Oil Wealth and Sustainable Development: the Case of Azerbaijan

1. Oil Wealth and Sustainable Development: the Case of Azerbaijan Presentation by Dr. KhaganiAbdullayev National Bank of Azerbaijan Director of the Department of Monetary Policy Fulbright Scholar at George Washington University Sponsored by the GWU European Union Research Center

2. Republic of Azerbaijan emerging as independent country • Macroeconomic stabilization and development in 1994-2003 • 2003 – present: New Oil Strategy and the Booming Economy • 2008 -2024: Temporary Oil Wealth and Development Scenarios • Sustainable Development – Main Goal of the Government of Azerbaijan Structure of Presentation

3. Population: 8.2 million • Territory: 86 th.sq.km. • GDP of Azerbaijan (PPP based) is around 2/3 of total GDP of South Caucasus region • GDP per capita in 2007 2620 USD, forecast for 2008 – 3640 USD

4. Republic of Azerbaijan emerging as independent country • 1991 – independence gained after the collapse of USSR, but complica-ted economic and political environment at the early 90’s delayed the transformation process • Economic picture in 1992-1993: • Annual inflation: 1600-1800% • Recession , output loss of 20-30% per year • Military aggression of Armenia – crisis exacerbating factor: • 20% of Azerbaijan occupied by Armenia • 1 million refuges, thousands of civilians massacred by armenian military in the Nagorni-Karabakh region of Azerbaijan • Plus internal political disputes and civil unrest

5. Macroeconomic stabilization and development in 1994-2003 • 1993: HeydarAliyevcoming to power with a huge support of society of a war torn country • 1994: ceasefire with Armenia, peace negotiations • Power consolidation, internal political stability • Macroeconomic Stabilization , Economic Reforms: • Standby agreement with IMF followed by EFF and ESAF (1994-99); • and later PRGF (2001-2004) • New Oil Era - signing PSA’s with international oil consortium headed by BP-AMOCO led to emergence of Azerbaijan as the regional economic leader • Average annual growth rate stood at 8.4% during 1996-2003, with the inflation rate at 2.8%, structural reforms started: privatization, liberalization and governance reforms

6. Oil strategy: Construction of the Baku-Tbilisi-Ceyhan Oil Pipeline leading to large-scale petrodollars inflow to domestic economy • More than 25 bln.USD FDI attracted to the oil industry in 1995 – 2007 • Since 1998 until now about 22 bln.USD of FDI was repatriated back by foreign companies Macroeconomic stabilization and development in 1994-2003

7. Short History of Baku oil • The presence of oil has been known since antiquity • By the 15th century oil for lamps was obtained from surface wells • Modern commercial exploitation started in 1872 – First Oil Boom – first azeri millionaires in tsarist Russia • The Baku oil field was the largest in the world at the beginning of 20th century • World War II – Second )il Boom – Baku becoming the first offshore extracting place in the world • At the early stages of World War II Baku satisfied 70% of the Soviet army and industry demand in oil • Currently – Third Oil Boom

8. Azerbaijan preparing for oil boom – State Oil Fund of Azerbajan (SOFAZ) established in December 1999 • SOFAZ – extra budgetary fund, separate legal entity, part of consolidated budget • SOFAZ objectives: • protection of macroeconomic stability through sterilization of oil revenues • accumulation of reserves for future generations • using part of reserves to stimulate economic growth • Sources of oil revenues to the budget: country’s share in exports of crude oil, bonus payments, asset management income Macroeconomic stabilization and development in 1994-2003

9. Azerbaijan preparing for oil boom – Long-Term Oil&Gas Revenue Management Strategy, approved by President, Sep.2004 • Covers period from 2005 to 2025, aims at: • Accumulation of reserves for future generations • Developing the non-oil economy through financing the public investment programs based on sound macro-fiscal planning • Resolution of other crucial problems of national dimension • Main principle: following a constant real expenditure path (sustainable path) when spending out of oil revenues Macroeconomic stabilization and development in 1994-2003

11. Oil GDP growth and Sustainable Real Expenditure Path

12. 2003 - PRESENT: New Oil Strategy and the Booming Economy • Increasing oil production contributed to rapid GDP growth in recent years • Average GDP growth rate stand at 24% in 2004-06 against the average rate of • 8.4% in 1996-2003

13. 2003 - PRESENT: New Oil Strategy and the Booming Economy

14. Oil exports (90% of total exports) is the driving force behind improving current • account balance, it almost doubled in 2006 and will grow by at least 50% in 2007 • Public external debt/GDP ratio went significantly down from the average 19% in • 1998-2002 to below 10% in 2006 due to growing volume of oil revenues to the budget • Sources of oil revenues to the budget: 1) SOFAZ transfers to budget 2) New profit taxes paid by oil consortium 3) State Oil Company profit taxes

15. Following a decade of moderate fiscal policy, an exceptional large fiscal expansion started in 2006 This is the core input into the economic modernization program announced by the new leader of Azerbaijan - Mr. IlhamAliyev elected in 2003- creation of 600,000 new jobs in the medium term Non-oil balance ratcheted up to 33% of non-oil GDP in 2006 compared to only 13% in 2005 Money Demand Shock

16. With increasing oil money inflow to the budget central bank has to conduct large interventions to prevent continuous exchange rate volatility (pegged regime) As a result large part of SOFAZ assets and governments foreign exchange deposits shifts to the balance of the central bank and it builds up reserves

17. Public investments saw huge growth (200%) in 2006 explained by implementing projects on enhancing the regional infrastructure As a result the share of investment composition in the budget jumped from 20% in 2005 to over 32% in 2007

18. Fiscal expansion underpinned high growth in non-tradable activities, because • Infrastructure is the main field of public investments fuelling non-tradable growth • Declining growth rate in the tradable sector may be explained by the effect of real • appreciation

20. Oil bum and large fiscal spending spurred inflation to some extent given the supply (non-oil sector’s supply) side capacity constraints in the economy But the wage and income growth in the economy exceeds average annual CPI twice: real growth of social indicators stands at around 10-15%.

21. Conclusion: Keynesian Model of Demand Stimulation Policy was put in place in Azerbaijan following a monetary tightening based stabilization policy conducted in 1994-2002: • Domestic economy saw growing non-oil deficit, excess of demand over supply, some inflationary pressure in 2004-2007 and jumping real estate prices – signs of overheating • Why spent too fast in 2004-2007? Main arguments: • National projects on reconstruction of the water supply and irrigation systems • Partial financing of the Baku-Tbilisi-Ceyhan pipeline • Improving the regional infrastructure – key precondition for investors activity • Urgent need to support 1 million refugees (mostly unemployed) living in tents, etc. • Government succeeded to hit its main target: POVERTY reduced from 49% in 2001 to currently below 20%*, more than 430 000 new jobs created *(poverty headcount ratio at national poverty line, % of population) 2003 - PRESENT: New Oil Strategy and the Booming Economy

22. Soviet Baku

23. NEW BAKU – Third Oil boom

24. What is the Appropriate Pace of Spending out of Oil Revenue? 2008 -2024: Temporary Oil Wealth and Development Scenarios

25. 2008 -2024: Temporary Oil Wealth and Development Scenarios

26. 2008 -2024: Temporary Oil Wealth and Development Scenarios • Scenario 1. Fiscal expansion (Worse or High Inflation Scenario) Assumptions for 2008-2016: • Average annual growth of budget expenditures: 25% • Average non-oil GDP growth rate: 5% • Average non-oil budget deficit/ non-oil GDP ratio: 52% • Oil price/barrel: 60$ • US T-bills rate : 4.5%, real rate of return: 3% • Scenario 1. Moderate fiscal policy (Good or Low Inflation Scenario) Assumptions for 2008-2016: • Average annual growth of budget expenditures: 9% • Average non-oil GDP growth rate: 8% • Average non-oil budget deficit/ non-oil GDP ratio: 15% • Oil price/barrel: 60$ • US T-bills rate : 4.5%, real rate of return: 3% • Forecasting technique used in simulation: Financial Programming framework with integrated econometric models (National Bank of Azerbaijan) • Simulations conducted by IMF: Neo-Classical Growth Model, 2007

27. 2008 -2024: Temporary Oil Wealth and Development Scenarios Elasticity relationships: • Every 1% of inflation above 8% causes 0.1% decline in both tradable and non-tradable sectors • 1% growth of public expenditure leads to: • 0.1% growth in tradable sector • 0.25% growth in non-tradable sector Elasticity relationships: • 1% growth of M2 causes 0.3-0.35% rise in CPI • This ratio is supposed to go up in the long-run with increasing GDP monetization • Inflation inertia - 1% of past year inflation creates 0.4-0.45% inflationary effect next year

28. 90% 80% 70% 60% 50% 40% Worse scenario 30% Good scenario 20% 10% 0% 2009 2011 2013 2015 2017 2019 2023 2001 2003 2005 2007 2021 -10% 2008 -2024: Temporary Oil Wealth and Development Scenarios Public expenditure annual growth rate scenarios

29. 2008 -2024: Temporary Oil Wealth and Development Scenarios

30. 2008 -2024: Temporary Oil Wealth and Development Scenarios

31. 2008 -2024: Temporary Oil Wealth and Development Scenarios

32. 2008 -2024: Temporary Oil Wealth and Development Scenarios

33. 250% 200% Worse scenario 150% 100% Good scenario 50% 0% 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2001 2002 2003 2004 2005 2006 2021 2022 2023 2024 2008 -2024: Temporary Oil Wealth and Development Scenarios External debt/GDP ratio scenarios

34. 2008 -2024: Temporary Oil Wealth and Development Scenarios

35. 2008 -2024: Temporary Oil Wealth and Development Scenarios

36. CPI -right

37. 2008 -2024: Temporary Oil Wealth and Development Scenarios

38. 2008 -2024: Temporary Oil Wealth and Development Scenarios

39. Sustainable Development – Main Goal of the Government of Azerbaijan • Policy agenda of Government in support of these objectives • Sound medium and long term macroeconomic management • Deepening structural reforms and building sound institutions to enhance productivity • Prevention of “rent seeking”, improving governance and providng high transparency • Long-term Policy objectives of the Government: • Diversification of economy and prevention of “Dutch disease” • Building democratic market economy • Poverty elimination and building a welfare society

40. Sound medium and long term macroeconomic management • Adoption of a Medium-Term Fiscal Framework (MTEF) starting in 2008 supported by World Bank and USAID: • First step: pace of expenditure increase for 2008 was moderated (from 60% to 28%). Investment program includes: • completion of investment projects in basic infrastructure started in previous years • most critical projects in social sectors • Linking annual budget to long-term policies and sustainability objectives – program budgeting • Adoption of a Medium-Term Fiscal Framework (MTEF) starting in 2008 supported by World Bank and USAID: • Integrated medium-term macroeconomic projections • Aggregate fiscal targets, target for the non-oil deficit based on stabilization and sustainability goals (top-down approach in drafting the budget expenditures) • Administrative capacity building – Public Financial Management Systems to ensure the quality of spending

41. Sound medium and long term macroeconomic management • Macroeconomic policy coordination and inflation targeting: • Setting reasonable operational target for non-oil deficit - more exchange rate flexibility through scaling down foreign exchange interventions • Setting achievable monetary policy operational targets (money base) backed by reasonable macro-fiscal framework • National Bank of Azerbaijan (NBA) – has goal and instrument independence by law • Current Sterilization Strategy of NBA: • 3-month bonds – limited issuance because it is expensive and may lead to speculative capital inflow • Macroeconomic policy coordination and inflation targeting: • Free capital account (outflow recently liberalized) • Imposing reserve requirements on bank’s foreign liabilities (now 5-6% of GDP ) – lessons from Kazakhstan • Improving prudential regulation to minimize system vulnerabilities against 1) credit-real estate boom and 2) short-term capital inflow • Communication strategy of NBA: • Drafting and Publication of Financial Stability and Inflation Reports • Inflation forecasting capacity: building monetary policy transmission models, measuring the output gap

42. Prevention of rent sEeking • Adoption of the anticorruption program: • National Strategy on Increasing Transparency and Fighting Corruption adopted • The law on fighting corruption adopted • State commission on fighting corruption established • Other anticorruption laws pending to be passed by Parliament: • Anti-money laundering law • Law on the Code of Conduct of Civil Servants • Law on Preventing the Conflict of Interest of Public Officials • E-government project started recently and supported by the World Bank

43. Structural reforms and building institutions • Public sector reforms: • Strengthening fiscal discipline at SOE via elimination of subsidies and developing corporate manage-ment standards • Introducing strategic planning in budgetary organizations • Improving governance and tax customs administration • Removing market distortions: • Privatization of large enterprises • Privatization of large two state owned banks (president decrees signed recently) • Improving business climate in the non-oil sector • President’s recent decree on simplification of licensing and registration – formalization of starting business through one ministry • New antimonopoly code and investment law pending to be passed by Parliament • Widening access to credit : • State Entrepreneurship Fund financed by budget and allocating credits through agent banks • Regional development : • Regional Development Program - enhancing infrastructure and improving business climate through tax incentives and widening access to credit

44. Transparency: AZERBAIJAN AND EXTRACTIVE INDUSTRIES TRANSPARENCY INITIATIVE (EITI) • SOFAZ has won the 2007 UN Public Service Award in the category of “Improving transparency, accountability and responsiveness in the Public Service” for EITI. • SOFAZ is the first governmental organization winning the award in CIS and Eastern Europe • Full reports and the press-releases related to EITI are disclosed on websites: • SOFAZ : www.oilfund.az • EITI Secretariat www.eitransparency.org • NGOs Coalition website: www.eiti-az.org • Azerbaijan volunteered to become a First country to implement EITI • 15 March 2005 – Azerbaijan disclosed First EITI reports in the World (2003 annual report and 2004 semi annual report) • By implementing EITI the government of Azerbaijan achieved full accountability and transparency in oil and gas revenues

46. THANK YOU!!!