AZERBAIJAN: RESPONSE TO REQUEST FOR INFORMATION ON

C O N F I D E N T I A L SECTION 01 OF 05 BAKU 000408

SIPDIS

FOR EUR/CARC

E.O. 12958: DECL: 05/18/2019
TAGS: AJ AM ECON EFIN EINT GG PINR
SUBJECT: AZERBAIJAN: RESPONSE TO REQUEST FOR INFORMATION ON
POLITICAL IMPLICATIONS OF GLOBAL FINANCIAL CRISIS IN
CAUCASUS

REF: SECSTATE 41027

Classified By: Pol-Econ Chief Rob Garverick, reasons 1.4 (b) and (d)

1) (U) Post provides the following responses to ref
questions on the political implications of the global
financial crisis in the Caucasus.

2) (C) WHICH NATIONAL LEADERS AND/OR CABINET FIGURES ARE
MOST ACTIVELY INVOLVED IN ECONOMIC DECISIONMAKING? ARE THERE
DIFFERING OPINIONS WITHIN THE NATIONAL LEADERSHIP REGARDING
APPROPRIATE ACTIONS IN LIGHT OF THE ECONOMIC CRISIS?

-- The key GOAJ ministers most actively involved in economic
decision making are Finance Minister Samir Sharifov, Economic
Development Minister Shahin Mustafayev and Central Bank
Chairman Elman Rustamov. As in most decisions in Azerbaijan,
President Ilham Aliyev is consulted prior to any decision and
will issue directives often on very specific, even minute
details. Differences in opinion among ministers and
ministries exist, though public debate on policy differences
is rare. Finance Minister Sharifov, who heads the
U.S.-Azerbaijan Economic Partnership Commission, is
considered by international observers to be competent and
constructive, and is widely respected. Economic Minister
Mustafayev, who replaced Heydar Babayev after the October
2008 presidential election, has been less forthcoming with
diplomats, and is generally seen as in the "bureaucratic"
mode.

-- While no country is expected to completely escape the
impact of the ongoing world economic crisis, the GOAJ
unanimously believes that it is in a position to withstand
the difficulties of the crisis relatively better than other
countries, thanks to its solid foreign assets position and
its still limited integration to the global financial system.
High export receipts and fiscal revenue for the last three
years contributed to the strong foreign exchange and fiscal
position of the country, which can be used to support demand
if the domestic economic slow-down becomes more severe.
However this assumes that expectations of devaluation,
speculative for now, will not continue/accelerate; this is a
difficult assumption to confirm at this time. So far this
year the CBA and the State Oil Fund (SOFAZ) together have
poured in over 3 billion manat to support the peg; Azerbaijan
held about 18 billion manat in net reserves as of December

2008. (Note: current exchange rate is 1 USD = manat 0.82.)

-- Obviously the sustainability of this policy depends on the
assumption that public expectations will stabilize and that
massive net injections of cash into the financial system will
not be required to protect the exchange rate throughout the
year. (NOTE: SOFAZ is also slated to support the GOAJ budget
to the tune of 5 billion manat this year. End Note.)
Additionally, ensuring efficient use of public finances,
including strengthening the selection process for project
funding, introducing cost and benefits analyses, and
monitoring budget-financed projects, assumes even greater
importance under these circumstances. Progress in improving
the business environment will help domestic and foreign
companies to maintain and expand their business activities
and improve competitiveness, even in the face of an
appreciating real effective exchange rate.

3) (C) WHAT ROLE DO OUTSIDE ADVISORS (FROM THE U.S.
TREASURY, IMF, WORLD BANK, EBRD) HAVE IN SHAPING ECONOMIC
POLICY? HOW DO NATIONAL LEADERS REGARD THEIR VIEWS?

-- The primary role of U.S. Treasury, IMF, World Bank and
EBRD is purely consultative. The GOAJ meets with
representatives from Embassy-Baku along with USAID, IMF,
World Bank and EBRD on a regular basis.

-- The influence of IFIs, USAID and U.S. Treasury is
further augmented by funded technical support programs.
These organizations can influence policy somewhat through
assistance programs, whether technical or financial. For
example, the U.S. government, through USAID, is assisting the
government of Azerbaijan in its financial regulatory
oversight strategy formulation process, and establishing a
Financial Investigative Unit in support of the new anti-money
laundering law, by providing extensive interagency advisors.
The U.S. DOJ was involved in the creation of the law from the
beginning. Now, through interagency consultations, Embassy
Baku expects to provide the GOAJ with advice from DOJ, FDIC

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experts, and the IRS to help formulate their anti-money
laundering implementation and enforcement strategies.

-- Both the IMF and World Bank have a third means of
influence; they issue reports to the international community
covering economic issues in a particular country. The GOAJ
places importance on their ranking in these and other such
reports. As a result, the IMF and World Bank offer their
advice on how to improve Azerbaijan,s rankings, and this in
turn may influence the GOAJ to make specific reforms. For
example, the GOAJ improved a number of indicators on the
World Bank's annual Doing Business Report and took great
pride in stating that they were the World Bank,s "Number One
Reformer". Critics contend that the GOAJ analyzes how these
rankings are determined and selectively chooses to work on
&low hanging fruit8, areas where improvement can be made
without seriously confronting endemic corruption in the
country. In addition, the GOAJ has made USAID-supported
advances critical to progress in the WTO accession process
over the past two years, although there is still much room
for improvement.

-- The Azerbaijani government believes that IFIs could
perform a greater function in the global financial system.
Finance Minister Sharifov noted the IMF's inability to
adequately respond to or predict the recent global financial
crisis, stating that "it simply follows events." The
Minister is in favor of strengthening and recapitalizing the
IMF and said that he believes it should be more proactive.
Sharifov has noted on several occasions that his Russian
counterpart, German Gref, has invited him and other CIS
finance ministers to Moscow for consultations, most recently
in advance of the G20 London Summit.

-- The Minister has also expounded on ways to improve the
global financial system by expanding the role and authority
of IFIs in general. He believes that they should have
greater responsibility for supervision, as well as additional
authority to monitor hedge funds and derivative transactions.
Sharifov expressed interest in more regulations in general
and greater interaction between national regulators at the
highest levels. When asked to elaborate on his idea of a
"global financial board," he has explained that he was more
concerned in creating an organization that would serve a more
consultative function rather than as a guiding or regulating
body.

4) (C) HOW DOES THE PUBLIC PERCEIVE THEIR COUNTRY'S
ECONOMIC SITUATION COMPARED TO OTHERS IN REGION (OTHER
CAUCASUS COUNTRIES, RUSSIA, UKRAINE, ETC)?

-- Generally speaking, the public seems to cautiously
perceive that Azerbaijan's economic situation is somewhat
better compared to others in the region (this is of course
augmented by the GOAJ,s public relations efforts in this
area). Azerbaijanis are aware that he economies of Russia,
Ukraine, Kazakhstan and Turkey have devalued their
currencies, with impacts on inflation and otherwise.
Azerbaijan's financial elite note that these countries have
considerable exposure to foreign debt, while Azerbaijan does
not. For example, Kazakhstan,s high dollar denominated debt
resulted in a demand by foreign banks to repay their debt
early. This coupled with the devalued currency created
financial sector adjustment problems in Kazakhstan.
Fortunately for Azerbaijan, foreign debt peaked at only 2.5
billion USD (relatively low in relation to the size of the
economy and the country,s reserve position). Although some
debt holders were asked to repay their debts early, this has
had little impact on the economy, and notably less than in
Kazakhstan. However, the loss in competitive positioning,
augmented by a strong manat, has negatively impacted the
non-oil export sector of the economy, and the GOAJ,s
projected real growth rates for the non-oil sector have been
adjusted downward to about 5 percent. This is still higher
than that of most transitional economy countries, but less
than half of last year,s growth. The number may also be
bolstered by real estate and construction activity,
particularly in Baku. The forecast assumes no further loss
of confidence in the currency/financial system and no further
drain on financial system liquidity.

-- Another reason the public perceives Azerbaijan's economic
situation is better than its neighbors, is that the public
has seen vast improvements in general living conditions over
the last ten years or so. After the Nagorno-Karabakh war,

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the country was a disastr, with refugees crowding the cities
and serious infrastructure deficiencies. In 2008, the GOAJ
cmpleted its relocation projects for refugees, moving them
out of tent cities and encampments and into fully functioning
settlements with infrastructure, schools, and support
services. Oil revenues have begun to flow and the GOAJ has
embarked on ambitious programs to rebuild or newly construct
infrastructure, including roads and bridges, water and
sewage, hospitals, schools, etc. Much work remains, but
observers recognize that Azerbaijan began at a very low base.

5) (C) HOW DO LOCAL BANK OFFICIALS VIEW THE PERFORMANCE OF
NATIONAL OFFICIALS IN HANDLING THE CURRENT FINANCIAL
SITUATION? ARE BANK OFFICIALS LOBBYING THE CENTRAL BANKS TO
TAKE CERTAIN ACTIONS--FOR EXAMPLE, RECAPITALIZING BANKS OR
PURSUING FOREIGN EXCHANGE POLICY?

-- Most local bank officials believe that national officials
have taken reasonable measures to handle the current
financial situation. For example, since August 2008, the
Central Bank reduced reserve requirements (the percentage of
bank deposits that banks must set aside at the central bank)
from 12 percent to one-half percent and lowered the discount
rate from 15 percent to 3 percent. The Central Bank also
provided liquidity to a few banks that were faced with
temporary liquidity difficulties. (NOTE: There has been
grumbling from some banks that access to the special
liquidity fund established for this purpose is rationed out
on an unequal discretionary basis. End Note.) Finally, the
Central Bank signaled to banks that it is ready to continue
to provide temporary loans to solvent banks faced with
short-term liquidity problems. In addition, the Ministry of
Finance injected additional capital in the largest state
owned bank, thus stabilizing for now its financial position,
although not mandating any governance reforms as a
quid-pro-quo. Furthermore, President Aliyev said the
government may inject up to an additional 2.5 billion manat
into local banks, although this could in fact be damaging
from a longer-term financial stability perspective,
particularly if rationed out on an unequal discretionary
basis to politically-favored financial institutions. USAID
and the major IFIs continue to speak proactively with the
GOAJ and the CBA about the importance of ensuring appropriate
design and formation of a sound incentive framework for any
additional liquidity enhancement facilities, and to encourage
the GOAJ to move towards full execution of the approved 2009
budget in order to stabilize aggregate demand and prevent
further recessionary pressures.

6) (C) WHAT PRECAUTIONS, IF ANY, ARE BANKS TAKING IN LIGHT
OF THE GLOBAL FINANCIAL CRISIS? SPECIFICALLY, ARE LOCAL
BANKS TAKING ANY PRECAUTIONS REGARDING THEIR FOREIGN EXCHANGE
EXPOSURE, OR ARE THEY PURSUING EXTERNAL FUNDING FROM WESTERN
BANKING OR INTERNATIONAL LENDING INSTITUTIONS? FOR
SUBSIDIARIES OF FOREIGN-OWNED BANKS, IS THERE CONCERN THAT
FOREIGN BANKS WILL WITHDRAW SUPPORT FOR THESE SUBSIDIARIES?

-- Selected commercial banks have made moderate use of the
CBA,s liquidity enhancement facility. In addition, most
banks have dramatically decelerated credit growth;
furthermore, some are aggressively looking to expand their
limited domestic deposit base in order to improve their
liquidity situation. Most have little prospect at this point
to access additional commercial international banking
resources; although a number of banks have recently expanded
IFI support programs designed to support SME/Microlending
activities. Azerbaijan is flush with U.S. dollars, given
strong revenues from oil exports. As of December 2008, the
country's reserves stood at about 18 million manat.

7) (C) TO WHAT EXTENT ARE BANKS EXPRESSING CONCERN ABOUT
CURRENCY DEPRECIATION?

-- Concerns regarding an imminent devaluation have been
tempered, for now, because the GOAJ has assured Azerbaijan
that this would not happen in the near term. It is expected
that the GOAJ will reassess mid-year. A number of major
banks are fearful about the potential impact of devaluation,
given the significant asset/liability mismatch positions
which they currently face (ie. high loan/deposit ratios,
accompanied by major foreign debt exposure and significant
foreign currency denominated loans which are backed by
manat-based earning streams).

-- Finance Minister Sharifov and Central Bank Director

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Rustamov strongly advocate a policy of supporting the manat
(currency) against depreciation/devaluation and have
indicated repeatedly to EconOffs that the policy would not
likely be changed any time soon; nonetheless, the Government
and the Central Bank of Azerbaijan (CBA) are still awaiting
the results of a USAID-supported stress test analysis of
major banks in order to gain a fuller readout of the impact
of a significant devaluation on the solvency/liquidity of the
financial system. The GOAJ feels that keeping the currency
stable favorably insulates the economy from the dramatic
effects of the economic crsis evidenced in the surrounding
countries.

-- GOAJ has also watched high inflation ensue in Russia and
Armenia which they attribute to the currency devaluation.
(Note: There has been significant real appreciation of the
manat in relation to the currencies of major trading
partners. As a result, non-oil exports have suffered
significantly as a result of the GOAJ/CBA,s determination to
maintain a pegged exchange rate. End Note.) In addition,
the GOAJ is concerned that devaluation may worsen public
expectations regarding the stability of the financial system
and of the currency as a store of value. This could impact
negatively on the financial position of major banks with
significant asset/liability mismatch issues. As a result,
the GOAJ remains committed to maintaining the currency as is,
in an effort to protect it from inflation.

-- There is certain pressure, in fact, for the manat to
continue appreciating. Oil contracts are denominated in U.S.
dollars. Those dollars flow into Azerbaijan (oil exports now
average about 1 million barrels per day). Some funds flow
directly to the State Oil Fund (SOFAZ) and the State Oil
Company (SOCAR) and may or may not be exchanged into manat.
Other funds are converted to manat and distributed to the
government budget. This conversion creates a demand for
local currency and serves to put upward pressure on the manat.

8) (C) ARE INDIVIDUALS SWITCHING LOCAL CURRENCY BANK
DEPOSITS INTO DOLLAR OR EURO-DENOMINATED ACCOUNTS?

-- Early in 2009, people seemed to be exchanging their manat
for dollars or euros. This has reportedly stabilized over
the past month, as people seem less concerned about a near
term devaluation. (NOTE: We are still confirming this. End
Note.) Because the Manat has remained stable, where other
currencies, particularly the Euro, the Turkish Lira and the
Russian Ruble, have fluctuated, Azerbaijanis expectations of
a near-term devaluation appear to be dampening.

9) (C) ARE BUSINESS OWNERS CURRENTLY ABLE TO OBTAIN BANK
LOANS? IF SO, AT WHAT TERMS?

-- The rate of credit expansion has decelerated massively
over the past 6-8 months, and with the slight deflationary
trend of the first quarter real rates on loans are now
positive for the first time in a number of years. The major
deceleration in credit availability underscores the severely
constrained liquidity position in which most financial
institutions find themselves at the moment, and is reflected
in the GOAJ,s dampened non-oil growth projections for the
year.

10) (C) HAS THERE BEEN ANY RECENT CHANGE IN REMITTANCES
FROM ABROAD? ARE WORKERS RETURNING FROM RUSSIA, EUROPE, AND
OTHER COUNTRIES DUE TO LACK OF WORK?

-- Estimates of Azerbaijanis working abroad, almost entirely
in Russia, range from 800,000 to two million. Because
Russia,s economy has been severely impacted by the financial
crisis, Azerbaijani officials and residents fear that the
economy will suffer a severe impact. It is estimated that
currently remittances are down 33 percent, which
disproportionately affects rural areas, rather than Baku.

11) (C) TO WHAT EXTENT ARE CONSTRUCTION PROJECTS BEING
DELAYED AND/OR FROZEN PRIOR TO COMPLETION? WHAT IS CAUSING
PROJECTS TO FALL SHORT OF COMPLETION?

-- Because of a slow down in the private construction
industry, there has been a decrease in demand. For example a
large steel company in Sumgayit failed and other construction
supply companies are suffering.

-- Minister Sharifov has said that the construction projects

BAKU 00000408 005 OF 005


in the pipeline would be completed. However, the GOAJ plans
to carefully scrutinize any new projects. There was a time
when almost all real estate projects received bank credit.
At this point, the banks will stringently look at every
project to determine which projects should be funded. That
is to say, times have changed since last summer, when oil
sold at $140 per barrel. Overall the GOAJ has determined
that it makes sense to fully execute the budget, assuming
that the price of oil remains in the 50 USD/barrel range or
higher. There may be a reallocation of expenditures away
from long-gestating projects and towards social expenditures
and private sector re-activation programs which jumpstart
spending and stimulate aggregate demand.

12) (C) HOW MUCH MONEY IS BEING TRANSFERRED FROM THE STATE
OIL FUND BACK INTO THE BUDGET? HOW IS THE GOVERNMENT
ACCOUNTING FOR THESE TRANSFERS IN THE GOVERNMENT BUDGET?

-- On 26 February 2009, President Ilham Aliyev approved the
budget of the State Oil Fund (SOFAZ). During that meeting,
Aliyev approved a 4.915 billion manat transfer from SOFAZ
into the government budget. The government is accounting for
these funds as a transfer into the state budget. However, so
far the money transferred from the budget by SOFAZ has
represented a net drain on reserves, since none of these
resources has been repurchased by the CBA. Instead, the CBA
itself funnele a large sum (greater than 1 billion manat)
intocurrency markets during the first quarter to supplment
SOFAZ foreign currency sales and stabilize the value of the
manat.


13) (C) WHICH PARTS OF THE GOVERNMENT BUDGET, IF ANY, ARE
OFFICIALS INDICATING WILL BE UNFUNDED IF OIL PRICES REMAIN
BELOW THE $65/BARREL BASELINE USED IN WRITING THE BUDGET? HOW
HAVE OFFICIALS INDICATED DEFENSE SPENDING SPECIFICALLY WILL
SUFFER, IF AT ALL?

-- As for the 2009 budget, the current lower-than-budgeted
world market oil prices will not create a substantial
problem, assuming that the price of oil remains in the
$50/barrel range during the course of the year. The amount
of the transfer is fixed in manat terms (4.915 billion) and
SOFAZ has sufficient resources and revenues that will enable
it to make the transfer and continue to maintain a solid
asset position (again assuming no further worsening of market
expectations regarding the stability of the currency and/or
the financial system). However, given that the revenues from
SOCAR and non-oil related tax collection might be lower than
previously envisaged because of lower world oil prices and
decelerating non-oil growth, and the costs related to some
budget expenditures that have high import content may also be
lower than budgeted, the government will undertake a
reassessment of the budget mid-year. As of April 2009, it
was estimated that SOFAZ and the Central Bank had
approximately 16 billion in reserves (down from 18 billion
manat in December 2008). Thus, the economic crisis has had a
moderate impact on the country,s reserve position.

-- According to a Locally Employed Staff member who
previously worked at the Ministry of Economic Development,
the GOAJ is emphasizing internally that their projections
will not be significantly negatively impacted until the price
of oil drops below $40/barrel (the point at which the current
account would become negative).

-- The GOAJ has no plans at this point to decrease defense
spending during the course of the fiscal year. If anything,
the budget will increase, as there has been some discussion
of supplemental spending.

14) (C) WHAT PLANS, IF ANY, DOES THE GOVERNMENT HAVE TO BUY
UP UNFINISHED OR UNPROFITABLE REAL ESTATE PROPERTIES IN BAKU?
ARE CONSTRUCTION/REAL ESTATE BUSINESSES LOBBYING FOR SUCH A
MOVE?

-- To date, the government has not announced any plans to
buy up unfinished or unprofitable real estate properties in
Baku. There are no indications that construction companies
are pressing for such an agenda or that the government would
be willing to consider such action. Around Baku,
construction work is continuing at existing sites; there does
appear to be a slow down in new construction works.
LU