 4.5 11.6 49 Communication 28.0 35.8 36.0 24.0 Wholesale, retail and repair 10.9 13.0 13.2 13.5 Hotels and restaurants 31.5 43.0 26.1 13.5 Social and other services 3.3 4.0 1.6 5.6 Note: Oil related transportation services have been typically included in Azerbaijan’s non-oil GDP estimates, but their contribution has been considered small before the opening of the BTC in 2006. Non-oil GDP growth, excluding oil related transportation services is estimated at about 8 percent in 2006

Source: Statcom.

32. Azerbaijan’s progress in the institutional aspects of the business environment has been moderate, but the actual conditions on the ground may well have deteriorated. The country’s ability to develop the non-oil economy is contingent on creating a fair business environment for the private sector. The Government drafted a unified Investment Law and a Competition Code to encourage investment and to protect businesses against unfair competition; both laws are being presented to Milli Majlis in the Spring 2007 session. Notwithstanding the drafting of these laws, and the passage of a State Program against Corruption, the Business Environment and Enterprise Performance Survey (BEEPS) for 2005 found that 14 out of 21 survey indictors had deteriorated relative to 2002, and 7 of those indicators related to anti-competitive practices, licensing, corruption, customs and trade regulation, and taxation had deteriorated significantly. In the Doing Business Survey 2006, Azerbaijan’s ranking improved by one point overall relative to 2005; within Easter Europe and Central Asia, it scores better in 15 measures and worse in 6. The survey does shows that the country’s administrative procedures for licenses and permits, customs and trade regulations, and tax administration to be worse than the region –these are important constraints that Azerbaijan needs to address if it is to diversify the non-oil economy, and increase capacity, and productivity, through greater competition. Both surveys suggest that there are substantial obstacles to the business environment, that could well hinder the development of the non-oil economy and prevent Azerbaijan from reaping well-deserved gains from the current infrastructure build-up.

33. The Government is making a significant effort to join the WTO. On trade, the Government has ensured that standards, policies, and practices are in line with WTO mandates. It has increased access to regional markets and the EU, implemented bilateral trade and transit agreements, and intensified dialogue on transit with neighboring countries, including through the realization of a pilot scheme for container trains in transit. The Government has prepared a draft transport and transit strategy, which is being reviewed. Six protocols have been prepared to amend the TRACECA Multilateral Agreement, which governs transit cooperation among 12 countries in the region. These

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modifications, which require consensus approval by all concerned countries, are expected to be submitted for official comments by June 2007.

34. Banks’ solvency and the access to financial services have improved, according to program objectives. Azerbaijan has made progress in the development of financial infrastructure geared to create better payment conditions and to move away from the cash economy, as well as to improve access to financial services outside of Baku. This has led to financial deepening, as credit to non-oil GDP as increased gradually from 12 to 21 percent between 2003 and 2005. For 2006, the ratio reached 29 percent which raises some concerns. The Government adopted a new Payment System Strategy, the Batch Payment System was completed and a national Settlement and Clearing System for E-payment instruments was completed by the NBA and sold to the Banking Association. This process was matched by a significant increase in the quantity of ATM cash machines, the number of which doubled between 2004 and 2006, reaching 1029 in the first 10 months of 2006. Consequently, there was a significant increase in cards and card payment transactions, as all pension payments are now made electronically, and the pubic and private sectors are increasingly making salary payments electronically. Another new element of the financial infrastructure is a credit risk register, the use of which has resulted dramatic reduction of non-performing loans and better access to credit for the SMEs and households. The next large financial infrastructure project is a creation of a centralized portal for utility payments (APUS), which is expected to increase competition in utility payment services as well as improve the collection rates. The feasibility study has been completed and the system is expected to be operational by early 2008. In addition, a new Banking Law and a new Law on the National Bank were enacted to improve the legal framework for banking. Increased competition and improvements in financial infrastructure resulted in reduced interest rate spreads: rates on deposits increased by about 1.5-2.5 percentage points depending on the currency and maturity of the deposit, while the interest rates on Manat loans increased by about 0.5 percentage points between 2003 and end 2005, depending on the maturity. Nevertheless, the sector remains concentrated. The market share of International bank of Azerbaijan (IBA, mixed ownership) and Kapital Bank (KB, fully state owned), dropped to 54 percent by 2005 from about 60 percent in 2003. At the same time, the two banks’ share in credit of the banking system (excluding non-bank financial institutions) fell from 49 percent in 2003 to 46 percent in 2005. The Government’s recent decision to double the KB capital by selling additional shares in an auction to eligible investors is encouraging, and, pending the success of the auction, is expected to increase competitive pressures. This could lead to further improvements in the quality of banking services and cost reductions.

35. The legislative framework for financial reporting, accounting, and auditing in the public and private sectors is improving. The Implementation Decree for the new Accounting Law was passed in February 2005; the Law covers International Financial Reporting Standards (IFRS) and National Accounting Standards (NAS). The Cabinet of Ministers (COM) has determined a list of 20 public interest entities (which includes the largest state-owned enterprises) for accelerated implementation of IFRS before the deadline prescribed in the Accounting Law (2004). To prepare themselves for the implementation of the law, which --ambitiously-- requires that by January 1 2008, all public interest entities need to have adopted IFRS, the country’s largest state-owned enterprises have commenced the training of their accounting personnel. The Government

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has also made significant progress with NAS. The Cabinet has issued a resolution with a timetable for NAS implementation for commercial, budgetary and non-governmental organizations. To date, the majority of the 15 standards for commercial organizations due to be implemented by end-2006 have been drafted; the next step is discussion, publication, and comment from the Advisory Council for Accounting. The remaining standards for commercial organizations are expected to be completed and implemented by end-2007. NAS for budgetary organizations and non-governmental organizations are expected to be developed and implemented by end-2008 according to the Cabinet of Ministers’ resolution. The implementation of IFRS by the country’s SOEs is a critical step towards improving the governance and the financial viability of the utility and transportation sectors, which pose the largest development bottlenecks for the non-oil economy.

Strategic Goal 3. Improving Social Services and Infrastructure

36. At the time of appraisal, the quality of the service delivery of utilities was very poor owing to low levels of investment, despite the Government subsidies to the sector, which aimed compensate in part for low tariffs, non-payments and poor management of the SOEs. The major issues with the utilities sector were restructuring problems and low collection rates. Similarly, the telecommunications sector was operating at below its potential. The delivery of social services to the most needy was also a major issue, as was the poor quality and inefficient use of resources in the education sector. The health situation was in no better shape, suffering from inadequate access, poor service provision, and highly fragmented primary health care services. Overall, major reforms were needed to improve the efficiency and delivery of social services, the targeting of benefits, and the protection of the vulnerable.

37. To begin addressing these issues, the PRSC supported the Government in: (i) improving utility services; (ii) improving infrastructure services; and, (iii) improving social services. It was anticipated that with the implementation of these polices the Government could achieve the following outcomes by the end of the three-year PRSC program period: (i) better utility services by economically viable companies regulated by an independent regulatory agency and with targeted subsidies for the poor only; (ii) transport and telecommunications sectors open to new and growing businesses; (iii) improved access to general education, especially for the poor and the IDPs; (iv) increased access to and improved quality of health care services, and improved health care financing and allocation of resources in the health sector; (v) improved services to pensioners and poor families receiving social assistance benefits, as a result of computerized record keeping, payments and management information systems, as well as modern techniques for assessing benefits eligibility (field visits, community monitoring, etc.); and (vi) the targeting of about 50 percent of the social benefits to poorest segments of the population.


38. Good progress is taking place in the utilities sector. The Government’s policy in the medium term is to render the utilities financially viable, operating under the framework of an independent regulator. To date, Azerbaijan has implemented significant

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increases in tariffs and has also made progress with institutional issues. On January 8, 2007, the Tariff Council increased the overall price of electricity by 212 percent, the price of water by 100 percent, and the price of gas by 50 percent, although increases for individual client categories vary. Over the duration of the PRSC program, gas prices have cumulatively increased sixfold, water prices fourfold, and electricity prices threefold. The most recent increases may possibly place the electricity and gas utilities within reach of cost recovery, although similar claims cannot be made yet for the water utility as billing norms were reduced and the utility’s electricity bill was tripled. Currently financial viability of the utilities by 2010, an important goal of the Medium Term Tariff Policy, seems to be within reach, although much will also depend on progress being made in billing and collections. The Government has advised the utilities to introduce metering to all customers. Azersu, the water utility, has increased metering and collections. At the institutional level, the Government has moved ahead in introducing IFRS for utilities and in strengthening the Tariff Council as the precursor to a future Utility Regulatory Agency. It has also operationalized the Medium-Term Tariff Policy to reach full cost recovery in the energy and water sectors by 2010. The phased Medium Term Tariff Policy is indeed a critical framework document which recognizes the efficiency challenges facing utilities and commits the Government to increases in tariffs but also to the elimination of subsidies. The budgetary institutions and the state-owned enterprises became current with their utility payments for the 2005 budget year. However, the financial conditions in the utility sector remain weak; in nominal terms, energy subsidies decreased by about 20 percent in 2005 and increased by about 40 percent in 2006 owing to rising oil prices, while and are budgeted to drop significantly in 2007. According to the Doing Business Survey 2005, the percentage of firms seeing electricity as a problem declined from 30 percent in 2002 to 25 percent in 2005. Collections in the power sector increased moderately from 54 percent in 2003 to 56.4 percent in 2005, but the collection rates in both the water sector and the gas sector declined in 2005. In July 2006, the President issued instructions for collection rates to increase to 100 percent by end-October 2006. Although this ambitious target has not been met, substantial progress had been made by end-September 2006: gas reached 83.1 percent, from 40.9 percent in 2005; and water reached 69.8 percent, compared to 32.7 percent for January 2006. In the future Azerbaijan needs to monitor quality of services in utilities.

39. The Government has also moved ahead in the telecommunication sector, while reforms in the transport sector are taking longer. Early actions in telecommunications, prior to the PRSC program, included the privatization of the Bakcell mobile phone company in December 2003. Under the PRSC program, the Government began separating regulatory and commercial functions and established the National Communications Regulatory Authority within the Ministry of Telecommunications. It approved a new Telecommunications Law in June 2005, and the State Program (E-Azerbaijan) on the development of information and communications technologies in the Republic of Azerbaijan for the years 2005-2008 was approved by the President in October 2005. In the transport sector, the Government started the separation of the regulatory and commercial functions: it prepared a new regulatory framework for the air, rail, and maritime sectors. In addition, plans were prepared for the national traffic safety plan and the functional classification of the road network, as well as for a Pavement Management System to prioritize road projects. The Government transferred the regulatory functions that had been exercised by the Caspian Shipping Company to the

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new Maritime Administration under the Cabinet of Ministers. Also a Civil Aviation Administration was recently (December 2006) established by Presidential decree. However, similar structures for railways have not yet been created, although it is under preparation. The implementation of the regulator structure in the maritime sector is in question.

40. Progress in education sector reforms is modest. In the education sector, the PRSC supported programs that complemented reforms in the IDA Education APL. These reforms covered critical areas such as quality improvement (through curriculum reform, teacher development, and provision of textbooks and reading materials); efficiency and financing improvement (through budget reforms, rationalization, and school improvement); equity and access to general education (through school grants in selected less advantaged districts); and strengthening of management (through student assessment, management information systems, planning, and monitoring capacity). The Bank and the Government completed a study on education finance and expenditure (2004) and a public expenditure tracking study (2006). The Government successfully implemented a new textbook policy including the financing free-of-charge of core textbooks to all grades. The Department for the Assessment of Pupils’ Achievement was established to reform curriculum, textbooks and educational management. The gross primary education enrollment ratio (grades 1-4) increased from 98.6 percent in 2001 to 102.4 percent in 2003. The upper secondary enrollment rate rose from 43.2 percent in 2001 to 70.5 percent in 2003. Higher education enrolment increased from 13.4 percent in 2001 to 18 percent in 2005. Over 90 percent of children in grades 1- 5 were provided with free textbooks in both 2003 and 2004. A critical reform that was partially implemented in 2005 and in 2006 was aimed at the financial independence of some pilot schools. The 2007 budget includes the introduction of a per capita funding formula for schools and the full implementation of financial autonomy for pilot schools, although the modalities for the latter have not been fully worked out and the implementation may therefore be delayed.

41. The health sector is actively planning a full-fledged reform. In the health sector, the PRSC complemented the IDA Health Reform LIL project. The planned reforms included improving access to and quality of primary health care services in selected districts, and building up the capacity in the Ministry of Health to learn from the ongoing process of PHC reforms and to design and carry out further reforms. Within the scope of the Health Reform LIL project, the Government completed a Health Financing Study which among other things concluded that the majority of the burden of meeting the costs of health care falls on the Azeri citizens through out-of-pocket expenses. The Government also issued a health policy and reform white paper with a set of diagnostics and recommendations for the health sector. The number of patients at renovated rural PHC facilities in the target districts rose by 65 percent. Important next step decisions for the near term are the preparation of a map for new facilities and the determination of the options of the financing packages.

42. The Government has made progress in the area of social protection. The PRSC program, together with the IDA Pension and Social Assistance Project, supported a range of actions, which included modernizing the social insurance benefits administration, strengthening the financial management of the State Social Protection Fund (SSPF), and

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moving the administration of all social insurance benefits from the enterprises to the SSPF. In an effort to improve the living standards of the elderly, the minimum pension was increased from AZN 25 per month to AZN 30 in April 2006; AZN 35 in October 2006; AZN 40 in January 2007 and AZN 50 in February 2007. Amendments to the Social Insurance Law clarified the functions of the SSPF to maintain the unified collection of social security contributions for social protection in a more transparent and efficient way. The SSPF now regularly modifies the existing procedures and the transfer of the administration of social insurance benefits from the enterprises to the SSPF was completed in early 2006. The Pension Reform Concept note has been approved by the President, and consequently a new Pension System Law was approved at the end 2005. The Law significantly streamlined the pension system and introduced links between benefits and contributions. The SSPF has almost completed modernization of its administration, including introduction of computerized individual record system.

43. The Government has made significant progress in social assistance. With regards to social assistance, the Government has enacted a framework Law on Targeted Social Assistance, has consolidated various benefits into a single targeted family poverty benefit, has modernized the capacity of Ministry of Labor and Social Protection of the Population (MoLSPP) to administer social assistance benefits through an automated management information system, has implemented a targeted family poverty cash benefit, and has implemented an extensive public information campaign and provided sufficient budget resources to cover the poverty gap. In June 2006, when the program of targeting social assistance was launched, 30,000 households with more than 150,000 members received assistance. By end-2006, 50,000 households with 250,000 individuals were benefiting from the program. The Government estimated that in 2007 the number of beneficiary households would increase to 170,000 (in relation to the utility tariffs increase) and, accordingly, sufficient resources were budgeted.

Strategic Goal 4. Realizing the Oil and Gas Potential

44. The State Oil Company of the Azerbaijan Republic (SOCAR) manages all national oil and gas production outside of the Production Sharing Agreements (PSAs), while participating in PSAs as a shareholder. At the time of PRSC preparation, the critical tasks for SOCAR were to implement the January 2003 Presidential Decree aimed at strengthening its management (with improved accounting standards and the introduction of management information systems), to separate core and non-core functions, and to separate commercial and non-commercial functions. Other major issues dealt with the pollution legacy dating back to the Soviet era. To address these issues, the PRSC supported the Government in: (i) improving the financial and organizational structure of SOCAR; and (ii) addressing environmental responsibilities. It was anticipated that with the implementation of these polices the Government could achieve the following outcomes by the end of the three-year PRSC program period: (i) a commercialized SOCAR with financial transparency according to IFRS and ISA, a better organizational structure concentrated on the core activities, and improved balance sheets; (ii) the separation of non-core activities of SOCAR; and (iii) the beginning of the environmental cleanup process, which would absorb labor made redundant by the reorganization.

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45. SOCAR has made some progress in improving its financial and organizational structure. Under the PRSC, SOCAR has made some progress toward the implementation of the 2003 Presidential Decree, by hiring international advisers to implement the company’s restructuring and by initiating the move to IFRS. SOCAR has also installed a comprehensive, computerized Management Information System (MIS). Further actions on the separation of core and non-core businesses have followed the December 22, 2005, Presidential Decree, which established the Social Development and the Security Departments of SOCAR, bringing together the like functions of the company’s subsidiaries. In September 2006, three more departments were established: Environment, Gas Operations, and Information Technology and Communications. The creation of these five departments (social, security, environment, gas, and IT) allows SOCAR’s remaining enterprises (Azneft, oil pipelines, Geophysics, two refineries, deep water jacket factory, marketing, foreign investment) to focus on their core services. The next steps for SOCAR are to transfer the assets and services of non-core areas (i.e. under social department) to local specialized entities (i.e., all transmission lines already transferred to Barmek; water, electricity, and gas transferred to Baku Executive Power) and to implement IFRS by July 1, 2007 in five of the core enterprises. This suggests that the three to four years originally foreseen for SOCAR’s implementation of the 2003 Presidential Decree will need to be extended.

46. Government has taken several steps to address environmental responsibilities, although clean-up actions are pending. To address environmental concerns and to minimize any eventual negative environmental impacts from the operations of the oil industry, the Government prepared a draft National Oil Spill Response Plan which has to be formally adopted. Moreover, a comprehensive detailed action plan for improving the environmental situation in Azerbaijan (2006-2010) was decreed in September 2006. The action plan details improvements mainly in the Absheron Peninsula (Baku Bay, Bibiheybat area etc.) and some other parts of Azerbaijan. For each of these areas, the action plan identifies the responsible implementing agencies and details the actions, which cover cleaning up wastewater, improving the natural qualities of water and air, reconstructing sanitation networks, and reclaiming polluted soil. Two other sets of measures that are included in the plan relate to the improvement of legislation and the addressing of general ecological problems. The action plan envisages adoption and/or improvement of environmental norms and standards for the cleaning up of brown fields based on the assessment of health risk. In addition, the Government prepared a preliminary map of industrial contaminated sites and conducted an environmental audit of SOCAR and adopted regulations for corporate compliance with environmental standards. To further strengthen the push for the environmental clean-up, the President appointed the Ministry of Environment as the lead agency responsible for monitoring of the implementation of the Absheron Peninsula clean-up.

Strategic Goal 5. Implementing SPPRED: Outcomes, Monitoring and Institutional Capacity Building

47. At the time of the PRSC the overall monitoring framework for the SPPRED had been put in place, but public access to information was limited. It was also recognized

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that the civil society needed a greater ability to organize and participate in the monitoring of the SPPRED. Consequently, the program focused on: (i) strengthening the capacities to improve performance monitoring; and (ii) strengthening oversight and participation. It was anticipated that with the implementation of these polices the Government could achieve the following outcomes by the end of the three-year PRSC period: (i) good performance monitoring and evaluation systems for SPPRED objectives with feedback to the policy and budget formulation process; and (ii) further strengthening of the civil society and participatory processes.


48. The SPPRED had contributed to developing a culture of consultation for public polices. In order to strengthen the monitoring of the SPPRED, the Government has strengthened the capacities of the SPPRED Secretariat (which falls under the Ministry of Economic Development) to monitor outcomes, and annual reports have been produced. At the same time, regular Household Budget Surveys were conducted and published, and with substantial technical assistance from the World Bank (Programmatic Poverty Assessment), high quality technical analysis has been conducted and published. Despite the availability of capacity and indicators, the Government has made only moderate progress in (i) integrating the SPPRED Secretariat into the annual budget process (as has been difficult for many countries), and (ii) improving the links between indicators and the budgetary process to create an effective feedback loop during the budgeting cycle. However, in 2007 the Government took significant steps to strengthen the integration of the SPPRED Secretariat and regional programs into the core functions of the Ministry of Economic Development by restructuring the Ministry (in 2006) and creating a new position of Deputy Minister whose main responsibilities include regional programs. Drafting of the phase II SPPRED, for 2007-2015 has been competed, but issuance is pending.

49. Significant gains have been made in the registration of NGOs since 2005. The Law on Legal Entities Registration and Registry was adopted to ensure the smooth registration of NGOs and their participation in outcome monitoring. To date, approximately 1064 NGOs have been registered since the adoption of the Law. Apart from simplification of the internal procedures, the Ministry of Justice undertook some important structural changes, uniting two departments of Notary and Registration into one Unit and strengthened the staff of the new unit. With the active participation of NGOs in monitoring oil revenues through EITI, as well as in monitoring the national budget and other issues, civil participation in the monitoring of expenditures is likely to increase.

3.3 Justification of Overall Outcome Rating (combining relevance, achievement of PDOs) Rating: Moderately Satisfactory 50. Azerbaijan’s performance under the program for 2005 was Satisfactory. The present ICR maintains a broader perspective, and assesses the progress, though early 2007, being made towards the achievement of the medium term program objectives under

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the entire Medium Term Policy Matrix. Although PRSC II and PRSC II have no financing rationale, the reform program remains largely intact and is being implemented under the CPS covering FY07-FY10. Overall, the progress at this stage of implementation of the reform program is found to be Moderately Satisfactory.

51. The program comprises what is effectively the Government’s governance strategy, incorporating key components in public sector reform, and in the management of the economy and the environment. The program is comprehensive, but is being executed in an ad hoc manner, so that some components that would have been considered most critical to the Government’s development objectives (largely the same as the PDOs) such as macroeconomic stability and the business environment, seem to be at risk or lagging behind, while the remainder of the program is being implemented. The overall rating of Moderately Satisfactory is based on the assessment provided in Sections 8.1 and 8.2, and in view of the design, the relevance of objectives, and the achievement of development objectives. The overall rating incorporates a satisfactory rating for the single year of the first PRSC achievements and a moderately satisfactory rating on the progress towards fulfillment of the program objectives over the medium term, which the ICR weighs heavily.

52. The most important achievements of the PRSC are that it has helped the Government to continue developing an institutional infrastructure that will be critical for Azerbaijan’s non-oil economy in the medium term. The most important institutional changes going forward are: (i) the passage of the Accounting Law, which is the linchpin to improving governance in state-owned enterprises and accountability in the public sector; (ii) the Medium Term Tariff Policy, which is an important framework document for improving utilities in the next four years and, in so doing, improving the very poor quality of utilities services; and finally, (iii) the Law on Targeted Social Assistance will be an important social policy tool for increasing the efficiency of government transfers and allowing the poor to cope with rising utilities tariffs and with other targeted social assistance, and (iv) the payment systems strategy will be important in increasing access to financial services throughout the country, and reducing the impact of middlemen. In addition, the Government maintained macroeconomic balance for most of the PRSC period, although inflation risks are accumulating. The PRSC’s contribution to some of the remaining components of program matrix (such as education, health, financial services) were modest, and progress made is attributable to existing operations or AAA tasks. In other components (such as the business environment) this report argues that more might have been attempted.

53. The PRSC operation generally achieved the expected outcomes identified in the Program Document. In terms of the Millennium Development Goals (MDGs), Azerbaijan is on its way to meeting most of the MDG goals for poverty, education, health, water supply, and sanitation. However, it will take some time before policies and institutional requirements can be established in order to significantly accelerate progress towards the MDG targets.

54. In terms of the ratings for each objective, the following paragraphs summarize and evaluate the major achievements under each component of the PRSC. Each strategic

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goal is rated separately, as are the major sub-goals that are distinctly identified in the appraisal document and the policy matrix.

Strategic Goal 1: Managing the Oil Boom

55. Implementation of this strategic goal is rated as moderately satisfactory. The rating for this objective rests on ratings for the two sub-goals: (i) moderately satisfactory rating for maintaining macroeconomic stability and non-oil growth, and (ii) moderately satisfactory rating progressing on public financial management. The policy actions taken under this component were critical in maintaining macroeconomic stability through 2005. However, the accelerated pace of public spending in 2006 has raised more recent concerns for macroeconomic stability, the efficiency of public investments, and the effectiveness of the budget process. The high public spending rates have the possibility of substantially affecting the real effective exchange rate (and hence the competitiveness) of Azerbaijan, and yielding low efficiency of investment, which could delay the desired quick productivity gains that would allow the non-oil economy to continue its diversification and robust growth. Oil revenue management has remained a bright spot. Given the progress made to date, to achieve the remaining objectives of the PRSC program (as envisaged under the planned PRSC2 and PRSC3 operations), on the macro side, more needs to be done to monitor macroeconomic developments routinely, especially in the absence of an active IMF program, to strengthen the implementation of the Medium Term Expenditure Framework, and to strengthen the quality of public investment; along with stronger institutions, Government may wish to deposit all oil-related revenues into the Oil Fund, and to quantify the LTORMS. On the public financial management side, the following are needed: improvements in the budget process, the strengthening of public sector accountability and the audit functions, the introduction of public internal financial controls, and the strengthening of the accounting and financial management capacity. The ongoing dialogue with the Bank and other donors, as well as E-procurement TA and the planned Corporate and Public Sector Accountability Project (CAPSAP, FY07), would assist with these efforts, but substantial initiatives need to be taken by the Government.

Strategic Goal 2: Generating Jobs and Sustainable Non-Oil Growth

56. The implementation of this strategic goal is rated as moderately satisfactory. The rating for this objective rests on ratings for the two sub-goals: (i) moderately unsatisfactory rating for improving Azerbaijan’s business environment and for increasing non-oil trade and (ii) a satisfactory rating for financial intermediation and financial reporting. Within the first sub-goal, Azerbaijan’s non-oil economy is continuing to grow, at reasonable rates, and the country’s non-oil trade is also increasing in a satisfactory manner. Employment is also increasing. Despite the stress that diversification may be subject to in the future (due to currency appreciation), the performance of the non-oil sector under the program thus far is considered satisfactory. The business environment part of the subcomponent, however, is rated as unsatisfactory, primarily because of the poor performance in the existing surveys and poor progress in improving the environment. In the future, the country’s ability to meet its non-oil development objectives may rest on reversing the trend in this component. Within the second sub-goal, on the financial sector, Azerbaijan is largely on track to achieving the program objectives, and hence the rating is

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satisfactory; while the program objectives do not include addressing the monopolistic position of IBA directly, the program objectives are being achieved as IBA’s dominance is being increasingly challenged by new private banks and by the availability of financial infrastructure allowing smaller banks to compete. On financial reporting, Azerbaijan is making good progress in the implementation of the Accounting Law, and the overall program progress is rated as satisfactory, particularly given the initiatives that state-owned enterprises, including SOCAR, are taking to meet the January 1, 2008 objectives of the Law; the leadership of the Ministry of Finance in this area has been critical. Interestingly, the two sub-components of this goal, the business environment and that implementation of the Accounting Law, are critical for the success of the overall program, and they are currently rated with divergent ratings.

Strategic Goal 3: Improving Social Services and Infrastructure

57. Implementation of this strategic goal is rated as satisfactory. The rating for this objective rests on ratings for the three sub-goals: (i) satisfactory rating for utility services; (ii) moderately satisfactory for improving infrastructure services; and (iii) satisfactory rating for improving social services. For the first sub-goal, Azerbaijan has progressed in implementing the utilities agenda, with the substantial increases in utilities rates, and the efforts to strengthen the Tariff Council. While the Government has chosen not immediately embrace the single regulator model, the overall progress is considered satisfactory. For the second sub-goal, Azerbaijan’s progress on the telecommunications sector can also be considered satisfactory, given the institutional progress made by the MoITC and progress made with cellular operators. Conversely, on the transport sector, the separation of commercial from regulatory functions in all sub sectors, has been progressing much slower than anticipated under the program, and hence the subcomponent is rated as moderately unsatisfactory. For the third sub-goal, on the social sector side, the reforms in education and health sectors have been largely consistently with the program objectives, and hence are considered satisfactory. The social assistance reforms have been introduced in a timely manner, enabling not only the poor to benefit from an improved support system, but also effectively allowing the utilities reforms to proceed, by providing a source of compensation to the poor, for the higher rates that need to be introduced; the sub component is rated as satisfactory.

Strategic Goal 4: Realizing the Oil and Gas Potential

58. Implementation of this strategic goal is rated as moderately satisfactory. The rating for this objective rests on ratings for the two sub-goals: (i) moderately satisfactory rating for improving the financial and organizational structure of SOCAR; and (ii) moderately satisfactory rating for addressing environmental responsibilities. For the first sub-goal, on the whole, SOCAR has improved its organization and financial structure, and the component is rated moderately satisfactory because the operational structure of SOCAR has started to be more transparent, separation of core and non-core services has progressed, and adequate progress seems to be made in preparation of implementing IFRS. However, concerns remain with SOCAR, since the separation of its commercial and regulatory functions has not advanced. For the second sub-g, on the environment side, progress is considered barely moderately satisfactory, because although substantial

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planning has taken place for the clean up of the environment, activities have not yet been initiated.

Strategic Goal 5: Implementing SPPRED: Outcomes, Monitoring and Institutional Capacity Building

59. The implementation of this component is rated as moderately satisfactory. The rating for this objective rests on the ratings for two sub-goals: (i) moderately satisfactory rating for improved poverty and performance monitoring; and (ii) satisfactory strengthening oversight and participation. For the first sub-goal, poverty monitoring institutional arrangements were strengthened to collect, analyze, and disseminate timely information to the Government and the public. However, particular attention needs to be paid to performance monitoring in the public sector, particularly of the governance agenda, which would need to be monitored on the basis of a shared framework in partnership with multilateral and bilateral donors, and with civil society participation. The monitoring framework would need to cover several areas, including the extractive industries, public expenditure, the financial sector, and financial accountability, including internal control, accounting and auditing. The Government needs to insure that the monitoring framework informs and feeds into budget preparation in the annual budget cycle. Porgr4ess in considered nevertheless moderately satisfactory. For the second sub-goal, important progress has been made with the registration of NGOs and structural reforms in this area in this area, in the Ministry of Justice. As such, the rating is satisfactory.

3.4 Overarching Themes, Other Outcomes and Impacts (if any, where not previously covered or to amplify discussion above) (a) Poverty Impacts, Gender Aspects, and Social Development 60. The 2004 Household Budget Survey (HBS) data suggest that the proportion of poor declined from about 41 percent in 2002 to 27.5 percent in 2004, a decline of 33 percent. Extreme poverty declined from 25 percent of the population in 2002 to 13 percent in 2004. The number of people living in poverty declined from 3.3 million in 2002 to 2.2 million in 2004. Social transfers to the poorest 20 percent of the households increased by over 35 percent in 2004 compared to their level in 2003. Pensions, which are the main component of the Government’s social program, increased by about 44 percent for the poorest segment during the 2002-2004 period. With inflation remaining for the most part in the single digits, the real incomes of the large majority of the population employed outside the energy sector, including teachers and health workers, rose noticeably. Azerbaijan is on its way to meeting most of the MDGs, which have been integrated into the SPPRED. The 2005 Millennium Progress Report ranks Azerbaijan as one of the countries on the fast track for achieving the MDGs by 2015. The Report considers Azerbaijan as having a better chance than most other CIS countries of meeting MDG1. Azerbaijan’s ranking for universal primary education (MDG2) is also better than that if other CIS countries. The Report also ranks the prospects of Azerbaijan for achieving the remaining MDGs by 2015, as being likely.

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61. However, challenges remain in meeting the MDGs. The education system faces a number of problems and is not yet equipped to meet the demands of a modern economy. And a fundamental reform agenda needs to be addressed in the health care system. The reforms to improve the targeting and administration of social assistance, which have recently been initiated, Access to improved water supply, which has deteriorated in cities outside Baku, needs to be increased. There are also statistical gaps that undermine the measurement of progress, notably the absence of regular labor market surveys and insufficient understanding of the economic status of IDPs. In health care, the discrepancy between Government statistics and survey data makes it difficult to gauge the progress in reducing maternal and under-five mortality. On the whole, the Government needs assistance to improve the statistical basis for benchmarks and for the monitoring of their progress.

(b) Institutional Change/Strengthening (particularly with reference to impacts on longer-term capacity and institutional development) 62. The PRSC was a fast-disbursing operation in support of the budgetary needs, but was expected to have important institutional development impact during its three-year time horizon. That impact, in the case of the PRSC, has been very significant as is described below. Part of this success was due to the fact that the PRSC coincided with the implementation of the IBTA-II operation, which helped strengthen the institutional capacities, including the computing capacities, of many agencies that were responsible for the implementation of SAC-II/PRSC measures.

63. On component 1, managing the oil boom, a wide range of institutional changes were implemented to increase efficiency of public resources and enhance the transparency of oil revenue management. The key agencies for which institutional developments have been significant, or have improved their operational system and procedures, include: SOFAZ, the Chamber of Accounts, the MED, and the MoF. Of particular importance has been the establishment of the Public Investment Appraisal Division in the MED and a Medium Term Expenditure Framework (MTEF) as well as an automated Treasury system in the MoF.

64. On component 2, generating jobs and sustainable non-oil growth, banking supervision was strengthened. The National Bank of Azerbaijan’s on-site inspections and payments system (RTGS) now meets the BIS norms. The minimum capital requirements have increased and international accounting and financial reporting standards have been adopted by almost all banks.

65. On component 3, improving social services and infrastructure, institutional development impacts include: the establishment of the Department for the Assessment of Pupils’ Achievement; an increased enrollment of students at all levels; an increased number of patients in primary health care facilities; changes in the Social Insurance Law to unify collection; adoption of the Pension Reform Concept; a computerized individual record system for pensioners; a Labor Force Survey; preparation of a National Employment Strategy; strengthening the Tariff Council; the establishment of the Road Administration; the preparation of a National Traffic Safety Plan and Pavement Management System; the development of National Caspian Action Plan; the preparation

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of a Hazardous Waste Management Strategy; the creation of a Toxic Waste Management Agency; and the establishment of National Monitoring Department to track pollution emissions.

66. On component 4, realizing oil and gas potential, the institutional impact has included: the financial restructuring of SOCAR.

67. Finally, in developing a monitoring mechanism and institutional capacity building to implement SPPRED, the institutional development impact has included: conducting a new Household Budget Survey; strengthening various organizations to collect, analyze, and disseminate information on poverty and other Government programs; adopting the Law on Legal Entities Registration to facilitate the participation of NGOs; and the completion of a three-year programmatic poverty assessment.

68. The above-mentioned institutional developments were complemented by those of the other donors and contributed to the further strengthening of the institutional capacity in the public sector.

(c) Other Unintended Outcomes and Impacts (positive or negative) 69. The partnership that was established between the Government and the Bank with the PRSC provided a good foundation for the preparation of the CPS for FY07-FY10, which allows the Bank to participate in Azerbaijan’s reform program in the medium term. This positive outcome is not unintentional, but is an outcome beyond the scope of the operation.

3.5 Summary of Findings of Beneficiary Survey and/or Stakeholder Workshops (optional for Core ICR, required for ILI, details in annexes) 70. A beneficiary survey was not conducted.

4. Assessment of Risk to Development Outcome Rating: Significant 71. The Government is committed to deepening the PRSC reforms under the Country Partnership Strategy in the next 4 years, and, as indicted above, reforms are progressing, albeit not at the originally agreed upon pace. However, risks identified in the CPS, which include delays in building reform consensus, a risk of state capture and corruption, a regional security risk, and a risk associated with a collapse of oil prices (or yet higher oil prices), could hamper the gains already made and the gains likely to be made under the full completion of the reform program.

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5. Assessment of Bank and Borrower Performance (relating to design, implementation and outcome issues)

5.1 Bank Performance (a) Bank Performance in Ensuring Quality at Entry (i.e., performance through lending phase) Rating: Moderately Satisfactory 72. Although no quality at entry review was carried out by the Quality Assurance Group (QAG) on this operation, the Bank aimed to uphold quality at entry by ensuring: (i) the consistency of the operation with the CAS and the development objectives; (ii) the timeliness of the operation; (iii) the continuity of policy dialogue on the reform measures; and (iv) close coordination with other donors.

73. Overall, the operation was timely and its objectives were directly linked to the SPPRED objectives, making it an appropriate instrument for supporting those objectives. Moreover, as has been mentioned, the operation was prepared with a full knowledge of the economy and Azerbaijan’s constraints. This preparation took into account the results achieved under other operations in Azerbaijan, particularly the SAC-II. In addition, poverty and social impact assessment were carried out for some key reforms and the results were reflected into the PRSC policy measures (e.g. implications of higher electricity tariffs on the heating bills of the urban poor).

74. The policy dialogue was constructive and it helped with the preparation of the operation in close collaboration with the responsible implementing agencies. The PRSC team was involved continuously in a relevant policy dialogue with the Government agencies and had technical expertise in the areas supported by the PRSC program. The team gained the trust of the counterparts and established a substantive working relationship with them. Strong efforts were made by the team to build consensus on the proposed reform measures (particularly among the MoF, MED, and Cabinet of Ministers) and to ensure a participatory approach in project design.

75. The Bank leveraged the involvement of other donors in Azerbaijan and ensured close coordination for this operation. Thus the PRSC was selective and did not aim to cover all lending areas identified in the CAS. Coordination with the IMF was strong, to ensure consistency with the macroeconomic framework and the continuity of the policy dialogue on macro-financial issues. Other areas of coordination included the following bodies: UNDP (to assess progress toward the MDGs and environmental protection); UNICEF (activities in the social sectors); IFC, EBRD, USAID and GTZ (activities involving private sector development); ADB (activities in rural development); ADB, Switzerland, and UNDP (formulation of the SPPRED); EU, OSCE, and USAID (technical assistance for the implementation of SPPRED Treasury Systems, PIP and utility regulatory reform); TACIS (accounting law, governance); and, EBRD, USTDA (SOCAR restructuring). Coordination was also carried out internally to ensure

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consistency with other IDA operations in agriculture, the environment, the social sectors, and financial services.

76. Despite these important gains, more might have been achieved if the Bank could have worked with the Government to define a narrower scope of the operation – one that that would have attempted greater success for those aspects of the reform agenda that seem most critical to securing the macro framework and the business environment.

(b) Quality of Supervision (including M&E arrangements) Rating: Moderately Satisfactory 77. As a multi-sectoral programmatic operation, the PRSC was supervised intensively by the country team members. The team monitored progress in the policy programs described in the LDP and the Program Document in both headquarters and the field. The presence of the Bank Office in Baku also greatly facilitated monitoring the implementation of the PRSC programs. The supervision team established a good working relationship with the Government counterparts and was able to resolve many implementation problems. Nevertheless, during the implementation the Bank team could have helped the government to be more aware of the risks of delays in the implementation of some of the reform areas.

(c) Justification of Rating for Overall Bank Performance Rating: Moderately Satisfactory 78. The overall Bank performance is rated moderately satisfactory in view of the performance during the lending phase and the quality of supervision.

5.2 Borrower Performance (a) Government Performance

Rating: Moderately Satisfactory 79. The preparation of the PRSC began on a solid base with the strong support of the Government to ensure its quality. During the preparation, each component and its related policy measures was discussed and agreed on with each implementing agency, with the Ministries of Finance and of Economic Development, with the Cabinet of Ministers, and the with Office of the President. The Macroeconomic discussion included consultations with the National Bank of Azerbaijan. This helped the authorities to obtain full ownership of the program as well as good understanding of the elements of the PRSC as highlighted in the Letter of Development Policy and the Matrix of Policy Measures. The relationship among different government agencies improved during the preparation and implementation of the operation as they needed to coordinate their activities. The four economic agencies, namely, the Ministry of Finance, the Ministry of Economic Development, the National Bank and the Oil Fund, played an active role in this regard, as

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did the Cabinet of Ministers. They were also instrumental in ensuring compliance with credit agreements. Nevertheless, the Government could have been more selective in defining its reform program, and providing less ambitious and more practical intermediate targets in the operation.

(b) Implementing Agency or Agencies Performance Rating: Moderately Satisfactory 80. Although the Ministry of Finance was nominally the main implementing agency for the operation, leadership for the reforms was provided by all of the leading economic agencies (the Ministries of Finance and of Economic Development, the National Bank and the Oil Fund) and by the Cabinet of Ministers. The Ministry of Finance took the lead in facilitating the policy dialogue on macro and fiscal issues, coordination accounting and other public finance-related reforms, while the Ministry of Economic Development took the lead in private sector issues and investment policy issues. All four leading economic agencies were active participants in the macroeconomic policy discussions. However, developments during the second half of 2006 require a more diligent effort by the Government to balance public spending priorities with a competitive macro environment that will ensure the sustainable development of the non-oil economy.

(c) Justification of Rating for Overall Borrower Performance Rating: Moderately Satisfactory 81. In view of its moderately satisfactory preparation and implementation, the overall performance of the Borrower is rated as moderately satisfactory.

6. Lessons Learned (both operation-specific and of wide general application) 82. Good policy dialogue can sustain Bank contributions to development in the absence of country financing needs. The experience in Azerbaijan shows that once the reforms were brought in at various levels of the Government, this lead to complementary reforms and further expansion of the policy dialogue, regardless of the financing needs of the country. Azerbaijan’s financing needs have been declining in recent years. However, the policy dialogue has expanded and the implementation of reforms has been on the rise with important outcomes. This is because the Government sees the value of Bank assistance in the shaping of its reform agenda more than in the financing of it. This has kept the policy dialogue active and vigorous despite the rising oil revenues and the lesser need for financial assistance.

83. A broad program can help secure policy dialogue in multiple areas, and can allow for the refinement of reforms as the policy environment permits. The policy dialogue under the PRSC was intensive. The PRSC county team members knew the country well and worked closely with their counterparts in shaping this dialogue into concrete policy actions. This helped the Government with the identification of reforms that would match the circumstances of Azerbaijan. It also allowed the fine tuning of the

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program during implementation. The involvement of the county team through the life of the program also proved to be important in keeping the dialogue on track and to sharpen the focus of the operation.

84. There are trade-offs between a broad program and a more focused one, which can have real effects in a risky economic environment. Resource rich countries face exceptional risks, over and above the “average” non-resource rich country, which the Bank and the Government identified. One risk, however, the resource flow risk, materialized in the inverse direction from what was anticipated –namely, instead of oil prices dropping, they rose and created windfall revenues from the “old oil” which raised spending pressures well before the implementation of the public finance reforms and the business environment reforms were completed. Should the PRSC have tried to secure the public finance reforms “as soon as possible” given the high risk environment, before pursuing reforms in the transport sector or social protection sector? Should the PRSC operation have included a component on customs or tax administration, given the development constraints that the business environment poses, and the risks those constraints place on non-oil growth? Did the Bank overestimate the window of opportunity for reforms, in designing a three-year program with Government. If within the broad operation, even greater emphasis had been given to the macro/fiscal and business environment issues, the operation may well have had a tapering impact on the rate of the public spending increase and to the challenges to competitiveness in the non-oil sector.

85. Long-term vision pays off. Overall, Azerbaijan and the Bank faced a narrow window of opportunity to establish a necessarily far-reaching medium term reform program, which addressed the large and urgent institutional development needs to prepare for the large resource revenue inflows. The reform program presented with the PRSC addressed that need, and was based on a longer term vision. Although ambitious, the PRSC was the most appropriate instrument at the disposal of the team, seeking to engage the country for the medium term, including after the rise in resource revenues. The PRSC helped establish a sound reform strategy and partnership between the country and the Bank, which today is being implemented throughout the 2006-2010 CPS period

86. The impact of operations with deep institutional reforms cannot be judged within a short or even a medium term time horizon, even if the lending program is interrupted. Institutional reforms are intrinsically time-consuming - to implement, with changes taking place at a slow speed. The institutional measures supported by the PRSC were combined with the introduction of new methods and procedures for the operations of many agencies (e.g. oil revenue management, public expenditure management). The assessment of the impact of these changes would need a time period beyond the one-year horizon of the PRSC. This is also true for some other reforms (e.g. governance, transparency). Many of the policy measures also required certain political decisions (e.g. the Oil Fund), the impact of which goes beyond the envisaged time period of the PRSC operation. Full review of the implementation of the medium term reform program supported by the PRSC should be undertaken during the mid-term review of the CPS, and during the final review of the CP in FY10

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7. Comments on Issues Raised by Borrower/Implementing Agencies/Partners (a) Borrower/Implementing agencies 87. The ICR was discussed in detail with Government. However, the government did not provide written comments.

(b) Cofinanciers 88. The operation did not have cofinanciers.

(c) Other partners and stakeholders (e.g. NGOs/private sector/civil society) 89. No comments were received from other partners and stakeholders as discussion on the Bank’s overall program (including the PRSC) were recently concluded as part of the preparation of the new Country Partnership Strategy.

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Annex 1 Bank Lending and Implementation Support/Supervision Processes

(a) Task Team members

Names Title Unit Responsibility/SpecialtyLending Aleksandra Posarac Senior Economist ECSHD Social Protection

Specialist Andriy Storozhuk Economist ECSPE Macro Economist Arvo Kuddo Senior Economist ECSHD Labor Specialist Bjorn Hamso Sr Energy Econ. ECSSD Energy Specialist Christian E. Petersen Lead Economist ECSSD Team Leader Christos Kostopoulos Senior Economist ECSPE Macro Economist Emin Huseynov Economist ECSPE Macro Economist Enis Baris Sr Public Health Spec. ECSHD Health Specialist Farid Alexander Mammadov

Operations Officer ECSIE Energy & Infrastructure

Frederic Gielen Lead Financial Management Specialist

PA9ES Private Sector Accounting Reform

Gareth Locksley Sr Telecom. Specialist CITPO Telecommunications Gokhan Akinci Sr Invest. Policy Off. CICFI Private Sector

Development Gurcharan Singh Sr Procurement Spec. ECSPS Procurement Halil Dundar Sr Education Econ AFTH3 Education Specialist Ida N. Muhoho Sr Financial Management

Specialist ECSPS Financial Management

Specialist Junko Funahashi Sr Counsel LEGEC Lawyer Jane Olga Ebinger Snr. Energy Specialist ECSSD Energy Johannes Stenbaek Madsen Sr Financial Management

Specialist ECSPS External Audit

John Hegarty Manager ECSPS Financial Management Julian A Lampietti Lead Speciaslist ECSSD Energy and Social

Protection Jim Stevens Education Specialist ECSHD Education Mansour Farsad Economist ECSPE Economist Matthew Andrews Public Sector Specialist OPCPR Public Sector TA Nina Todorova Budina Senior Economist ECSPE Macro Economist Olivier P. Le Ber Senior Transport Specialist ECSSD Transport Panagiota Panopoulou Economist (Health) ECSHD Health Peter D. Thomson Director ECSSD Energy Richard L. Symonds Sr Counsel LEGPS Legal Rughvir K. Khemani Adviser CICPO Competition S. Brajovic-Bratanovic Lead Financial Sector

Specialist ECSPF Financial Sector

Saida R. Bagirli Senior Operations Officer ECCAZ NGO & PRSP

35

Supervision/ICR Gokhan Akinci Sr Invest. Policy Off. CICFI Business environment Elvira Anadolu Health Specialist ECSHD Health Enis Baris Sr Public Health Spec. ECSHD Health

Ranjan Kumar Ganguli Consultant - Financial Management Spec ECSPS Public Sector

Accounting

Frederic Gielen Lead Financial Management Spec PA9ES Private Sector

Accounting Bjorn Hamso Sr Energy Econ. ECSIE Electricity and Gas

Jonathan George Hooper Sr Financial Management Specialist ECSPS Private Sector

Accounting Rasim Ali Jafarov Economist ECSPE Macro Economist Christos Kostopoulos Senior Economist ECSPE TL (SPN and ICR) Olivier Le Ber Sr Transport Specialist ECSIE Trade/Rail transport Gareth Locksley Sr Telecom. Spec. CITPO Telecommunications

Ida N. Muhoho Sr Financial Management Specia ECSPS Financial Management

Gerald Olivier Sr Transport Specialist ECSIE Road transport Christian Petersen Lead Economist ECCU3 TTL (SPN) Aleksandra Posarac Senior Economist ECSHD Social Protection Nathanael Smith E T Consultant ECSPE Education James A. Stevens Sr Operations Off. HDNED Education Peter D. Thomson Director ECSIE Energy Mark Warner Consultant ECSPE Competition

Cem Dener Public Sector Mangt. Specialist ECSPE Public Sector Mangt -

Treasury

36

(b) Staff Time and Cost

Staff Time and Cost (Bank Budget Only)

Stage of Project Cycle No. of staff weeks

USD Thousands (including travel and

consultant costs) Lending

FY03 14.00 FY04 70 427.22 FY05 58 295.14 FY06 0.00 FY07 0.00

Total: 128 736.36 Supervision/ICR

FY03 0.00 FY04 0.00 FY05 0.00 FY06 0.62 FY07 18.28

Total: 18.90

37

Annex 2. PRSC Policy Reform and Results Matrix Strategic Goal 1: Managing the Oil Boom 1a. Avoid Dutch Disease

Objectives PRSC-I Prior Actions (2005) Expected Tree-Year PRSC Program Outcomes and Monitorable Indicators

(post 2007)

Outcomes and outputs: Status at time of PRSC ICR

Maintaining macroeconomic stability

Maintain a satisfactory macroeconomic framework

• An appropriate macroeconomic framework conducive to growth and poverty reduction in place.

• Indicators include Economic Indicators of SPPRED Progress Report 2004, Appendix 3

• Satisfactory macroeconomic framework maintained in accordance with the IMF program, which ended in 2005. Overall GDP grew by an average of 15.9% per annum in 2004-05, while non-oil GDP grew at the average rate of 12.3% per annum; in 2006 the respective growth rates were 34.5 percent and 12.1 percent. End of period inflation came up from 3.6% in 2003 to 10.4% in 2004 and then was reduced to 5.4% in 2005. End of period inflation in 2006 reached 11.4 percent.

• Poverty declined from 39.7% in 2003, to 24% in 2005.

• The 2006 fiscal expansion has fuelled a rapid monetary expansion and raised macroeconomic concerns that suggest intensive monitoring of the economy is needed.

Maintaining prudent policies in the use of oil resources.

Ensure all Oil Fund (SOFAZ) expenditure decisions are included in the 2005 Budget, MTEF and PIP. Approve a sustainable, rules-based

• Oil Fund expenditure decisions have been part of the consolidated budget, and have supported the MTEF and the PIP

38


(post 2007)


long-term strategy for the use of oil revenue consistent with the SPPRED priorities

• Non-oil trade is increased by

more than 10% p.a., external debt stays in the range of 20% - 25% of GDP, and foreign exchange inflow are managed to avoid inflationary pressures from domestic money supply.1

• The Long Term Oil Revenue Management Strategy (LTORMS) has been approved; however it requires quantification to make it a more meaningful policy instrument.

• Non-oil merchandise exports grew by 36%,

50%, and 23% in 2004, 2005, and 2006 respectively; external debt declined from 24% in 2003 to 15% in 2005 around 10 in 2006; foreign exchange inflows in 2005 were sterilized and inflationary pressures were avoided (End of period CPI was 10.4% in 2004, and 5.5% in 2005) but accelerated into double digits (11.4%) in 2006 as oil-financed government expenditures were ramped up

• The real effective exchange rate appreciated by

around 14% in 2003-05, and by 4% in 2006.

Maintaining a prudent governance framework in the Oil Fund (SOFAZ).

Publish the 2003 audited accounts of SOFAZ.

Publish quarterly financial and budget execution statements.

• SOFAZ annual audited accounts published and in good order.

• SOFAZ quarterly financial and budget execution statements and shows full compliance with Budget Systems Law

• SOFAZ’s 2005 audited accounts are in good order and have been published

• Governance and management framework for SOFAZ adopted.

• Regular publication of SOFAZ financial/budget execution statements on internet.

• All SOFAZ expenditures are incorporated as part of the annual consolidated government

1

39


(post 2007)


budget presented to the Parliament for approval. • SOFAZ accounts in full compliance with

Budget Systems Law

1b. Improve Efficiency and Effectiveness of Public Resources Improving strategic priority setting and transparency of medium-term budgeting.

Submit to Parliament the 2005-2008 MTEF and prepare the PIP for 2005-2008.

• MTEF and PIP of increasing quality are submitted to Parliament as part of the annual budget process.

• Line ministries do not adequately participate in the MTEF process and the capacity of the Public Investment Appraisal Division needs to be further strengthened. Substantial TA programs are now in place.

• Since 2003 all budgets have been prepared, published and executed according to the new budget law.

Improving transparency and accountability in public financial management

Implement Budget Systems Law (BSL) by: (i) approving regulations; (ii) initiating training of the MOF staff involved in budget formulation and execution of BSL; and (iii) drafting Budget Process Manual based on the new BSL and modern management practices. Adopt the new Budget Classification system within the framework of the GFSM. Adopt legal framework for Public Sector Accounting

• BSL implemented and staff in MOF, and health and education ministries are trained in BSL and budgeting processes.

• New Budget Classification

scheme approved and fully implemented.

• TIMS established and access provided for the Chamber of Accounts.

• Internal Audit function reestablished in x number of budget organizations

• Fiduciary framework for governance in public entities and in the private sector strengthened via auditing and accounting legal reform and reform of public procurement.

• New procurement law adopted and new accounting legislation based on IFRS enacted for private and public sector entities. This legislation is scheduled for full implementation by 2008 and 2009 respectively, which experts view as rather optimistic stretch targets.

• Although the Chamber of Accounts has been established and staffed, its capacity and access to information are limited, thereby restricting the scope of its activities. Further strengthening is needed.

40


(post 2007)


according to international standards (IPSAS).

Strategic Goal 2: Generating Jobs and Sustainable Non-Oil Growth 2a. Improve the environment for increased non-oil trade and investment Facilitate trade to enhance integration in the international market

Identify areas in existing legislation that needs to be amended to ensure standards, policies, and practices are in line with WTO mandates. Draft a strategy for integrated transit management.

• Increase in non-oil trade of more than 10% p.a.

• Progress in WTO accession process.

• Reduced cost and time of transit; improvement in border control operations, relative to TTF report, 2003.

• Non-oil exports to GDP rose from 6.0% of GDP in 2002 to over 10% in 2005. The average growth rate of non-oil merchandise exports between 2003 and 2005 was over 40% per year.

• FDI in non-oil sector increased by more than threefold between 2002 and 2005, and in 2006 rose by another 60% in comparison with 2005.

• Progress has been made in WTO accession.

Attract private investment to the non-oil sector by improving the legal framework and streamlining processes

Submit to Parliament the unified Investment Law. Study Administrative Barriers to Private Investment, hold consultations with Entrepreneurs Council and streamline administrative procedures for private investors.

• Growth in non-oil sector and in domestic and foreign investment of more than 5% p.a.

• Improvements in investment climate evidenced by regular surveys (BEEPS, FIAS).

• During 2003-2005, banking sector credit to economy grew by 145%. This trend continued in 2006 when banking sector credit to economy increased by 64% relative to 2005. However, sector remains small and at end 2003, banking system assets were 17 percent of GDP, compared to typical banking sector assets of 30-40 percent of GDP in transition economies in central Europe. The ratio of banking system assets to GDP reached 19 percent in 2006.

• Total volume of short-term finance increased by 145% between 2002 and 2005.The growth rate of short-term finance was 25% in 2006.

• Total volume of investment finance increased by 263% between 2002 -2005 and by 131% in 2006.

41


(post 2007)


Protect against unfair competition

Draft Competition Code and review all related legal instruments, including competition, safeguard, and price regulating frameworks to ensure coherence and consistency.

• New competition legal framework.

• Number and quality of antimonopoly cases.

• Database established, analytical tools used, and authority to enforce exercised.

• Share of private sector in GDP has risen from 71.8% in 2001 to 76% in 2005, and 81% in 2006 (Statcom data).

• Key barriers to business development identified, import tariffs reduced; new anti-monopoly and investment laws drafted.

Promote regional diversification and SME development

As part of SPPRED implementation, adopt a medium-term program (RSEDP) for private sector, infrastructure and social development in the regions outside Baku, and establish implementation coordination unit.

• Real growth of regional outputs and wages.

• Increase in number of private enterprises and cluster production in regions.

• Non-oil sector growth averaged nearly 12.2 percent a year in 2003-2006, exceeding the benchmark of 5-7 percent a year. However, only limited increase in number of jobs in SME since 2002 according to official statistics.

• FDI in non-oil sector rose from US$79.3m in 2001 to US$322m in 2004, to US$346 million in 2006 (SCC data).

• Growth in jobs in construction, transport, and communications was in the range of 3-5 percent, although employment in agriculture declined.

• According to government estimates, the State Program for Development of Regions has contributed to the creation of over 340,000 jobs over the last couple of years.

• Of the 21 “Problems Doing Business” indicators in the 2005 BEEPS, Azerbaijan fares better than the CIS average in 15 of them.

• Despite improvements in the business environment reflected in CPIA and BEEPS, Azerbaijan still scores poorly on international ratings.

42


(post 2007)


2b. Improve financial intermediation and discipline Objectives PRSC-1 Measures Indicators (end-PRSC3) Outcomes and outputs

Improve banking solidity and the financial service network especially in the regions outside Baku.

Enact Banking System Law adhering to Basel principles. Adopt a new payments system strategy to further develop payments systems and card payments, establish fair and equal competition in this area and create access of regions to financial services.

• Capitalization of banking systems and adherence to sound CAMELS parameters.

• Number of financial services

access points in regions. • Number of banks participating

in payment services and card processing system. Array of card services the population can choose from.

• Banking System Law enacted • FSAP assessment confirmed that the large value

payment system (RTGS) and the small value batch payment system meet BIS norms for systemically important payment systems

• Capitalization improving; target $10 million for all banks by 2008, although new entrants already need to comply

• CAMELS already used for bank supervision by National Bank of Azerbaijan.

• National Settlement and Clearing System for

electronic payment instruments completed and taken over by banking association

• Number of electronic payment sites (in commercial centers and shops nationwide increased from approximately 400 in 2003 to 987 in 2005, and to about 2053 in 2006.

• Number of cash machines increased nationwide from about 500 in 2003 to 873 in 2005 and 1073 in 2006.

• 30 banks offer e-payment services. • Percentage of cash settlements declined by 3.4%

2003; and 5% in 2005 • The cost of services as measured by the interest

43


(post 2007)


rates on bank credits fell on average by 100-200 basis points, at the same time average profitability of banks as measured by rate of return on banks assets rose on average by 1% (possibly due to increased competition in the system).

• Bank fees for processing payments decreased by 1-2% between 2003 and 2005.

• Use of non-cash payment means rose by over 150 % 2003 and 2005.

• Lending rates reduced from average 19% in 2003 to average 17% in 2005.

• IBA is still the dominant bank, but its share of total banking assets has fallen to 49% in 2005 (IMF data).

• Banking supervision has been strengthened. New banking legislation and prudential regulations compliant with international standards in effect. FSAP finding indicate that the NBA on-site inspections generally meet the BIS norms. Yet, further strengthening is needed.

Enhance the legislative framework and create a sustainable institutional infrastructure in financial reporting, accounting, and auditing

Enact the new Accounting Law, which: (i) mandates the use of “pure” IFRS by public interest entities; (ii) mandates the use of National Accounting Standards (NAS) by all other entities except micro enterprises and natural persons for which a simplified accounting system is sufficient;

• Number of entities converting to new accounting standards, and measured as a share of GDP.

• Improvements in the number and quality of audited financial statements from the corporate and financial sectors, as perceived by key user groups

• In 2005, 160 bank branches were based in the regions, with at least 10 banks participating.

• 55 credit unions have been licensed. 29 credit unions and some 1100 operating Borrower Groups were supported under Bank projects, reaching over 20,000 farmers.

• There are now 19 microfinance institutions with an overall credit portfolio of $52 million and over 64,000 active clients, with 39 percent being

44


(post 2007)


and (iii) establishes an appropriate framework for governance of the accounting standard setting process under the responsibility of the Ministry of Finance.

(survey data). • Increased use of audited

financial statements to support lending and investment decisions, lessening reliance on relationship- or collateral-based lending.

businesswomen. • Project is under implementation to increase

number of access points for financial services outside Baku to include 1200 postal offices.

Strategic Goal 3: Improving Social Services and Infrastructure 3a. Improve utility services Developing tariff policy and establishing a utility regulatory framework to accelerate reforms in the utility sector.

Develop a medium-term tariff policy for the utilities (electricity, natural gas, water, wastewater, and heating services) and a regulatory framework, with an independent regulatory agency, according to the Letter of Intent of GoA, dated April 21, 2003.

• Financial viability of utility companies.

• Coverage and reliability of utility services increased by x%.

• Between 2002 and 2006, electricity production increased by 21%, and gas production by 18%.

• There were no repeats of the 2002 nationwide electricity blackout. However, system reliability remains fragile with frequent localized outages and occasional widespread system failures. Gas tariffs were quadrupled in 2004 and water tariffs doubled in order to move closer to cost-recovery.

• Progress with regard to collections in the utility sector has been mixed. While collections in the power sector increased from 54% in 2003 to 56.4% in 2005, collections in the gas and water sectors fell in response to increased tariff rates; for the same period, collections in the gas sector fell from 70% to 50% and in the water sector from 73% to 69%. The collection rate for 2006 was 63% for the water sector and 41% for the gas sector.

• Management contracts were in effect in the power distribution sector and part of the water sector (in several regions of the country).

45


(post 2007)


• Overall, the financial condition of the utility sector, while improving, remains weak and increased metering and improved regulatory framework are needed for electricity, gas and water entities to become commercially sound.

• Around 76 percent of all households have access to an improved drinking water source, including 93 percent in urban areas.

• Rehabilitation of the main water treatment plant in Baku nearly complete, improving source quality.

• Survey data in Baku show improvement in drinking water safety.

• Percent with access to improved sanitation: Urban areas - increased from 96.2% in 2002 to 98.4% in 2003; Rural areas – increased from 78.3% to 84.1% in 2003 (HBS data).

Enforcing financial discipline.

Reduce implicit energy sector subsidies by 20% and ensure all budgetary organizations are current with utility payments

• Reduction in subsidies to utilities

• Level of energy-related subsidies in the budget declined in 2004 and 2005, but increased in 2006, with the adjustment in domestic prices.

• Percentage of firms seeing electricity as a problem doing business declined from 30 percent in 2002 to 25 percent in 2005 (2005 BEEPS).

• Tariff setting institution has been strengthened considerably.

• Budgetary organizations current on utility payments.

• Phased medium term tariff policy for utilities has been adopted.

• Water tariff have been doubled, and gas tariff quadrupled.

46


(post 2007)


3b. Improve infrastructure services TELECOM: Restructuring the communications sector by divestiture of relevant state-owned assets and separating commercial and regulatory functions

Approve a comprehensive communications sector policy. Privatize Bakcell mobile phone company. Establish independent, transparent and accountable National Communications Regulatory Authority

• Coverage, affordability, and reliability of communications services.

• New investor-friendly, pro-competitive, WTO-compliant and EU-reflective regulatory and institutional framework in place.

• Communications sector is among the leading drivers of economic growth in the non-oil sector (average real value added growth of over 30% in 2003-05).

• Bakcell privatization completed in December 2003.

TRANSPORT: Restructuring the transport sector by divestiture of relevant state-owned assets and separating policy, regulatory and commercial functions.

Transfer regulatory functions currently exercised by Caspian Shipping Company to the Ministry of Transport, and initiate a similar process regarding AZAL and Azer Rail

• Monitor that competition is established in compliance with antimonopoly regulation.

• Sea Port, Airport activities,

increased traffic scope and new entrances to market

• Road administration in conjunction with the establishment of the Ministry of Transport.

• A functional classification of the road network was completed and a Pavement Management System to analyze and prioritize road projects has been operational since January 2005.

• National traffic safety plan prepared in March 2005.

• Budget increases for road maintenance have exceeded the 10 percent a year target and there has been increasing competition among suppliers and contractors.

• Transported goods along Europe-Caucasus-Asia Transport Corridor in Azerbaijan rose from 32,485 thousand tons in 2001 to 46,700 thousand tons in 2005.

• More than 60% of road budget are tendered via competition.

47


(post 2007)


• Freight tariffs from Amsterdam to Baku decreased by 8-12%, while from Baku to Amsterdam by 5-6%.

• Transport time from Amsterdam to Baku decreased by 1 day.

3c. Improve social services Improving access to Primary Health Care (PHC) services

• Number of outpatient visits at the PHC level per capita increased.

• Patient referral rate is reduced. • Increased perceived quality of

care by users. • Increased satisfaction by

providers at the PHC level. • Essential drugs are used for

treatment in at least 80 percent of health centers

• The number of patients at improved PHC facilities in the target districts rose by 65 percent and patient satisfaction rose from 34 percent to 61 percent.

• Accomplishments limited to pilot projects that improved access to and quality of primary health care in selected districts.

• ESW and intensified dialog on health issues are raising awareness and momentum for health sector reform.

• Health expenditures rose from 5.3 percent to 5.8 percent of public expenditures but with limited rationalization of expenditures, including in right-sizing of the number of hospitals

Improving effectiveness and coverage of national health programs

• Indicators include Health Indicators of SPPRED Progress Report 2004, Appendix 3.

• Limited Bank objectives due to weak ownership of reforms prior to November 2005.

Improved equity in health care and efficiency in resource allocation

Completed health expenditures study satisfactory to IDA

• Health Policy White Paper • Implementation of the labor

adjustment strategy in the health sector

• Increase in Public Outlays for Health

• Health policy white paper under preparation

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(post 2007)


• Evidence of improved allocative and technical efficiency in resource allocation.

Improving effectiveness and efficiency in education expenditures

Complete Education Finance and Expenditure Study, satisfactory to IDA

• Indicators include Health Indicators of SPPRED Progress Report 2004, Appendix 3.

• Department for the Assessment of Pupil’s Achievement was established in 2004.

• Pilot assessment in Math and Azeri language conducted for 1900 children in grade 5.

• Ministry of Education (MoE) plan has been approved to reform curriculum, textbooks and educational management.

• Gross primary enrollment ratio is 102.4%. • Gross upper secondary enrolment rate rose from

43.2 percent in 2001 to 70.5 percent in 2003. • Over 90% of children in grades 1- 5 provided

with free textbooks in both 2003 and 2004. • Higher education enrolment increased from

13.4% in 2001 to 18% percent in 2005. .

Improve pension systems to strengthen social protection of population

Draft a plan with timetable for the transfer of administration of social insurance payments from enterprises to the State Social Protection Fund

• New fiscally sustainable and affordable Labor (Social insurance) pension system that provides links between contributions and benefits in place.

• Indicators include Social Protection Indicators of SPPRED Progress Report 2004, Appendix 3.

• Effective January 1 2005, the minimum pension amount was increased to AZN 25 per month, to AZM 30 in April 2006, AZN 35 in October 2006; AZN 40 in January 2007 and AZN 50 in February 2007. There are no wage and pension arrears.

• Amendments and changes to the Social Insurance Law will unify the collection of social security contributions for social protection.

• Pension Reform Concept approved by President; new pension legislation under preparation

• Computerized individual record system for

49


(post 2007)


pensioners under implementation. Strengthen and target social assistance to the poor and minimize negative social impacts of utility sector reforms

Submit to the Cabinet a draft framework Law on Targeted Social Assistance

• At least 50 percent of the funds allocated to the targeted social assistance and social benefits accrues to the bottom consumption quintile

• Social assistance benefits are paid on time and have increased 5% annually in real terms.

• New targeted social assistance framework approved by Parliament.

• The full introduction of a targeted family/poverty benefit scheme is scheduled for mid-2006 and already budgeted for.

• The full introduction of a targeted family/poverty benefit scheme is scheduled for mid-2006 and already budgeted for.

• Poverty prevalence among IDPs is less than average of population.

Strategic Goal 4: Realizing Oil and Gas Potential

4a. Improve the financial and organizational structure of SOCAR

Financial restructuring and separation of regulatory and commercial functions

Implement the agreed action plan, including adoption of IFRS, on financial and corporate restructuring of SOCAR

• Ability to finance stakes in joint ventures.

• Profitability of SOCAR. • Extent of environmental clean

up. • Divestment of non-core

business activities

• BTC pipeline commissioned in May 2006. • Shah Deniz gas field and South Caucasus gas

pipeline launched in late 2006. • Oil sector grew at over 60 percent a year during

2005-06. • Financial health of SOCAR improved with the

rise in oil prices of 2005 and 2006. • Important steps taken to strengthen information

management systems and accounting practices. • Substantial challenge remains in restructuring

the State Oil Company of the Azerbaijan Republic (SOCAR). There is a need to separate SOCARs commercial and regulatory functions

50


(post 2007)


and improve the transparency of its operational activities and financial reporting

4b. Address environmental responsibilities

Minimize negative environmental impact of energy sector and industries, and address legacy pollution.

Approve a Hazardous Waste Management Strategy

• Environmental clean-up efforts. • Improved policy and regulatory

system and incentive structure towards improved environmental compliance of corporate sector and utilities

• National Caspian Action Plan developed. • Hazardous Waste Management Strategy adopted

in 2004 to mitigate the environmental impacts of industrial production. MENR established National Monitoring Department to track pollution emissions and created an Agency for Management of Toxic Wastes to coordinate waste disposal.

• A Comprehensive Action Plan for Improving Environmental Situation in Azerbaijan for 2006 – 2010 approved by the Presidential Decree of September 28, 2007

5. Implementing SPPRED: Outcomes, Monitoring, and Institutional Capacity Building

5a. Improve poverty and performance monitoring Providing timely and reliable information on living standards and poverty situation Monitoring implementation progress of the development agenda

Conduct Household Budget Survey, publish results and make databases available on a timely basis. Develop a list of reliable performance indicators to monitor implementation of SPPRED

• HBS Data Base accessible to the public and annual review reports including poverty profile are published regularly.

• Move toward performance-

based strategic planning and budgeting

• Programmatic poverty assessment has produced good collaboration and good analytical work with the Statistical Commission. However, the HBS still needs improvement, and labor market data are weak.

• Agreement reached in 2006 with the Minister of Health on appropriate monitoring of health indicators.

• Government has made modest progress towards

strategic planning and budgeting. The draft of the Budget Process Manual was delayed. has

51


(post 2007)


objectives

been delayed

5b. Strengthen oversight and participation

Ensuring high-level Government oversight

Enhancing participatory process in the implementation of reform

Develop a process for monitoring the implementation of the overall reform program.

Put in effect the Law on Legal Entities Registration and Registry, and its implementation regulations to ensure smooth registration of NGOs. Develop a satisfactory mechanism for monitoring the process of registration of NGOs

• Preparation of Annual Progress Reports on implementation of SPPRED

• Regular public consultations

resulting in effective two-way communication with civil society in order to enhance design and implementation of the reform program with institutionalized monitoring of implementation

• An annual progress report on the SPPRED was prepared for 2004 and 2005.

• Public consultations with civil society have

taken place during the preparation of the SPPRED. Town halls, as a means of public consultations, continued to be held in the post PRSP period covering SPPRED implementation and preparation of the new ten year poverty reduction and sustainable development program.

• A number of NGOs review government policies

and budgets and communicate advice to the government.

• The number so registered NGOs are as follows:

Year NGOs 2003 100 2004 164 2005 379 2006 548 2007Q1 137

Utilities services include electricity, natural gas, water, wastewater, and heating services. Core measures are in Bold font.

52

Annex 3. Summary of Borrower's ICR and/or Comments on Draft ICR The draft ICR was discussed in detail with the borrower. The borrower has not submitted written comments.

53

Annex 4. Comments of Cofinanciers and Other Partners/Stakeholders There were no cofinanciers. No comments were received from other partners and stakeholders as discussion on the Bank’s overall program were recently concluded as part of the preparation of the New Country Partnership Strategy.

54

Annex 5. List of Supporting Documents

1. Letter from Prime Minister to Country Director, dated February 13, 2006, Confirming the Government’s Commitment to the PRSC’s LDP for the implementation of the Country Partnership Strategy FY07-FY10 (IRIS)

2. Azerbaijan - Country Partnership Strategy FY7-FY10 (Report No. 37812-AZ)

3. Azerbaijan - Program Document for a Proposed Poverty Reduction Support Credit (Report No. 31978-AZ); includes:

a. Program Document b. Letter of Development Policy (Annex I) c. Policy Matrix (Attachment 1 to Annex I) d. Medium Term Tariff Policy for Utility Services (Attachment 2 to Annex I)