IMF BELIEVES GOAJ UNDERSTANDS RISKS OF EXCESSIVE

C O N F I D E N T I A L SECTION 01 OF 03 BAKU 001124

SIPDIS

SIPDIS

STATE FOR EEB ASSISTANT SECRETARY DANIEL SULLIVAN
STATE PLEASE PASS TO TREASURY OFFICE OF EUROPE AND EURASIA
DEPUTY DIRECTOR JEFF BAKER

E.O. 12958: DECL: 09/12/2017
TAGS: ECON EFIN PREL AJ
SUBJECT: IMF BELIEVES GOAJ UNDERSTANDS RISKS OF EXCESSIVE
SPENDING

REF: BAKU 737

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


1. (C) SUMMARY. IMF Azerbaijan Country Manager Vitali
Kramarenko briefed the Ambassador September 5 on the IMF's
latest staff visit, characterizing it as the most positive of
his tenure. He said that the GOAJ understood the political
and economic dangers of high inflation and excessive fiscal
spending and was planning to submit the 2008 state budget
with a relatively small increase in public expenditures. The
IMF's message to the GOAJ focused primarily on the importance
of restraining government expenditures, increasing foreign
exchange flexibility, reducing inflation, and tightening
monetary policy. Kramarenko told the Ambassador that the
Azerbaijan economy continues to expand rapidly with GDP
growth exceeding 35 percent during the first six months of
2007 (driven primarily by the energy sector) and with
inflation hovering around 16 percent. Kramarenko said that
the poor business environment and sectoral monopolies were
holding back investment and private sector growth. END
SUMMARY.

SUCCESSFUL IMF STAFF VISIT
--------------


2. (C) In a September 5 meeting with Ambassador Derse, IMF
Azerbaijan Country Manager Vitali Kramarenko briefed on the
Fund's staff meetings with the Government of Azerbaijan.
Kramarenko told the Ambassador that after three years of
working on Azerbaijan, this round of discussions with the
GOAJ had been the most positive and that he has seen
significant change for the better. Kramarenko was sure that
the GOAJ understood the dangers of high inflation and
excessive fiscal spending and were planning to reduce
government expenditures in the 2008 state budget. The IMF's
message to the GOAJ focused primarily on the importance of
restraining government expenditures, foreign exchange
flexibility, reducing inflation, and tightening monetary
policy.


3. (C) Kramarenko said that the GOAJ recognizes the economic
and financial inefficiencies in its systems and he believes
that it is not too late for the government to improve the
macroeconomic situation. He told the Ambassador that there
is growing recognition in certain GOAJ ministries of the
dangers of higher prices and the political benefits of lower
inflation. He noted that the "voices of reason" in the GOAJ
could prevail. Kramarenko stated that reform of the banking
and financial services sector is critical and that a stronger
banking and financial services sector would support the
development of a stronger private sector. He warned that
real estate credit lending has doubled in the first half of
2007 and could represent a long-term concern.

MACROECONOMIC ENVIRONMENT
--------------


4. (C) Kramarenko told the Ambassador that Azerbaijan's
economy continues to expand rapidly with GDP growth exceeding
35 percent during the first six months of 2007. He added
that the non-oil deficit remains high. The energy sector
continues to account for more than 50 percent of GDP growth.
Kramarenko said that based on current projections, Azerbaijan
will receive approximately USD 200 billion in total energy
revenues over the next 15 years which, in constant dollars,
represents USD 5-6 billion per year.


5. (C) Non-oil sector GDP growth totaled approximately seven
percent. Kramarenko said that the tradables sector's growth
(non-oil sector growth, excluding non-tradable items),
however, increased at only one percent, highlighting the
economy's reliance on the energy sector. (NOTE: The IMF is
using official trade statistics to calculate non-oil growth.
Many other economic observers, skeptical of GOAJ data,
estimate that non-oil sector tradable sector has experienced
negative growth over the past two years. Whether one percent
or negative, the anemic growth in the tradables sector is a
strong indicator of Dutch disease/oil curse.) He stated that
the non-oil manufacturing and agricultural sectors are not
doing well and have experienced decelerating growth during
the past two years. GOAJ spending represents more than 75
percent of the non-oil sector.


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6. (C) Kramarenko said that based on official GOAJ
statistics, year-over-year inflation in July reached
approximately 16 percent, noting that inflation could be
higher as the USAID-funded CPI showed inflation above 20
percent for the same period. He added that in 2008 it would
be unlikely that inflation would drop to single-digits as the
inflationary pressures from 2007 spending would pass into the
following year. Kramarenko said that government expenditure
inefficiencies, weak investment project oversight and the
continuing poor business climate all cloud Azerbaijan's
economic future.


7. (C) Kramarenko stated that foreign exchange flexibility
was lacking and the National Bank had been slow to tighten
monetary policy. Kramarenko indicated that tightening policy
was a "political issue" that the National Bank was reluctant
to push. He said that there were concerns about the
financial sector and that banking reform was essential. In a
subsequent meeting with visiting U.S. Department of Treasury
officials, the Deputy Governor of the National Bank Rufat
Aslanli, reiterated the difficult position of the National
Bank to implement monetary policy and combat inflation
without a similar tightening in fiscal spending. Aslanli
also alluded to the "institutional impediments" (i.e. the
State Customs Committee) that resisted the Bank's ability to
implement successfully monetary policy.


8. (C) In his meetings with the GOAJ, Kramarenko said he also
expressed the IMF's continuing concerns with the poor
business environment, adding that it was holding back
investment. He cited the State Customs Committee as a
serious problem, adding that rampant under-invoicing was
hindering retail consumer product growth. Kramarenko noted
that despite the numerous complaints with Customs and the
lack of clearing agents, the GOAJ appeared unlikely to change
any policies soon. The dismantling of monopolies, according
to Kramarenko, would help the economy expand and lower
overall price levels. The GOAJ is moving forward with its
plans to sell majority shares of state-owned Kapital Bank to
three domestic investors. Kramarenko noted that there were
major "leakages" on the expenditure side and within the GOAJ
tendering and procurement processes.

GOAJ 2008 BUDGET
--------------


9. (C) Kramarenko said that the GOAJ is beginning to realize
that higher inflation is becoming a political issue with
presidential elections scheduled for October 2008. He
believed that there is growing momentum within the GOAJ to
slow spending, adding that the Ministry of Finance plans to
submit a 2008 state budget that forecasts a relatively small
20 to 25 percent increase in public expenditures. Calling
the 2008 budget "sensible and a first step in the right
direction," Kramarenko said that in 2007 the GOAJ was
planning to under-spend the current budget by as much as
three percent of GDP or USD 750 million. In 2008, the GOAJ
would look to focus spending on completing current projects
and limit the number of new investment projects. In a later
meeting with visiting U.S. Treasury Department officials,
Ministry of Economic Development Deputy Minister Hasanova
reiterated the same plan to limit the number and scope of
2008 investment projects. According to Hasanova,
GOAJ-financed public investment projects in 2008 will total
approximately USD 4.5 billion


10. (C) Kramarenko related to the Ambassador that beginning
in 2005 the GOAJ developed a long-term oil management
strategy to prepare it for the increasing energy revenue
inflows. By 2006, however, the GOAJ shifted strategy and
began to spend more of its wealth accepting higher inflation
for faster economic growth and modernization. Now, according
to Kramarenko, a new realization about the dangers of
inflation is evident in some quarters of the GOAJ.
Specifically the Ministry of Finance, appears to be debating
internally on the way forward with spending and saving its
energy resources.

SIGNS OF DUTCH DISEASE
--------------


11. (C) Based on current official statistics, Kramarenko
raised the specter of increasing signs of Dutch disease in
the Azerbaijani economy, adding that it was not a "welcome

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long-term development." He noted that there has been a
migration of labor from rural areas to Baku to work in the
construction sector. This labor migration has also hurt
agricultural and manufacturing production. (NOTE:
Azerbaijan's manufacturing and agricultural sectors have been
contracting since the mid-1990s, the last period that the
country's production was significant.)

SOCIAL PROGRAMS NEED TO BE BOOSTED
--------------


12. (C) Kramarenko said that the IMF has told the GOAJ that
it should boost its targeted social assistance programs,
noting that current GOAJ efforts are "not sufficient." In
the 2007 budget, the GOAJ allocated only USD 115 million from
the total USD 10 billion budget for social spending.
Moreover, he said, GOAJ social assistance programs are not
well designed or effective. Kramarenko noted that according
to the GOAJ more than 25 percent of the population lives
below the poverty level. Public sector wage increases were
not benefiting the population as high inflation acted as a
tax on the poor. Kramarenko stated that some in the GOAJ
believe the economic benefits eventually will trickle down to
the poorer citizens. Some GOAJ officials also doubt the
dangers from higher inflation and argue that in the long term
all citizens will benefit.

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


13. (C) The true test of the GOAJ's ability to restrain
government spending in 2008 will be seen in early October
when details of the state budget begin to emerge. While the
key GOAJ economic advisors understand the danger of
accelerated spending, many other officials in the government
do not see the need to restrain spending as the level of oil
revenue increases. As seen in the 2007 supplemental budget
(reftel),Minister of Finance Sharifov's track record in
holding back GOAJ spending has been mixed. Corruption,
inefficiencies in public expenditure, and inflation remain
the largest dangers to Azerbaijan's sustainable development.
Rumors abound of another round of price hikes scheduled for
September. Price increases could become a political issue in
the run-up to the 2008 presidential election. The GOAJ walks
a difficult line between spending massively to address real
development needs - with the effectiveness of spending
limited by weak economic governance - and ensuring growing
inflation does not undercut development and economic and
political stability.
DERSE