IMF CONSULTATIONS REVEAL GROWING INFLATION AND

C O N F I D E N T I A L SECTION 01 OF 04 BAKU 000274 SIPDIS SIPDIS DEPT FOR EEB A/S SULLIVAN TREASURY FOR DAS NANCY LEE, JEFF BAKER AND ERIC MEYER E.O. 12958: DECL: 03/07/2017 TAGS: ECON EFIN EAID PREL AJ SUBJECT: IMF CONSULTATIONS REVEAL GROWING INFLATION AND POSITIVE TRENDS IN GOAJ ECONOMIC DECISION-MAKING REF: (A) BAKU 131 (B) BAKU 89 (C) BAKU 39 Classified By: AMBASSADOR ANNE E. DERSE PER REASONS 1.4 (B,D) ¶1. (C) SUMMARY: The IMF briefed the international community February 27 on its recently concluded Article IV consultations with the Government of Azerbaijan (GOAJ). In an upbeat session, lead IMF economist Vitali Kramarenko noted that initial estimates for inflation in 2007 were close to 20 percent, adding that it would be "virtually impossible" to keep it in the single-digits this year. According to a USAID-funded economic research consultant, inflation in the month of January totaled 12.3 percent. Kramarenko said that the IMF had held productive meetings with the GOAJ and that poverty in Azerbaijan had declined due to government efforts but that the non-oil sector remained weak. Finance Minister Sharifov told the IMF that the GOAJ plans to increase expenditures in the 2008 state budget by 40 to 50 percent. Public expenditures in subsequent annual budgets, however, would be more restrained, noting the need for fiscal discipline. Based on these latest Article IV consultations, the IMF believes that some policy makers in the GOAJ are more cognizant of the macroeconomic dangers of the government's fiscal policy, a view echoed by World Bank representatives following a GOAJ-World Bank roundtable to discuss efforts to develop a medium-term expenditure framework. END SUMMARY. SUCCESSFUL ARTICLE IV CONSULTATIONS -------------- ¶2. (C) IMF lead economist Vitali Kramarenko briefed the international community February 27 on the recently concluded IMF Article IV consultations with the GOAJ. Noting that he had good meetings with all economic ministries, Kramarenko stated that the economy is growing extremely fast, with the oil sector GDP growing at 60 percent and the non-oil sector growing at 8.2 percent. Kramarenko also said that although overall poverty was declining due to the GOAJ's efforts to improve salaries and living standards, the non-oil sector remained weak. (NOTE: These consultations are the last before the IMF resident representative office closes in July for budgetary reasons.) INFLATION TO REACH 20 PERCENT -------------- ¶3. (C) Kramarenko stated that projected inflation for 2007 would be close to 20 percent due partly to the GOAJ's decision to raise fuel prices and utility tariffs in early January (Reftels). He added that underlying inflation in 2007 would be approximately 16 percent, with the price increases adding an additional 4 to 5 percent. Kramarenko stated that the GOAJ is aware that inflation in 2007, no matter how the consumer price index is adjusted, will be in the double-digits. According to a USAID-funded economic research consultant, inflation in the month of January was 12.3 percent based partly on the price increases. (Other economic observers note that price increases for some goods already have reached 30 to 40 percent, leading them to believe that the overall inflation rate could exceed 20 percent. In addition, Minister of Economic Development Babayev recently held a televised press conference to quell rumors that the GOAJ planned to raise prices again in March and April.) According to the IMF, money growth in 2006 expanded more than 130 percent and based on the current economic environment shows no signs of slowing in 2007, further fueling inflationary fears. GOAJ EXPENDITURES TO MODERATE -------------- ¶4. (C) The Ministry of Finance has told the IMF that the GOAJ will "moderate" the rate of growth of government expenditures in the 2008 state budget to between 40 to 50 percent, compared to the 80 percent increase in 2006. Kramarenko noted that the GOAJ's monetary policy from September to December 2006 was "accommodating" and "passive," adding that National Bank of Azerbaijan had implemented a strategy to stabilize the dollar-manat exchange rate. The National Bank's change in exchange rate policy occurred after President Aliyev publicly stated that a stable exchange rate was important for Azerbaijan. Deputy Chairman of the National Bank, Rufat Aslanli, told EconOff that the National Bank will resume shortly its monetary policy of appreciating the Azerbaijani manat in order to hold down inflation. BAKU 00000274 002 OF 004 IMF POLICY ADVICE -------------- ¶5. (C) The IMF provided the GOAJ with numerous fiscal and monetary recommendations for 2007, including moderating wage growth and allowing for gradual exchange rate appreciation. On the fiscal side, Kramarenko stated that the GOAJ has no flexibility in 2007 due to the large infrastructure projects currently under construction or already in the pipeline. The IMF has told the GOAJ that it should focus on increasing utility tariff collection, especially among the state-owned enterprises, such as the State Oil Company (SOCAR). The IMF has suggested that the GOAJ encourage SOCAR to pay its full taxes which in turn will remove some money from the financial system and dampen inflationary pressures. ¶6. (C) The IMF has warned the GOAJ that its current fiscal policy threatens to develop into a spiral of increases. Kramarenko stated that the GOAJ risked falling into the trap of spending more money in order to pass more benefits to its citizens while at the same time harming the macroeconomic environment and neutralizing the government's beneficial efforts. Kramarenko stated that Finance Minister Sharifov acknowledged to the IMF the risks of increasing government expenditures. Kramarenko noted that based upon Azerbaijan's large energy reserves, there is no upper limit to the amount of money the GOAJ can spend. Finance Minister Sharifov has noted that the GOAJ plans to moderate government expenditures in 2008 with further decreases planned in 2009. The IMF believes that some policy makers in the GOAJ are more cognizant of the macroeconomic dangers of the government's fiscal policy. IMPROVING BUSINESS CLIMATE -------------- ¶7. (C) Kramarenko briefed on GOAJ efforts to improve the business and investment climate. The Ministry of Economic Development has been working with the IFC and World Bank to improve the business climate and the MED planned to pass to the President's office draft legislation on facilitating the registration of companies and other steps to improve the business operating environment. (COMMENT: According to the World Bank representative in Baku, these are three to five short-term steps to help address problems raised in the 2006 Doing Business Report. The World Bank helped the GOAJ devise them and is making recommendations on other steps to be taken over 12 to 18 months that will tackle many significant problems. The World Bank identified for the GOAJ the Customs Committee and Tax Ministry as key larger issues that need to be addressed. END COMMENT) In addition, the GOAJ has acknowledged that it has "structural problems" at the State Customs Committee and the Ministry of Taxes. When asked to expand on these problems, Kramarenko refused noting that it was a delicate internal GOAJ issue. (COMMENT: According to private businessmen, the Customs Committee and the Ministry of Taxes continue to exert a negative effect on private enterprise and inhibit private investment. The recognition by some in the GOAJ that Customs Committee and Ministry of Taxes suffer from "structural problems" highlights the extent of the problem and a possible new strategy to find a solution to a difficult and politically delicate problem.) HOUSING BUBBLE -------------- ¶8. (C) Kramarenko characterized the current real estate market as suffering from a price "bubble" with prices rising more than 30 percent in 2006. While the risks to the economy are present, the banking sector appears not to be at high risk of a real estate correction as many of the housing transaction involve cash or the collateralization of non-bank assets. Kramarenko noted that some of the cash transactions involved enormous sums of money, as much as USD 250,000 to USD 300,000 in cash. (NOTE: The hot Baku real estate market and prevalence of unregulated cash transactions have long led economic observers to suspect that many housing construction projects are attempts to illegally launder illicit funds.) MEDIUM-TERM EXPENDITURE FRAMEWORK -------------- ¶9. (SBU) Separately, the Ministry of Finance hosted a World Bank roundtable meeting February 8-10 to discuss issues in implementing a medium-term expenditure framework (MTEF). Minister of Finance Samir Sharifov chaired the meeting which BAKU 00000274 003 OF 004 included senior GOAJ economic staff from the Ministry of Economic Development, the National Bank, and the Oil Fund. The presenters at the meeting included consultants and government officials from Georgia, Ukraine, Sweden and the Slovak Republic. The meeting was designed to allow GOAJ officials to engage directly with practitioners from other countries about their experiences with reforming budget systems. The roundtable focused on policy prioritization and budget calendar, program-based budgeting and costing of policies, monitoring of budget implementation, and reform experiences of transition countries. ¶10. (SBU) Finance Minister Sharifov actively engaged in discussions with the presenters and noted that GOAJ economic decision-making suffers since many line ministries lack the capacity to prepare adequately their internal budgets. The Ministry of Finance, according to Sharifov, has to provide assistance from the beginning of the budget process. In addition, Sharifov noted that the GOAJ has to compete with the private sector for good accountants and that the limit on government salaries hinders retention. Sharifov stated that the GOAJ needed to take cautionary measures to deal with its problems. ¶11. (C) In a meeting with the Ambassador, World Bank Country Manager Gregory Jedrzejcak and Senior World Bank Economist for Azerbaijan Christos Kostopoulos commented on the roundtable, noting that Finance Minister Sharifov took the meetings seriously and recognized the lack of capacity within the GOAJ. Sharifov said that the GOAJ was contemplating transforming many state-owned companies, including the water utility and railroad, into government owned "corporations" that would operate more as private businesses. ¶12. (C) Kostopoulos told the Ambassador that the GOAJ appeared to be taking the medium-term macroeconomic framework more seriously, adding that there was momentum growing in the GOAJ to improve its economic decision-making processes. Kostopoulos said that Sharifov was interested in examining other countries' budget preparation best practices in order to explore ways to improve Azerbaijan's budget process. Sharifov understood that public expenditures are not effective without control and oversight and that proper allocation of resources is necessary. Kostopoulos opined that IFI engagement with the GOAJ was "starting to pay dividends" and that the World Bank remained prepared to assist the GOAJ shape its bureaucracy. COMMENT -------------- ¶13. (C) Compared to past IMF briefings, the mood of this meeting was more upbeat as the GOAJ expressed its concern about the macroeconomic environment with IMF officials. As the IFIs have long pointed out, Azerbaijan is entering a critical period in its economic development, as its energy revenues begin their exponential rise with the potential for distorting and destabilizing effects throughout the economy. Based on the IFIs latest round of consultations with senior GOAJ economic policy-makers, there appears to have been a significant shift in attitudes since the price increase debacle in early January (reftels),with GOAJ officials much more aware of the fragile macroeconomic environment and the need for long-term planning. This is an encouraging development, likely due in part to the efforts of a BP-funded macroeconomic modeling unit established in the summer of 2006 at the State Oil Fund. Similarly, the World Bank representatives underscored new momentum in their dialogue with the GOAJ, ongoing fora year and a half, with respect to the medium-tem economic framework and the need for better pubic investment processes. They pointed in particulr to GOAJ officials' interest in talking to otherexperienced government officials, in a practical way, about grappling with real world challenges of policy management. ¶14. (C) COMMENT CONTINUED: While senior GOAJ decision-makers appear to be increasingly cognizant of the risks of unfettered spending and ill planned public investment, the GOAJ as a whole still lacks the structure and capacity necessary for effective medium and long-term planning. The IFIs could play a helpful role in developing the requisite structure and capacity; this very positive round of recent discussions could play a role in helping to repair the often tense relationship between the IFIs and the GOAJ. This is also an opportune time for the USG to engage the GOAJ more intensively on these issues as agreed at the EPC to see where BAKU 00000274 004 OF 004 we can add value and spur development of capacity. DERSE