"The medium-term outlook for the economy is very positive, with the main driving force switching from investments in the oil sector to resultant production and export," the report says.

Construction of the Shah-Deniz gas field and its pipeline as well as further development in the ACG oil field will continue to energize the construction sector, which has more than quadrupled in size during the past three years. The pace is likely to be maintained in the coming years as the Government rehabilitates the east-west and the north-south road corridors.

The authorities are expected to maintain prudent fiscal and monetary policies over the medium term. With world oil prices likely to remain firm, the earlier deficit projection of less than 2% of GDP is likely to hold in spite of wage and pension increases and an ambitious public investment program.

With greater foreign exchange inflow coming from the oil sector, the central bank will have difficulty in managing price stability. The efforts of the National Bank of Azerbaijan to avoid a nominal appreciation of the exchange rate, coupled with the thin Treasury bill market, had earlier led to an unsterilized accumulation of foreign assets and rapid expansion of the money supply.

Despite introduction of new monetary tools, inflation is likely to range from between 4.0% and 5.5% during the three-year period, higher than the 5% inflation rate projected by the central bank for 2005, and lower to 2% to 3% for 2006 and 2007.

The current account position will shift from a deficit of 30.7% of GDP in 2004 to a surplus of 4.5% of GDP in 2007. Overall, the Government will be able to amass foreign reserves in the medium term and external debt will remain low, ADO says.

Despite recent economic growth, the country's poverty rate remains high at 46.7%, based on monthly minimum consumption needs of food and nonfood items of $36 per person. Urban areas suffered higher poverty rates than rural areas, due to local migration to the cities. Official unemployment rate remained low in 2004 at around 1.5%, but this figure includes only individuals registered for unemployment assistance. The State Statistical Committee carried out a labor force survey in 2003 following international standards, showing the unemployment rate at 10.7%, with the urban rate double that of rural areas (14% versus 7%).

The move to diversify Azerbaijan's economic set-up will hinge on how effective the Government is in implementing the structural reform agenda, the report says. Financial sector reforms are a good start, but more work lies ahead if the authorities are to foster an economy with a diverse production base.

Governance reforms, including the implementation of an anti-corruption law that was passed in January 2004, and simplification of business paperwork requirements are needed to help local business develop and attract foreign capital to the non-oil sectors.