Assa-Irada,
7, April 2008

Azerbaijan's economy continued to grow in 2007 but foreign direct investment in the country is predicted to slow down in the coming years, the Asian Development Bank (ADB) said. Assessing economic performance, the bank's report entitled Asian Development Outlook 2008 said that at 25.4% last year, Azerbaijan's GDP growth was underpinned by surging crude oil production and exports, which leaped by 31.5% and 39.1%, respectively. This performance was due to increased production at the Azeri-Chirag-Gunashi (ACG) offshore oil field operated by the Azerbaijan International Operating Company, the largest exporter and accounting for over 90% of total crude oil exports. Oil from that field is exported to Western markets through the Baku-Tbilisi-Ceyhan pipeline. Oil production is expected to reach 1 million barrels a day this year. Natural gas production increased by over 70% in 2007 as production at the Shahdaniz offshore block came on stream.

The ADB said further that the boom in production and exports of oil and gas "is seeing few signs of ending" in Azerbaijan.

"Operations at large new investments began in 2007, and are expected to reach their peak in the next few years. Earnings from hydrocarbons have led to a large current account surplus and strong currency appreciation in real terms.

"Significant fiscal loosening in 2007 fueled domestic demand and inflation, as the central bank lacked adequate instruments for controlling monetary expansion. A key policy aim in the medium term is to diversify the economy, and reduce the heavy dependence on oil and gas," the report said.

According to the ADB, services and construction also expanded rapidly in 2007. Growth in services at 25.1% was bolstered by the expansion of communications and transport, which grew by 20% and 13%, respectively. Services' robust growth was also helped by comprehensive tariff adjustments and policies to expand private sector services in rural areas. Reforms in customs and tax administration have increased the transit of goods through Azerbaijan. Construction, predominantly residential, grew by 19%, due to substantial improvements in regulations and licensing.

Foreign direct investment, particularly by international oil and gas companies, has been the main driver of heady investment in the past decade. However, it declined by 28.9% or about $1.3 billion in 2007, with the completion of several significant oil and gas exploration projects. A further decline in foreign direct investment is expected over the next five years. In 2007, domestic investment (mainly public) balanced the decline in foreign investment, to account for over 53% of the total.

Public investment focused on social sectors and improvement of public utilities. These investments were aligned with the state program on socioeconomic development of the regions and with the national employment strategy. Compared with public investment, growth in domestic private investment was modest. However, the government consolidated efforts to strengthen the non-oil sector by improving the investment climate. While most reform efforts were more procedural than structural, the authorities achieved solid progress in easing business registration generally and that of small and medium enterprises (SMEs).

Another significant change was a decline in the average cost and time for opening a new business, from over 50 days in 2006 to less than 30 in 2007. The government also established the Azerbaijan Investment Company with an initial capital of about $100 million as a public equity fund to invest in private non-oil companies.

The report said continued strong foreign currency inflows from oil and gas exports put additional pressure on inflation. Despite sterilization efforts by the National Bank of Azerbaijan (NBA), money supply rose by about 71.6% in 2007. The manat appreciated by about 5% against the dollar in nominal terms. A stronger local currency could potentially help alleviate the upward pressure on consumer prices, but the authorities are reluctant to allow further appreciation to avoid harming the non-oil tradable sectors. However, due to higher inflation than in major trading partners, the real effective exchange rate has appreciated by over 20% since end-2004.

The inflation rate doubled from an average of 8% in 2002-2006 to 16.7% in 2007. The biggest jump in consumer inflation was recorded in January 2007 when the government raised public utility tariffs including water supply and sanitation, electricity, and gasoline. At year-end, prices were 20% higher than a year earlier.

Inflation was also fueled by a surge in government expenditures. In 2007, the total public sector wage bill, for example, soared by over 60%. With a presidential election to be held in October this year, the authorities will probably attempt to use administrative tools, such as price ceilings on key commodities, to avoid further price rises. Controls may be efective at least in the short term, but in the longer term the government will have to consider their possible impact on agricultural production. he increases in global oil prices and in the export volume of hydrocarbons resulted in a current account surplus estimated at $8 billion, equivalent to 27% of GDP in 2007. According to preliminary data, the trade surplus rose by over 30%, driven by crude oil exports, which account for about 90% of the total. Gross international reserves, excluding gold, increased from $2.5 billion at end-2006 to $4.3 billion at end-2007.

As for economic prospects, the bank said the economic outlook for 2008 and 2009 remains positive and GDP growth rates are projected at 15.7% and 18%, reflecting a moderate increase in hydrocarbon production and exports. Crude oil and natural gas production, respectively, are projected to rise by an average of 21% and 26% in the forecast period. While FDI inflows into the sector will gradually decline, domestic investments, largely public, will increase by 8%, supporting growth. Expansion in the non-oil sector, including agriculture, is expected to remain at about 9%. Since GDP growth will be concentrated in capital-intensive sectors, a sharp drop in unemployment is unlikely, although average nominal wages are expected to continue rising.

According to the ADB, the main challenge for the government is to maintain macroeconomic stability in an oil-related boom. Growth in public expenditures and robust development in infrastructure in the next couple of years will increase pressures on inflation and the exchange rate.

The annual Asian Development Outlook provides a comprehensive economic analysis of 44 economies in developing Asia and the Pacific. This 20th anniversary edition examines trends and prospects in Central Asia, East Asia, South Asia, Southeast Asia, and the Pacific.