IMF concludes consultation for results of 2023 with Azerbaijan

On January 11, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Azerbaijan and endorsed the staff appraisal without a meeting on a lapse of time basis.

Following the strong rebound from the pandemic, growth moderated in 2023, and inflation eased . Real GDP increased by 4.6 percent in 2022, driven by a 9 percent increase in non-hydrocarbon GDP, with recovery in the construction and transportation sectors. Hydrocarbon GDP shrank by 2.7 percent, with oil production facing technical challenges only partially offset by rising gas production. Growth has been moderating in 2023, reflecting a deceleration of non-hydrocarbon growth to about 3 percent and declining hydrocarbon production. After increasing sharply to 14.3 percent (yoy) in December 2022, inflation declined to 3.9 percent in October 2023, driven by a broad-based decline in food, nonfood, and services prices.

High oil and gas prices sustained a strong external and fiscal position . The current account balance improved to a surplus of 29.8 percent of GDP in 2022 (from 15.1 percent in 2021) and remained strong in the first half of 2023 (10.1 percent of GDP). Combined Central Bank of Azerbaijan (CBA) and Sovereign Oil Fund of Azerbaijan (SOFAZ) reserves reached about $55.5 billion by October 2023. The overall budget surplus increased to over 6 percent of GDP in 2022, from 4 percent in 2021, while the nonoil primary balance also improved by about 1 ½ percent of nonoil GDP. During January-October 2023, overall budget surplus remained broadly similar as in the same period of 2022.

Growth and inflation are projected to moderate in the medium term . With the post-pandemic surge waning and continued structural decline in oil production, growth is projected to decelerate to around 2.4 percent in 2023 and to 2.3 percent in the medium term, and the output gap is expected to close in 2024. Inflation is projected at 4.4 percent by end-2023, and to remain within the CBA target band in the medium term. Supported by elevated oil prices, the external position is projected to remain strong with trade surpluses and continued foreign reserves accumulation.

Risks to the outlook remain broadly balanced, but external uncertainty is high . An intensification of the war in Ukraine and the conflict in Israel and Gaza could result in high hydrocarbon prices and demand, boosting exports and fiscal revenues. However, it could also lead to higher food prices, presenting downside risks for food security and inflation. A global slowdown could negatively impact Azerbaijan’s terms of trade and, along with weakness of trading partner economies and deeper geoeconomic fragmentation, weigh on the outlook. Domestic risks to the baseline projection arise from pro-cyclical fiscal policy, fiscal risks from state-owned enterprises (SOEs), and extreme climate events that would affect agricultural production, food security, and inflation. On the upside, a peace agreement with Armenia could potentially increase trade in the region.

Executive Board Assessment

In concluding the AIV consultation with Azerbaijan, Executive Directors endorsed the staff’s appraisal as follows:

Growth is moderating, following the post-pandemic surge in 2022, and inflation has eased. In the first 10 months of 2023, oil production declined, while non-hydrocarbon growth moderated. Hydrocarbon output is projected to continue contracting gradually as the expected structural decline in oil production will be only partially offset by rising gas production. The external position in 2022 is assessed as stronger than implied by fundamentals and desirable policies. After peaking in late 2022, inflation has recently returned to the target band of 4 ± 2 percent. However, inflation risks remain, both from potential external shocks and from continued strong domestic demand. Risks to the outlook remain broadly balanced but high, reflecting highly uncertain external developments.

Fiscal policy should remain prudent in the near term. Although the authorities are expected to continue meeting the non-oil primary balance target of -25 percent of non-oil GDP this year, owing to the overperformance in 2022, the projected increase in the deficit is unwarranted based on cyclical considerations, as the output gap is still positive. Inflation has also just returned to the target band and inflationary pressures remain. Saving any revenue overperformance or expenditure shortfall would help to reduce the risk to inflation and sustain gains from the last two years of consolidation.

The authorities’ continued commitment to medium-term fiscal consolidation is welcome. Continued fiscal adjustment of at least 1.5 percent of non-oil GDP in the medium term is needed to reduce the gap with the permanent-income-hypothesis benchmark of 12.5 percent of non-oil GDP. This adjustment will require both continued spending prudence, as well as measures to boost non-hydrocarbon revenues. The authorities are also encouraged to clarify the conditions for revising the fiscal targets and correction mechanisms to further strengthen the credibility of the fiscal rule.

The monetary policy stance is appropriate, and caution is advised before further easing monetary policy. With inflation returning to the target band, the central bank cut policy rates in November 2023, after tightening by 275 points from mid-2021 to May 2023 and increasing reserve requirements. However, inflation risks from external and domestic factors remain. Therefore, tightening fiscal stance, decelerating income and wage growth, and the absence of adverse food price shocks are needed before considering further easing.

The CBA should continue to strengthen the monetary transmission mechanism. The launch of the new operational framework and following efforts to mop up liquidity are welcome and have led to improvements in the transmission from the policy rate to the interbank rate. Further effort to strengthen transmission to bank lending rates are needed, which, along with improved forecasting and communication, would help pave the way in the medium- to long-run to greater exchange rate flexibility and a hybrid inflation targeting regime.

The banking sector is resilient and should play a bigger role in the economy. Financial soundness indicators continue to show a strong banking sector, though they do not fully capture risks. Staff recommends that continued comprehensive assessments of credit quality are needed, given restructured loans remain elevated, as well as moving to risk-based supervision and consolidated supervision of large banks. The authorities’ ongoing assessment of the financial sector role in the economy is welcome and should be followed by enhanced efforts to deepen financial markets.

Diversification will entail reforms to strengthen governance, limit the role of the SOEs, and de-carbonize the economy. Progress on increasing fiscal transparency and judicial independence, as well as ongoing efforts to increase private sector participation in SOEs and improve their financial position, will help improve the business environment, increase private investment, and enhance productivity. Implementation of MONEYVAL’s recommendations is crucial. The authorities’ efforts to achieve their climate commitments are welcome and would benefit from taking stock of the associated fiscal burden, as well as reducing it through complementary policies, such as phasing out fossil fuel subsidies.