INTERNATIONAL COMMUNITY CONCERNED ABOUT POSSIBLE

C O N F I D E N T I A L SECTION 01 OF 03 BAKU 001405

SIPDIS

SIPDIS

DEPT FOR EUR A/S FRIED AND EB A/S SULLIVAN

E.O. 12958: DECL: 09/27/2016
TAGS: ECON EFIN PREL PINR AJ
SUBJECT: INTERNATIONAL COMMUNITY CONCERNED ABOUT POSSIBLE
ECONOMIC "TRAIN WRECK" IN AZERBAIJAN

REF: (A) BAKU 1274 (B) BAKU 1176

Classified By: AMBASSADOR ANNE E. DERSE, PER REASONS 1.4 (B,D)


1. (C) SUMMARY. On September 14 Ambassador Derse hosted the
Friends of Azerbaijan Revenue Management Group, a group
consisting of representatives from the diplomatic community
and international financial institutions. The group
discussed the current macroeconomic environment, the
challenges facing the country and the Government of
Azerbaijan and the urgent need for an unified message from
the international community that participants would use with
government interlocutors, now under development. According
to the group, the economy appears to be a "train wreck"
waiting to happen due to the GOAJ's inability or lack of
capacity to reform key parts of the economy. Azerbaijan's
economy is becoming overly reliant upon its energy resources
and the non-oil sector is suffering. The agricultural sector
is stagnating at zero percent growth and the government has
not found a sound policy balance between maintaining
macroeconomic stability and development, including meeting
infrastructure and social needs (health, education).
Concerns about the 2008 elections and the need to "deliver
results" appears to be driving GOAJ spending decisions,
putting pressure on macroeconomic stability -- "They are
driving their economy off a cliff," the IMF representative
said to general agreement.


2. (C) SUMMARY CONTINUED: In a separate meeting on September
6, the IMF's lead staff economist for Azerbaijan said that
GDP growth for the first six months of 2006 was 35 to 40
percent faster compared to the same period in 2005.
According to official statistics, inflation was 10.2 percent
to date for the year. The National Bank continues its policy
of currency appreciation and the Azerbaijani manat has
already appreciated four percent against the U.S. dollar.
While the 2007 budget has not been finalized, the Minister of
Finance told the IMF that government expenditures will
increase 40 percent compared to the 2006 budget. The
concerns expressed by the international community underscore
the need for a sustained, senior-level macroeconomic policy
discussion with the GOAJ. END SUMMARY.


3. (C) On September 14, Ambassador Derse hosted the Friends
of Azerbaijan Revenue Management Group (RMG),consisting of
representatives from the diplomatic community and
international financial institutions. The discussio focused
on the current macroeconomic environmen, how much time the
Government of Azerbaijan (GOJ) has to reform its economy,
before the impact of exploding oil revenue and GOAJ spending
hits, and broader economic reform in managing oil revenues.
In addition, participants reviewed the need to develop the
non-oil sector and the role of the international donor
community in working with the GOAJ to strengthen its oil
revenue management. At the end of the meeting, the
participants agreed to develop a concerted strategy and core
message that could be presented to GOAJ officials at every
opportunity. The RMG will meet again in October at the World
Bank in order to finalize the core message points and
brain-storm on possible next steps to engage the GOAJ as a
group.

RMG DISCUSSION AND CONCERNS
--------------


4. (C) RMG meeting participants noted that the government's
fiscal policy appears to be out of control and that the
government's anti-inflationary strategy was unclear. The IMF
representative questioned whether the government would allow
the Azerbaijani manat to appreciate or allow inflation to
edge higher. With a view to the 2008 presidential elections,
there is pressure to spend more to deliver results on the
social and infrastructure needs. This broader macroeconomic
issue appears to be a current topic of debate among the
National Bank, Ministry of Finance and Ministry of Economic
Development. According to the group, the economy appears to
be a "train wreck" waiting to happen due to the GOAJ's
inability or lack of capacity to reform key parts of the
economy, and its apparent preference to endure higher
inflation to allow increased spending.


5. (C) The UN representative stated that efforts to develop
the country's "human capital" are critical, especially

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through strengthening education. In addition, the non-oil
sector is suffering and for the first six months of 2006 the
agricultural sector grew zero percent. In addition, overall
farm and agricultural activities appear to be decreasing as
more agricultural workers leave rural areas for higher paying
jobs in Baku. Overall, the group agreed that the economy is
not diversifying and is actually becoming more and more
reliant on the energy sector. One of the key problems
affecting the economy and its diversification is the role of
state monopolies in stifling small and medium enterprises and
domestic economic activity. The banking/financial sector is
anemic, provides only poop intermediation and its reform is
critical. Financing is scarce, high-cost, and short term
which is also strangling business development. Several group
participants opined that a robust banking sector is critical
for intermediation, SME growth and the government's
macroeconomic management.


6. (C) As the GOAJ increases public investment and
infrastructure projects, the UN rep noted, it must balance
macroeconomic stability. The Ambassador stated that
Azerbaijan's eventual WTO membership will improve the
investment climate and advance legal reforms which will
increase overall transparency. All participants agreed,
underscoring that endemic corruption is harming the economy.
The discussion turned to the window of opportunity for
enacting necessary economic reforms before the impact of
exploding oil revenue hits. Some participants stated that
the window would close in two or three years while others
felt that Azerbaijan had as many as 15 years. Several
participants noted that the 2008 Presidential elections are
already influencing current economic decisions in both
positive and negative ways. The Asian Development Bank
representative stated that the GOAJ understands necessary
reforms but is taking no action - a disturbing possibility.


7. (C) The IMF representative warned that in two to three
years Azerbaijan's economy could become totally reliant upon
its oil and gas sector if there is no change. The World Bank
representative stated that absent reform, Azerbaijan could
experience an "Argentine Curse" (hyperinflation) and/or
"Nigerian Curse" (violent conflict for energy resources). In
addition, he noted that "Dutch Disease" in Azerbaijan is a
misnomer since the non-oil and trade sectors are small and
may not alert economic observers to potential difficulties
and problems.

CURRENT MACROECONOMIC ENVIRONMENT
--------------


8. (C) IMF resident representative Basil Zavoico briefed on
the recently concluded staff consultations with the
Government of Azerbaijan that primarily focused on the 2007
budget process. Zavoico said that the amount of GOAJ
spending in 2006 had created a 30 percent non-oil sector
fiscal deficit. Zavoico said that the GOAJ appears to have
accepted double-digit inflation as an acceptable consequence
of rapid growth and modernization, noting that 15 percent
seemed to be the threshold for GOAJ economic decision makers.
Zavoico told the group thatthe non-oil sector totaled USD
10 billion, of whch more than 50 percent represented
government spending. For 2007, the IMF estimates that annual
inflation would range between 15 and 20 percent.


9. (C) Zavoico briefed the group on the supply side, noting
that imports into Azerbaijan had actually dropped during the
first six months of 2006. He indicated that the economic
system is not flexible since large monopolies control large
sectors and inhibit business development. As an example,
Zavoico relayed to the group that delivery of apples from
Guba to Baku had been restricted in favor of apples imported
from Iran and controlled by a large monopoly. Zavoico said
that for Azerbaijan it is easier to import goods than spend
the money on domestic production infrastructure and other
expensive inputs. The group noted that this mentality would
be deadly in the long-term as individual economic sectors
would atrophy and would not be able to recover quickly.

VISITING IMF TEAM BRIEFING
--------------


10. (C) In a separate meeting with the diplomatic community
on September 6, the IMF's lead staff economist for

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Azerbaijan, Vitali Kramarenko, said that GDP growth for the
first six months of 2006 was 35 to 40 percent faster compared
to the same period in 2005. The agricultural sector,
however, experienced zero percent growth during the first six
months of 2006, highlighting the economy's over-reliance on
the energy sector. Kramarenko stated that according to
official statistics inflation was 10.2 percent to date for
the year. In 2005, President Aliyev signed a Presidential
Decree that implemented several measures to keep inflation to
single-digits, which the GOAJ successfully executed. This
decree remains and the GOAJ has yet to abandon the goal of
single-digit inflation in 2006.


11. (C) According to National Bank data, the money supply has
increased 70 percent as the government increased expenditures
70 percent in the first six months of 2006 compared to the
same period in 2005. The National Bank continues its policy
of currency appreciation and the Azerbaijani manat has
already appreciated four percent against the U.S. dollar.

2007 BUDGET
--------------


12. (C) Kramarenko indicated that the IMF team had held
discussions with the Minister of Finance on the macroeconomic
environment and the 2007 state budget preparations. While
the final 2007 budget has not been finalized, the Minister of
Finance told the IMF that government expenditures will
increase 40 percent compared to the 2006 budget. Minister
Sharifov said that the GOAJ had originally wanted to increase
expenditures by a much larger amount but that he and other
economic ministers had cautioned against spending too much
and destabilizing the macroeconomic environment. On the
budget revenue side, Kramarenko, stated that the GOAJ is
expecting an increase in personal and corporate tax and
customs collections. Minister Babayev told Ambassador Derse
in July that the GOAJ wanted to increase the collection rate
for many public utilities, including water and electricity;
Minister of Industry and Energy reiterated recently that
goal.

COMMENT
--------------


13. (C) The uniform concerns expressed by the international
community underscore the need for a sustained, senior-level
macroeconomic policy dialogue with the Government of
Azerbaijan. The new BP-funded macroeconomic modeling unit at
the State Oil Fund (ref a) will help the GOAJ better
understand the risks inherent in its current budget planning
approach, but it will not provide the strategic guidance and
pressure needed to help Azerbaijan successfully balance its
competing macroeconomic and development policy needs.
Through our new Economic Partnership Commission (ref b),the
USG needs to help the GOAJ understand that serious economic
reform and revenue management are key to Azerbaijan's
stability and in turn its reliability as a partner for the
U.S.
DERSE