AMBASSADOR DISCUSSES ECONOMIC ENVIRONMENT WITH

C O N F I D E N T I A L SECTION 01 OF 03 BAKU 001076 SIPDIS SIPDIS E.O. 12958: DECL: 07/17/2016 TAGS: ECON EFIN EAID PREL AJ SUBJECT: AMBASSADOR DISCUSSES ECONOMIC ENVIRONMENT WITH INTERNATIONAL FINANCIAL INSTITUTIONS Classified By: AMBASSADOR ANNE E. DERSE, PER REASONS 1.5 (B, D). ¶1. (C) SUMMARY: The Ambassador July 11 hosted a breakfast with representatives from the IMF, EBRD, ADB and World Bank to review recent developments on international assistance to Azerbaijan and the status of the economy. The Ambassador explained U.S. economic priorities, highlighting the importance of WTO membership, transparency and anticorruption, development of the non-oil sectors of the economy, and oil revenue management. The IFIs described to the Ambassador their current and future operations and projects. The IMF noted that inflation in 2006 would most certainly be in the double-digits and worried that continued appreciation of the manat (2.6 percent so far in 2006) and a 14 percent increase in GOAJ expenditures would overheat the economy. The bulk of the conversation revolved around the difficult operating climate in Azerbaijan. The EBRD and IMF representatives highlighted endemic corruption, lack of government coordination and the increasingly independent attitude of the GOAJ economic leadership in light of Azerbaijan's new oil wealth. The overall pessimistic attitude of the IFIs operating in Azerbaijan reinforces the need for renewed and intensified Western engagement with the GOAJ on economic issues. As the energy revenue flow increases, the GOAJ will require the international community's technical assistance to ensure that the country remains on the development path. END SUMMARY. ¶2. (C) At a breakfast meeting with Ambassador Derse, representatives from the International Monetary Fund, World Bank, Asian Development Bank and European Bank for Reconstruction and Development briefed on their respective operations, current projects and challenges of working in Azerbaijan. The Ambassador explained U.S. economic priorities, highlighting the importance of WTO membership, increasing transparency and fighting corruption, oil revenue management and development of the non-oil sector. The World Bank and ADB have been focusing their efforts on developing the public sector infrastructure. The World Bank representative told the Ambassador that it would fund five to six projects per year worth approximately USD 300 million. The EBRD representative said it has financed both private and public sectors but noted that the bank's financing operations in 2006 will decrease dramatically as it finds it more difficult to find eligible clients. The IMF representative briefed on the macroeconomic environment and noted that an IMF Article IV team planned to visit Baku in early September. MACROECONOMIC ENVIRONMENT -------------- ¶3. (C) The IMF stated that macroeconomic growth during the first half of 2006 remained relatively tame as the GOAJ moved slowly to begin government disbursement of budgetary and capital expenditures. (According to official GOAJ figures, released after this meeting, GDP growth was a record 36 percent for the first half of 2006. Full details septel.) According to the IMF, the GOAJ accelerated its expenditures in late March and early April 2006. The IMF representative noted that inflation has begun to increase and will most likely accelerate in 2006 reaching double-digits. He told the Ambassador that year-over-year inflation in June had risen to eight percent, although this figure may under-report true price increases. The IMF representative told the Ambassador that the government's official CPI statistics have been consistently lower since late 2005 when the GOAJ adjusted the manner in which it calculated the CPI. The IMF representative added that the National Bank is experiencing difficulty controlling the money supply. ¶4. (C) Compounding this situation, according to the IMF, is the expansionary fiscal policy that the GOAJ is pushing. The IMF representative added that while the National Bank had an excellent team, it does not wield the political influence necessary to affect fiscal policy, nor does it possess the tools, including open market operations, to control money supply. In addition, with more U.S. dollars than Azerbaijani manat flowing in the economy, the National Bank has been forced to convert its dollar reserves to manat, further appreciating the currency and hurting the export sector. The government's large capital expenditure projects were also contributing to the overheating of the economy. So far in 2006, the manat has continued its upward trend and has appreciated approximately 2.7 percent. ¶5. (SBU) The IMF representative told the Ambassador that BAKU 00001076 002 OF 003 long-term oil revenue management was a key issue that the IMF discusses regularly with the GOAJ. He noted that some officials in the GOAJ used to maintain an anti-inflationary stance, notably current Finance Minister Sharifov, but that this attitude had shifted in late 2005. This shift was evident in the 2006 State Budget and the revised budget. The 2006 State Consolidated Budget forecast government expenditures of USD 3.78 billion. In May 2006 the GOAJ submitted a revised budget increasing government revenues to USD 4.2 billion and government expenditures to USD 4.4 billion, an increase of approximately 14 percent. The GOAJ justified the increase in government expenditures based on the high price of crude oil and increased government receipts. ¶6. (C) The IMF noted that the "economic lag" in Azerbaijan is longer than other developing countries, equaling between eight and nine months. For this reason, the true macroeconomic effects of increasing government expenditures on prices and currency appreciation may not be fully felt until late fourth quarter 2006 and early 2007. By the time the macroeconomic environment begins to show signs of destabilizing consequences, the GOAJ may not be well positioned to reverse course and rein in government spending leading to macroeconomic harm. NEW SOVEREIGN DEBT RATING -------------- ¶7. (C) The IMF and EBRD representatives both told the Ambassador that Moody's has sent a sovereign debt rating team to Azerbaijan in order to obtain a second sovereign rating. In January, Fitch reiterated its "BB" rating for Azerbaijan. The GOAJ is interested in a second rating in order to float a Eurobond offering in order to establish a benchmark. The EBRD representative noted that the lack of transparency in Azerbaijan would limit Moody's ability to rate the country higher than Fitch's rating. Economic Development Minister Babayev and Finance Minister Sharifov have both highlighted to Embassy interlocutors the government's interest in a second sovereign rating. Citibank has assisted Moody's with its review in Azerbaijan, hoping to take the lead on any debt offering by the GOAJ. (Comment: The Citigroup advisor working with the GOAJ on the Moody's rating was less pessimistic, citing Azerbaijan's low and falling sovereign debt, shift from deficit to surplus in the current account, growing reserves and ability to service its debt. See septel.) WTO MEMBERSHIP -------------- ¶8. (C) The Ambassador raised with the group the importance of WTO membership, transparency and anticorruption efforts, noting that these elements would be key to the Embassy's economic strategy. While all agreed on the benefits of WTO membership, the IMF representative told the Ambassador that the GOAJ really just wants to "belong to the club" without actually abiding by the rules and reforming the economy. The EBRD representative added that Azerbaijan viewed international organizations as a means to win support for its side in the Nagorno-Karabagh issue with Armenia. In addition, several participants noted that the GOAJ appears also to use it relations with the IFIs to gain "legitimacy." DIFFICULT OPERATING ENVIRONMENT -------------- ¶9. (C) All the breakfast participants agreed that Azerbaijan is becoming a more difficult environment in which to operate. They highlighted the lack of inter-ministerial coordination, rampant corruption, lack of procurement procedures and the government's increasing disinterest in conditionality in loan and financing terms. The new World Bank head, a lone holdout, told the Ambassador that he believed the Ministers of Health, Economic Development and Justice were efficient and supportive of the Bank's programs. He noted that the Bank is moving away from IDA funding for Azerbaijan and moving towards the loans on IBRD terms. (NOTE: The GOAJ generally has been supportive of the World Bank compared to other international financial institutions. This support may be due to the Bank's enormous lending plans in the country and the projects' focus on large infrastructure (roads, highways, water sanitation) and social reform projects (judiciary and primary health care). ¶10. (C) The EBRD representative noted that the Minister of BAKU 00001076 003 OF 003 Finance has recently refused several EBRD loans based on "negative pledge clause." He particularly noted a power generating station deal that the GOAJ now wanted to cancel based on this conditionality. While the EBRD representative personally understood the reasoning behind the refusals, he noted that all the IFIs included such language and that only as a group should remove it from lending conditionality. Both the EBRD and IMF representative opined that the GOAJ really only wanted to support the "perception of engagement with the IFIs" while really disengaging from their programs. The EBRD representative told the Ambassador that the IFIs bring value added with project implementation and management and that the GOAJ is not interested in this aspect of financial assistance. ¶11. (C) In addition, the EBRD representative said that while the new Minister of Finance Samir Sharifov is an effective manager, he is "not a power-player" and is for "show" for the international community. (NOTE: Embassy does not fully agree with this assessment of Sharifov and believes that he has access to key individuals in the government, including the President.) He added that "other people" are actually controlling the GOAJ and making decisions. In addition, several of the IFI representatives noted that the attitudes of key officials in the GOAJ appear to be more nervous and less secure. Some officials are afraid to discuss potentially negative issues, and instead only focus on the positive. This perception, however, may come from the new economic team's growing confidence and experience. CORRUPTION -------------- ¶12. (C) Corruption remains one of the largest impediments to doing business in Azerbaijan. According to some of the IFI representatives the system in Azerbaijan is built upon corruption and without it, it would collapse. They added that there are no cultural norms against corruption and no recourse to combat it. All Azerbaijanis depend upon the system since there is no credible alternative. The EBRD representative highlighted the "punishment" of Turkish electricity distributor Barmek for not participating in corrupt activities. ¶13. (C) The EBRD rep also related to the Ambassador the difficulty of finding good private sector companies with clean balance sheets to finance and invest. He noted that GOAJ authorities, especially the Customs service, pressure many companies to under-report imports and kickback money to officials. He added that good companies were not being allowed to operate in Azerbaijan. Due to the poor business and investment climate, EBRD will only invest USD 30 million after having invested USD 280 million in 2005 and USD 250 million in 2004. COMMENT -------------- ¶14. (C) While the problems cited by the IFIs are real, some of the IFIs' comments appear to reflect their growing unhappiness that their influence with the GOAJ is waning as oil revenues come on line. The waning influence of the IFIs reinforces, in our views, the importance of intensified USG dialogue with the GOAJ on critical issues of economic policy, reform and liberalization. DERSE