International Conference

«Conflicts in the Caucasus: History, the Present and Prospects for Resolution»

Baku (Azerbaijan) 22-23 October, 2012 and Tbilisi (Georgia) 25-26 October, 2012

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THE ECONOMY

Fuad MURSHUDLI

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Fuad Murshudli, Ph.D. (Econ.), advisor to chairman of the board, International Bank of Azerbaijan (Baku, Azerbaijan)

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Introduction

The socially oriented market economy chosen by Azerbaijan as a development model for the country is being created through phased liberalization of economic activity combined with active government support for priority sectors. Other important constituents of this process include measures to create a favorable investment environment and a proper market infrastructure and to improve the social protection system. The Azerbaijan economy today is one of the most dynamically developing economies in the world.

Macroeconomic Indicators

Macroeconomic indicators point to the continuation of positive trends characteristic of the republic’s economy since the turn of the century. In 2005, GDP grew by 26.4% (compared to 10.2% in 2004). In terms of GDP growth, Azerbaijan ranked first in the world. Per capita GDP was $1,518, and at purchasing power parity (3.38), $5,129. The main driving force behind this recovery was industrial production, which increased by 33.5% (compared to 5.7% in 2004). This was due in large part to high oil prices and increasing oil production.

Fixed capital investment reached 28.9 trillion manats (Azerbaijan’s currency unit, AZM), with investment in production constituting about 87% of the total. In terms of per capita investment ($1,518), the republic is high on the list of CIS and East European countries. According to a report by the U.N. Conference on Trade and Development (UNCTAD), Azerbaijan is the world leader in investment attractiveness. At the same time, the rate of increase in capital investment in 2005 was down to 16.6% compared to 35.4% in 2004. The main reason here was the decline in demand in the oil and gas sector owing to the completion of the bulk of construction work and the related sharp slowdown in the inflow of foreign investments (4.1% increase compared to 30.4% in 2004), which constitute over two-thirds of total investments.

At the beginning of the year, there was a clear upturn in inflation caused by a surge in domestic demand and rising oil prices (which entailed a rise in the prices of imported goods), by an increase in the money supply and a number of other factors. In April, inflation reached a maximum of 15.5%. Then the government announced that its main macroeconomic goal for the year was to reduce inflation to a single-digit figure. And on 31 May the president issued a decree on strengthening anti-inflation measures, setting concrete tasks before all the economic agencies. Control over the execution of the state budget was enhanced, monetary policy was tightened, and a number of measures were taken to improve the competitive environment and ensure more effective financial management. In December, inflation was down to 2.2%, and for the year as a whole it amounted to 9.6%. The prices of food products rose by 10.9%, nonfood products by 5.4%, and services by 9.7%.

Sectoral Composition of the Economy

The oil sector prevails, accounting for more than two-thirds of industrial production. In February 2005, the Central Azeri oil field came on stream, and exports from the field began in March. The Azerbaijan section of the Baku-Tbilisi-Ceyhan (BTC) export pipeline was put into operation in May, and the first million barrels of oil was already pumped into the pipeline in July, which was one of the main economic events of the year. The construction of the Baku-Tbilisi-Erzurum gas pipeline was continued (70% of the work has already been performed), and production was started at the Shah Deniz gas condensate field.

In April, there was a change in the composition of foreign companies taking part in the oil consortium: Chevron Texaco (U.S.) became the holder of the second largest stake (10.3%). In June, an oil and gas conference and exhibition was held in Baku with the participation of 331 companies from 29 countries. In August, yet another (26th) oil contract worth $400 million was signed with RAFI OiL EfZeI (United Arab Emirates). The large share of oil in industry, in GDP and especially in exports is the country’s main structural problem. This entails another problem: unequal distribution of business activity across the territory of the republic, with the economy mostly concentrated in the capital. The government has been trying to remedy this situation by taking energetic measures to expand non-oil sectors in the regions. In 2004, it adopted a state program for regional economic development, under which hundreds of manufacturing enterprises and sociocultural facilities with about 200,000 new jobs were put into service in 2005. Nevertheless, GDP growth in the non-oil sector fell to about 8.2% (from 14.0% in 2004). One of the reasons here was the slowdown in construction activity (to 2.0%) after the completion of the BTC pipeline.

In the transport sector, the freight turnover growth rate was 13.5%. In March, the largest air terminal in the CIS with an annual capacity of up to 100,000 tons opened in Baku. In May, agreements were signed on the construction of two trunk rail corridors: Qazvin-Rasht-Anzali-Astara and Kars-Akhalkalaki-Tbilisi-Baku, the latter being included among the U.N. top-priority projects for the construction of a trans-European railway network. Work was also started on the construction of new highways. All of this will facilitate the country’s deeper integration into the international transportation system.

An important aspect of the development of non-oil industries is an effort to optimize the management of oil revenues. With this aim in view, a special program was adopted in February 2005 designed to develop the non-oil sector, raise the level of education (including higher education institutions), help Azerbaijanis to get an education abroad, develop a single system for reducing resource dependence, and achieve other goals of sustainable economic development and poverty reduction. A forum entitled “Oil Revenues and Diversification of the Azerbaijan Economy,” held in Baku in August, resulted in the drafting of a package of proposals to that effect. In this context, great importance attaches to a joint public investment project launched in August by the country’s Ministry of Economic Development and the United States Agency for International Development (USAID). An advertising campaign to promote local goods was conducive to the development of the non-oil sector and helped to enhance the competitiveness of its products. But in the fall, after the arrest of the minister of economic development,¹ it was, unfortunately, scaled down.

Poverty Reduction and Social Protection

Nominal household income in the country increased by 27.0%, and real income, by 16.0%. The average monthly wage rose by 21.9% (to $137). The consumption basket of 585 goods and services was estimated at roughly AZM 260,000 (about $58), and the subsistence level, at AZM 213,000 ($47). Allowances to low-income categories of the population were raised twice during the year (in March and August). In October, the minimum wage was increased by 20%, to AZM 150,000 ($33). That same month, the president signed an order on indexing deposits with the U.S.S.R. Sberbank made by the republic’s citizens prior to 1992. In addition, an Employment Strategy for 2006-2015 was approved and a Law on Targeted State Social Assistance entered into force. Economic growth has naturally helped to reduce poverty to a significant extent (from 40.2% to 29.3%), but its level remains high.

At the same time, it should be noted that official statistics do not give an adequate picture of poverty, because the informal economy, which remains one of the largest in Europe (according to the World Bank, about 62%), provides for a relatively large share of informal incomes, although it goes without saying that their distribution cannot be regarded as equitable.

Business

During the year, there was active discussion of factors holding back the development of business. A number of measures were taken to improve the business environment. One of the positive steps in this area was a reduction in the maximum statutory time for state registration of new companies. An appropriate amendment to the relevant law entered into force in September.

In order to give business broader access to financial resources, numerous credit fairs were held both in the capital and in the regions. In April, over 300 business people took part in the first congress of the Confederation of Entrepreneurs. In June, the Ministry of Economic Development together with experts from the U.N. Industrial Development Organization (UNIDO) embarked on a project to create an industrial park near Sumqayit (30 km north of Baku) with about 10,000 new jobs. In August, a Fund for the Promotion of Exports and Investments was set up to help domestic business to develop and enter international markets. Note should also be taken of measures to popularize leasing and give businesses broader access to it.

Finance and Credit

In February, the president signed a decree on the redenomination of the national currency (from 1 January, 2006). That was due to the need to improve currency circulation, simplify the accounting and settlement system, and reduce government spending. One new manat (AZN) equals 5,000 old manats (AZM), so that given the current exchange rate it should virtually equal the U.S. dollar. During the year, the old manat will circulate alongside the new one. This redenomination was supported not only by independent experts, but also by members of the opposition. However, it could have certain negative effects as well (for example, generate a degree of technical inflation). The new national currency was officially presented on 28 December.

While taking anti-inflation measures, the government was obliged now and again to keep the manat from rising against foreign currencies. The crunch came on what has come to be known as “Black Saturday” in October, when the dollar’s free fall (14-15% in two days) was only halted by means of a massive manat intervention. The explanation of the National Bank of Azerbaijan (NBA) that such a fall was the result of gambling on the financial market was clearly unconvincing, although this factor had evidently played a certain role. However, the root cause of these events was probably that the country is already receiving huge (by the standards of its economy) amounts of petrodollars, which naturally exert pressure on the financial market. In the years ahead, the government as a whole and the NBA in particular will have to display much greater flexibility in exchange regulation matters.

The government’s decision to go over (starting from 2006) to predominantly non-cash payments was of great importance. In particular, measures were projected for the use of plastic cards and installation of POS terminals, and also for switching customs and tax payments to a card system.

Certain steps were also taken to strengthen the banking system. In March, the president entrusted the Ministry of Economic Development with power to launch a package of measures to reduce the government share in the authorized capital of two state banks, the International Bank of Azerbaijan (IBA)² and KapitalBank, which is to take place with the participation of these banks themselves. In December, under a newly launched mortgage loan program, the NBA set up a Mortgage Fund. This program has two purposes: to improve people’s living conditions by creating effective financing mechanisms; and to attract local and foreign investors into the mortgage sector.

In January, a Central Credit Register containing the entire array of information on borrowers was established at the National Bank of Azerbaijan. In order to attract additional resources and reduce inflationary pressure, the NBA raised the discount rate on three occasions (in May, July and October), bringing it up from 7% to 9% per annum. In September, the National Bank called on the international community to prevent the opening of Armenian banks in Nagorno-Karabakh and the use of the dram (Armenia’s national currency) in that territory as a currency unit.

The banks of Azerbaijan worked hard to gain international recognition. In March, the international agency Fitch IBCA confirmed the IBA’s ratings: long-term BB- (outlook stable), short-term B, individual rating D/E, and support rating 3. Such authoritative magazines as Euromoney and The Banker, in July and September respectively, ranked UniBank as the Best Bank in Azerbaijan in 2005. In October, yet another IBA branch was opened in Ekaterinburg (Russia), in addition to its representative offices in London and Frankfurt and IBA-Moscow with a branch in St. Petersburg.

In January, Azerbaijan presented its national report on action against money laundering and funding of terrorism to the Council of Europe Select Committee of Experts on the Evaluation of Anti-Money Laundering Measures (Moneyval). It is encouraging to note that Azerbaijan was ranked among states basically meeting the standards of the OECD’s Financial Action Task Force (FATF).

Progress has also been recorded in fiscal reforms. These include measures to upgrade tax legislation and the budget process, the development of a legal framework for targeted social assistance, participation in the initiative to enhance transparency in the mining industries, etc.

In January, new amendments and addenda to the Tax Code, mostly concerning taxation of the transport sector and rates of tax on the production of natural resources, entered into force. In February, a decree was signed on improving control over the use of state budget funds, and the government traditionally renewed its list of import goods exempt from VAT.

An important and growing role in the financial system is played by the State Oil Fund, whose resources are already comparable with the state budget and are expected to exceed it in the next few years. That is why the approval of the Fund’s budget (in March) attracted public attention. In June, the country’s parliament approved amendments to the 2005 State Budget (with an increase in revenue and expenditure by 7.4% and 10.1%, respectively), and in November it approved the 2006 State Budget. The budget deficit is to amount to 1.3% of GDP, with due regard for the repayment of a part of the external debt.

In February, the procedure for protecting Azerbaijan’s property rights abroad, including in international courts, was revised. From now on, the costs of such protection are to be covered from state budget funds transferred to the account of the Ministry of Economic Development. Twenty-five percent of income from privatization of state property is to be used for these purposes.

Foreign Economic Relations

As an independent participant in the world process, Azerbaijan has increased its role in the development of the system of international economic relations from year to year, focusing its attention on regional economic cooperation, primarily with countries of the Caucasus and Central Asia.

There is active cooperation with Georgia, which accounts for 4.8% of Azerbaijan’s export operations. Trade between the two countries ($253.9 million in 2005) has been growing with a surplus in favor of Azerbaijan ($162.9 million). Cooperation under transnational projects has also been expanding. Together with delegations from Azerbaijan and Turkey, Georgia’s representatives took part in the first meeting (in February) of the working group for the construction of the Kars-Akhalkalaki-Tbilisi-Baku Rail Corridor, which discussed the establishment of a tripartite consortium to implement the project and prepare a feasibility study. In March, the government signed an agreement on rescheduling Georgia’s debt to Azerbaijan in the amount of $16.2 million. In April, the State Securities Committee of the Azerbaijan Republic and the National Securities Commission of Georgia signed a memorandum of cooperation, which is seen as the first step toward the creation of a single securities market in the Caucasus. On 19 July, a forum of business people from Azerbaijan and Georgia was held at the Baku Business Center. And in December, during the Georgian foreign minister’s visit to Azerbaijan, the parties discussed matters of further cooperation and interaction between the two countries in the transportation of energy resources from the countries of Central Asia and the Caspian basin to Europe, use of their transit potential to ensure long-term security, and the idea of developing a trans-Atlantic energy concept.

In view of Armenia’s expansionist policy toward Azerbaijan, economic relations with this Central Caucasus republic are not maintained.

Noticeable changes have taken place in Azerbaijan’s relations with Kazakhstan, the leading country of Central Asia. In April, representatives of the two countries meeting in Baku started talks on the transportation of Kazakhstan oil through the Baku-Tbilisi-Ceyhan pipeline. In June, a two-day bilateral business forum was held in Baku in order to develop an arrangement for the supply of fruits and vegetables from Azerbaijan to Kazakhstan. And in July, the two countries signed a protocol on expanding economic relations.

International economic cooperation is largely promoted by Azerbaijan’s activity in various regional structures (CIS, GUAM, ECO) and projects (TRACECA and North-South international transport corridors).

Azerbaijan maintains traditionally close relations with neighboring countries: Russia, Turkey and Iran. The Russian Federation is high on the list of the country’s trade and economic partners, and 2005 was declared to be a Year of Azerbaijan in Russia. Its share in Azerbaijan’s foreign trade is 11.7%. In the past year alone, bilateral trade increased by over 20% and exceeded $1 billion. One of the most active Russian business entities operating in the country is the company LUKoil, which takes part in the development of the Shah Deniz field and in the construction of the South Caucasus gas pipeline. In March, the Azerbaijani-Turkish Association of Businessmen initiated the establishment of a Union of Eurasian Businessmen (Russia, together with the aforesaid countries, is to constitute its basis), and a declaration on the establishment of this Union was signed in Baku in October. During visits to Azerbaijan by official Turkish delegations, the parties signed a number of intergovernmental agreements in various spheres of the economy. Cross-border cooperation with Iran mostly covers projects in the electric power industry designed to enhance the technical possibilities for energy exchange between the two countries.

Economic relations with other Islamic states, including Pakistan and unrecognized Northern Cyprus, are strengthening as well. In July, a branch of the National Bank of Pakistan was set up in Baku; a direct air route was opened between Baku and Karachi; and a joint business forum was held at the Middle East University in Northern Cyprus. The Azerbaijani-Turkish Association of Businessmen and a number of organizations of Northern Cyprus signed protocols on trade and economic cooperation.

The question of Azerbaijan’s integration into Europe came into even sharper focus. Trade with countries of the European Union increased, just as the amount of investment in the Azerbaijan economy. The EU share in the republic’s foreign trade exceeded 38%. A special place here belongs to technical assistance programs (TACIS). In February, a department of European integration was set up at the TACIS Coordinating Unit in Azerbaijan. Under the European Neighborhood Policy program, the parties began drafting an action plan to implement the necessary measures for closer relations between Azerbaijan and Europe. Among the priorities of EU cooperation with Azerbaijan let us note the following: poverty reduction, completion of oil and gas pipelines, modernization of the tax system, and food security. But this cooperation had its weak points as well: Azerbaijan’s low share in the EU countries’ foreign trade and asymmetric commodity structure of mutual trade, when Azerbaijan exported to Western Europe mainly energy resources and raw materials, while exports of manufactures were confined to a narrow range of relatively simple goods and intermediate products. Various business forums with the participation of business people from Azerbaijan and leading European countries (Germany, France, Italy, Finland, etc.) were held throughout the year.

Developing economic interaction with the United States was mostly connected with projects for the use of alternative energy sources in Azerbaijan, development of promising deposits of oil, gas, gold, silver and copper, and tourism in Azerbaijan.

Trade and economic relations with countries of the Asia-Pacific Region—China and Japan—developed dynamically. Trade with these two countries has been growing steadily, and their companies successfully operate and actively invest in the republic’s economy. In 2005, priority was given to the energy sector: Chinese companies are interested in larger supplies of Caspian oil and seek to increase their investments in this area, and Japanese companies are working on such major projects as the Sangachal Terminal and the Shimal State District Power Station (SDPS). Among the other areas of cooperation one should note the reconstruction of electric power stations, engineering, agriculture, the textile industry, tourism, and the development of the infrastructure. In March, the governments of Japan and Azerbaijan concluded a grant agreement, under which the republic has purchased 25 new combines for the amount of $1.82 million. Contacts were also on the rise with South Korea, which has expressed an interest in deepening cooperation in the energy and construction sectors, in the field of electronics and information technology.

Economic relations with foreign countries should intensify still further in connection with the submission to the WTO (in May) of a package of six documents, which made it possible to start bilateral negotiations.

Cooperation with International Financial Institutions

Significant progress was achieved during the year in cooperation with global and European financial institutions.

The International Monetary Fund mostly provided advisory assistance on a wide range of issues, including an improvement of statistical reporting (March), fiscal policy (April), assessment of inflation, targeted social assistance to poor strata of the population (May), implementation of the new economic reform program and development of the non-oil sector (December).

The World Bank and members of its group—the International Finance Corporation (IFC) and the International Development Association (IDA)—were active in their relations with Azerbaijan. In January, the World Bank approved a soft loan ($11.3 million) to Azerbaijan for the support of refugees and displaced persons and considered the question of disbursing the first credit tranche ($20 million) for the poverty reduction program. The parties also discussed possible lines of cooperation in the area of infrastructure projects, signed credit agreements (over $20 million) for the development of the postal system and environmental protection in rural areas, and considered the question of a grant ($481,250) for preparing a project to utilize petroleum gas at the Gunashli field. The IFC began implementing corporate governance projects (in the amount of $2.1 million) and signed an agreement to provide a $5 million line of credit to UniBank. And the IDA, for its part, signed an agreement on a $19.2 million credit for poverty reduction.

At the same time, when speaking of IMF and World Bank loans, one should draw attention to a number of indicative facts: in June, the government declined an IMF tranche in the amount of $19 million in view of an increase in currency reserves, and in December it took a decision to return to the World Bank $4.6 million saved under the second project of technical assistance for institution building in Azerbaijan (IBTA-2).

The European Bank for Reconstruction and Development (EBRD) financed four projects to the tune of $200 million (repair of the Hajigabul-Kiurdamir road, reconstruction of the Baku-Samur highway, upgrading of the locomotive fleet of the Azerbaijan State Railways, and support for small and medium businesses). In November, the EBRD adopted a new country strategy for Azerbaijan, according to which its main operational objectives are the non-oil sector (agribusiness, tourism, telecommunications, general industries), the financial sector, infrastructure and natural resources. In addition, the EBRD became a shareholder in the Mbask insurance company and two commercial banks: Bank of Baku and Azdemiryolbank.

In August, the Black Sea Trade and Development Bank (BSTDB) provided a five-year loan of 5 million euros for the purchase of equipment for a glassworks in Baku, and in November it signed an agreement with UniBank on a $3 million revolving line of credit for funding export and import operations.

The Asian Development Bank (ADB) took a decision to provide Azerbaijan with credits ($104 million) for implementing three projects: one road project ($52 million) and two water projects ($52 million).

The Islamic Development Bank (IDB) entered into four loan agreements for a total of $62.4 million.

Germany’s KfW Development Bank allocated a technical assistance grant of 1 million euros and a soft loan of 5 million euros for the initial capitalization of the Azerbaijan Deposit Insurance Fund, and also a $500,000 grant for the development of projects to renovate the water supply systems of the cities of Ganja and Sheki. Together with the Sparkassen International Development Trust (SIDT), the KfW became a shareholder in the Republic Bank.

In February, the State Securities Committee and Deutsche Bank discussed the latter’s proposal for the issue of Eurobonds by Azerbaijan.

A forty-year loan agreement with the Japan Bank for International Cooperation ($273.6 million) for the construction of a combined cycle gas turbine at the Shimal power station, approved in July, will make it possible to ensure stable energy supply to Baku and neighboring areas. Under another agreement approved in July, the Czech Export Bank is to raise a credit ($180 million) for the reconstruction of the Baku-Samur road. In August, one of the leading banks of Kazakhstan, TuranAlem, presented its representative office in Azerbaijan.

On 19 August, the IBA signed an agreement with a number of Western banks, including the American Citigroup and the German Commerzbank, on raising a syndicated loan in the amount of $56 million.

In May, representatives of the country’s government, UNDP, ADB, EBRD, World Bank and IMF meeting in Baku signed a declaration on the development of a long-term poverty reduction and economic development strategy for Azerbaijan for 2006-2015. Apart from that, the EBRD, BSTDB, IFC, USAID and other foreign financial organizations are involved in microfinance projects, having attracted $100 million for their implementation from foreign sources.

Economic Consequences of Armenian Occupation

In 2005, as in the previous 18 years, the interstate conflict between Armenia and Azerbaijan (Nagorno-Karabakh conflict) exerted a negative influence on every sphere of public life. Its adverse effects will impede the socioeconomic development of Azerbaijan for a long time to come.

Armenia seized the Nagorno-Karabakh Region of the Azerbaijan Republic and seven districts adjacent to it. Almost 20% of Azerbaijan’s territory is under occupation, and this has resulted in huge material damage to the republic totaling $26.2 billion. The number of refugees and displaced persons in Azerbaijan is close to one million, with about 60% of them living below the poverty line. In order to improve their material status and everyday living conditions, the government is obliged to allocate significant budget funds, which exerts constant pressure on the economy: in 2005, allocations for these purposes amounted to $153 million. Another $30 million was provided by international financial organizations.

Special note should be taken of the environmental damage from Armenian occupation. In the occupied territories, the invaders engage in illegal development of mineral deposits (over 90 officially registered and evaluated mineral deposits are located in these territories), destroy forests, nature reserves, pastures, etc., and deliberately pollute rivers flowing into the Caspian Sea. Under a 1998 agreement with Canada’s First Dynasty Mines Ltd, only in 2002-2003 Armenia produced 5,000 kilograms of gold from the Zod deposit in the Kelbajar District (located outside Nagorno-Karabakh). In defiance of international legal norms, Armenia has set up a joint venture with India’s Sterlite Gold Ltd and has continued to develop this deposit, laying waste 500 hectares of adjacent territory. In view of this, and also because of the forced cessation of rail and road communications with the Nakhchyvan Autonomous Republic (blockaded over the past 18 years) and of transit traffic through its territory, Azerbaijan’s budget annually loses colossal amounts.

Conclusion

So, 2005 was a period of active implementation of concrete plans and programs oriented toward sociopolitical and macroeconomic stability, structural reforms, improvement of the business climate, a massive inflow of investment into the oil sector, enhancement of its export potential, faster growth of production in the non-oil industries, and a significant increase in real household income. On the whole, objective conditions have been created in the country for dynamic economic and social development.

In many respects, Azerbaijan remains the most attractive country for investment. Its leadership’s strategy of socially oriented market transformation has created prerequisites for accelerating economic development and integrating the republic into the world economy in cooperation with friendly countries and international financial institutions.

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¹ See: Section “Politics.” _{Back to text}
² The largest banking institution in the Caucasus. _{Back to text}