MANAGING AZERBAIJAN,S LOOMING ECONOMIC STORM

C O N F I D E N T I A L SECTION 01 OF 05 BAKU 000407 SIPDIS SIPDIS E.O. 12958: DECL: 03/16/2016 TAGS: ECON EFIN EAID ETRD PREL PGOV AJ SUBJECT: MANAGING AZERBAIJAN,S LOOMING ECONOMIC STORM Classified By: Ambassador Reno L. Harnish III per 1.4 (b,d). ¶1. (C) SUMMARY: Azerbaijan faces a massive economic challenge over the near-term. With oil revenue projected to reach USD 42 billion by 2010, Azerbaijan has the opportunity to transform from a cash-poor developing nation into an economically confident regional leader. While the GOAJ in theory has the right tools in place to make this transition, we see troubling signs that the GOAJ is moving in the wrong direction. Quick GOAJ action is needed in its economic decision-making structure, anti-inflationary measures and banking reform. Over the medium-term, the GOAJ also must take action on the business climate, anticorruption measures and increasing citizen oversight of GOAJ activities. Continued, high-level engagement by the U.S. and the international community will be key to convincing the GOAJ to take these hard steps. END SUMMARY EXPANDING ECONOMY PRESENTS DIFFICULT CHALLENGES -------------- -- ¶2. (C) Azerbaijan,s rapidly expanding economy poses a massive challenge tQhe GOAJ. With oil revenue projectQto reach USD 42 billion by 2010, Azerbaijan must apply a balanced approach to fiscal and budgetary policy that maintains macroeconomic stability while allowing sustainable capital investment and infrastructure development. While the GOAJ in theory has many of the right tools in place to manage this transition -- including an internationally audited State Oil Fund and an economic reform program -- we see increasing, troubling signs that the GOAJ is moving in the wrong direction. With a whopping 70 percent increase in the state budgQor 2006, there is a real danger that the combination of weak monetary tools and sharply increased public expenditures as petro-dollars flood into a weak economic environment could lead to higher inflation and the potential for economic and political instability. ¶3. (C) The GOAJ has yet to show sufficient respect for the economic and financial perils that can come with an economy reliant on oil, i.e. Dutch Disease. The onset of Dutch Disease would only worsen Azerbaijan,s already large poverty problem, with 40 percent of the population currently under the poverty line. While the international community continues to be engaged on economic issues, our ability to maintain pressure on the GOAJ to continue reforms, control inflation, and diversify the economy will decrease as GOAJ revenues increase. The GOAJ already has not hesitated to break off negotiations with IFIs if the lending conditions prove too stringent or the conditions of the financing do not meet the government,s satisfaction. IFIs are also worried that anti-reform elements appear to be gaining the upper hand within GOAJ economic decision-making circles. ¶4. (C) Azerbaijan,s economic policy drift over the last decade could be remedied by GOAJ action in its economic decision-making structure, renewed attention to anti-inflationary measures and banking reform. Over the medium-term, the GOAJ also must take action on the business climate, anticorruption measures, trade and increasing citizen activism and oversight of GOAJ activities. All of these measures are necessary to prevent the onset of Dutch Disease. ¶5. (C) The U.S. is deeply engaged in promoting economic and legal reform through our assistance programs and, on a policy level, through regular dialogue via the Revenue Management Group and the Joint Economic Task Force. Given the urgency of economic reform and its key role in preserving stability in Azerbaijan, sustained, higher-level dialogue on these issues over the coming year will be critical to protecting our interests in this strategically important, energy-rich Muslim country in the heart of the Greater Middle East. The U.S. and U.K. ambassadors lead the locally-formed Revenue Management Group (RMG),a high-level group of international donors that carries significant political and economic clout within the GOAJ. A key priority of the RMG is to increase GOAJ awareness of revenue management and economic reform. Members of the RMG work to coordinate directly the various economic reform and assistance efforts of USAID and the IFIs as well as provide strategic guidance to high-level GOAJ officials on economic and fiscal policy items. In coordination with the RMG, the U.S.-Azerbaijan Joint Economic BAKU 00000407 002 OF 005 Task Force provides a valuable mechanism for U.S. and Azerbaijan economic decision makers to discuss bilateral economic priorities and goals. The November 2005 meeting, which included the Minister of Finance, Minister of Economic Development and the Chairman of the National Bank, brought together the key GOAJ officials that directly affect economic policy decisions. Continuing the active participation of senior U.S. and GOAJ is critical to encourage the GOAJ to follow a more reformist path. COORDINATION OF U.S. ASSISTANCE GOALS -------------- ¶6. (C) Using the U.S. Azerbaijan assistance strategy statement as a road-map, the U.S., in conjunction with the international donor community, will continue its efforts to lead the GOAJ towards reform and sustainable development. U.S. assistance objectives in Azerbaijan will focus on growing and developing competitive private enterprises, supporting a more representative, participatory and better functioning democracy and expanding the use of quality health care services and practices. The U.S. leads all international donors in Azerbaijan striving to transform Azerbaijan's economic growth and potential into economic prosperity for all its citizens. U.S. assistance targets improving the efficiency and accountability of public expenditures, improving access to credit and improving the business environment as well as working with the most vulnerable segment of the population. Working to combat corruption, improve fiscal policy, develop the financial sector and business environment as well as working with grass-roots non-governmental organizations provides one of the most effective manners to reach underdeveloped Azerbaijanis in need. Indeed, the U.S. needs to expand its assistance to NGOs, business associations and other civil society groups that are taking innovative steps to combat corruption, improve the business and investment climate, and expand government transparency. GOAJ NEEDS AN ECONOMIC ADVISORY BODY -------------- ¶7. (C) An easy, yet critical reform that the U.S. and the RMG have been pushing the GOAJ to adopt is a formalized economic advisory body to advise the President on economic issues. This body, comprised primarily of the Ministers of Economic Development and Finance, along with the Chairman of the National Bank, should take the lead in developing macroeconomic and budgetary policies. Current economic and budgetary decision-making is disjointed, lacking in transparency, not properly informed and does not appear to include all the relevant actors. More often than not, the key budgetary ministries and agencies, including the Ministry of Finance and Ministry of Economic Development, are not consulted on the budget and public investment program as dictated by Azerbaijani law. Using existing U.S. assistance programs at the Ministry of Finance and the Ministry of Economic Development, and its role in the RMG, the U.S. will endeavor to convince the GOAJ of the importance of an economic advisory body before any detrimental economic effects occur in the economy. Delivery of this message during high-level visits also would be helpful. BANKING REFORM -------------- ¶8. (C) Strengthening Azerbaijan,s banking sector is critical to prepare for the "Tsunami" of money coming from oil and gas revenues over the next decade. The U.S. is already working with the National Bank of Azerbaijan to improve its banking supervision capabilities, but the GOAJ needs to do more to ensure that the National Bank plays a strong role in regulating and controlling the banking system. Large state-owned banks, such as the International Bank of Azerbaijan, make it difficult for the well-managed mid-tier banks to be successful. IBA,s market position also stifles competition and has limited the growth of banking products and services available to customers. Additionally, the GOAJ, in coordination with the National Bank, needs to develop and nurture the stock market and growing securities market. ¶9. (C) In addition to reforming the commercial banking sector, the GOAJ needs to take steps to strengthen the BAKU 00000407 003 OF 005 overall role of the National Bank. The National Bank,s job to combat inflation has been undercut by a 70 percent increase in public expenditures in 2006. The GOAJ did not closely coordinate with the National Bank to determine economically safe levels of government expenditures prior to drafting the budget. As a result, many economic and financial observers are expecting much higher inflation in the second half of 2006 and early 2007. In addition, the ability of the National Bank to effectively control inflation using monetary policy is limited and the National Bank risks damaging the non-oil sector with further appreciation of the manat. Senior U.S. economic policy makers need to warn GOAJ officials about the growing potential for a banking crisis and uncontrolled inflation if the system is not strengthened. Visits to the U.S. for educational purposes and meetings with senior officials at the Treasury Department and U.S. Federal Reserve also would be useful. IMPROVING THE BUSINESS CLIMATE & INCREASING U.S. INVESTMENT -------------- -------------- ¶10. (C) Improving the business and investment climate is another goal that will promote Azerbaijan,s sustainable development. Increasing competition in the economy will translate to decreasing costs for consumers and increasing opportunities for Azerbaijani entrepreneurs and international companies. Court reform aimed at eliminating corruption in the judiciary and an emphasis on enforcement of contracts and judgments are important elements of improving business climate. In addition, the USG should push the GOAJ to implement the changes in legislation and practice already recommended by the AmCham in its December 2005 White Paper, which was presented to President Aliyev. Many of the changes suggested in this document would improve the business climate for foreign and local enterprises, and would reinforce a USG message that government's policies must be linked into feedback by civic groups, be they economic or social. Senior level engagement in this area would be helpful. ¶11. (C) The structured privatization of select public interests, including the national airline AZAL, the International Bank of Azerbaijan, and elements of State Oil Company (SOCAR) would begin to open the domestic market to an infusion of international investment, technology and know-how. Senior U.S. visitors need to push GOAJ officials to take the hard decisions now to improve the business and investment climate. One payoff for the GOAJ,s efforts would certainly be increased U.S. investment in the non-oil sector. As in many developing countries, privatization of key state companies and sectoral reforms will prove intensely difficult. In Azerbaijan, international financial institutions have attempted to table several initiatives to privatize key companies only to have their efforts die a slow death due to government inactivity. In addition, efforts to diversify the banking sector have been thwarted. By again leading the privatization efforts with the RMG and international community, the U.S. will open up additional markets to U.S. goods and services while strengthening the Azerbaijani economy. WTO ACCESSION -------------- ¶12. (C) In the near-term, the GOAJ would like to join the World Trade Organization. Azerbaijan,s interest may offer an opportunity to push for reforms while holding out a carrot in WTO membership. Active engagement by U.S. trade officials on WTO membership may offer an incentive for the GOAJ to push for necessary reforms if it believes its efforts will be rewarded. Any WTO reforms would have an immediate positive effect on the business and investment climate and would signal Azerbaijan,s willingness to move towards a more market economy. Currrently, Azerbaijan has a fourth working party meeting scheduled for March 30 in Geneva. All of the preparatory documents have been sent to the WTO. While some weaknesses persist in the documents, Post's USTDA-funded accession advisor believes that the documents will allow for progress in the working party meetings. Separately, Post has learned that USTR has agreed to begin bilateral negotiations on tariffs, an important step. Azerbaijan may be planning other bilateral negotiations on the margins of the working party, perhaps with Turkey and Georgia, as well. While the pace of accession is up to Azerbaijan, Post's target of 2008 BAKU 00000407 004 OF 005 remains a real possibility. REDOUBLING INTERNATIONAL ANTI-CORRUPTION EFFORTS -------------- --- ¶13. (C) Combating corruption in all its forms and supporting rule of law go hand-in-hand with improving the investment and business climate. Corruption and non-competition practices through state monopolies and monopolization in many sectors of the economy by political-economic elite remain serious threats to economic growth and democratic stability in Azerbaijan. The Parliament and the government have passed laws to combat corruption but on-the-ground inaction by government officials have made most laws ineffective. ¶14. (C) The U.S. will continue to be actively engaged with the GOAJ to improve its record on combating corruption. The government has not made a high profile arrest due to corruption and most corruption charges against government officials or individuals are politically motivated. The government will need to do more to elevate the attention it gives to this problem, and take real action against egregious violators. Senior U.S. policy makers need to highlight this point to the GOAJ and push for more government action. The lack of transparency and accountability in public expenditures and abuse of government offices for personal gain are having a very negative effect on the growth of investment. The government has also used its various services, for example tax department auditors, for political purposes. ¶15. (C) Key to combating corruption is the strengthening of the state institutions that ensure the accountability and transparency of public expenditures such as capital expenditures, treasury operations, international controls in budget agencies, the supreme state auditor and the state procurement agency, all of which are deplorably weak and under-resourced. This effort will prove additionally difficult, as the government,s Anti-Corruption Commission chief, Ramiz Mehdiyev, has been widely rumored to be associated with corrupt activities, such as using political influence to benefit personally. Ironically, this person is also one of the few political actors that can improve Azerbaijan's anti-corruption record. AGRICULTURE'S ROLE IN POVERTY REDUCTION -------------- ¶16. (C) Agriculture remains Azerbaijan's second largest sector after oil and gas, and is perhaps the best hope for medium-term poverty reduction in the rural regions. However, development of the agricultural sector is hampered by a clumsy bureaucracy that at times appears unable to facilitate worthy development projects, as well as the legacy of a land privatization program that all but ensured no farmer received enough land to be commercially-viable. U.S. assistance is active is the commercial agriculture sector with projects focusing on improving the business practices of pocessors and exporters and bringing farmers moreinto the marketing chain. Post has high hopes tat three commercial farm pilot projects by U.S. irrigation firm Valmont will catch the full attention of the GOAJ. With GOAJ support, Valmont's methodology has the potential to develop value-added agriculture in the regions and assist poverty reduction. At the same time, such a success would open a large market for U.S. exports. ROLE OF CONSTRUCTIVE CITIZEN ACTIVISM -------------- ¶17. (C) Coupled with international efforts to strengthen the economy, improve the investment climate and fight corruption, is the important role Azerbaijani citizens could play in demanding greater government accountability and transparency. Increased citizen awareness about the government,s use of the country,s natural resources appears to be a good starting point to push for full government transparency. Already some civil society activists are studying ideas to establish mechanisms to oversee governmental budgetary expenditures. These groups have experience working with the State Oil Fund within the Extractive Industries Transparency Initiative and will require some backing and support from the international donor community. International efforts to BAKU 00000407 005 OF 005 increase transparency and government accountability will be enhanced when Azerbaijanis add their voices to the mix. COMMENT -------------- ¶18. (C) In the short-term, Azerbaijan's wealth will continue to grow as more oil and gas is extracted from the Caspian and shipped through new pipelines to Western markets. This wealth presents unique challenges to a country as poor and loosely regulated as Azerbaijan. The potential for economic mismanagement and widespread corruption by government-connected elites will increase. The U.S., in close coordination with the international donor community, will continue its efforts to lead the GOAJ towards reform and sustainable development. Whether Azerbaijan is a success or failure over the next decade will be influenced by the amount of pressure the U.S. and the international donor community can apply to secure reforms that will lead to a stable and prosperous development. In addition, Azerbaijan,s leadership will need to be held accountable for the proper administration of the country,s wealth and sustainable development. A strong political will to enact hard reforms, along with active U.S. engagement, will be necessary in order for Azerbaijan to be securely on the path to an economically stable country. HARNISH