The Macroeconomic Stabilization in Azerbaijan : “Who Is To Blame?”

Abstract

This paper discusses the starting stage of macroeconomic reforms in Azerbaijan in the mid-1990:  the macroeconomic stabilization. It defines major actors and evaluates their role in achieving the macroeconomic stabilization. The situation before the reforms as well as the results and consequences of the macroeconomic stabilization in Azerbaijan are also analyzed in this paper.I argue that the macroeconomic stabilization was successful but the problem is that other dimensions of market reforms: privatization, liberalization and especially institution-building have not gone that far.

According to Shafiqul Islam there are four interlocking wheels in the transition vehicle: 1) macroeconomic stabilization; 2) liberalization; 3) privatization of the economy; 4) development of market-supporting institutional infrastructure[1]. The last three wheels he grouped together under the label of "marketization". Macroeconomic stabilization is the first and the crucial condition for further marketization. Once economy is stabilized further reforms are possible. The same was in case of Azerbaijan , where reforms were started only after the macroeconomic stabilization had been achieved as a result of tight monetary and exchange rate policy by the National Bank of Azerbaijan accompanied by the proper fiscal policy.

Islam also agrees that reforms should be “initially fueled”, not just lubricated, by massive foreign governmental assistance - moral, intellectual, technical and financial[2]. However, Azerbaijan did not have much of this kind of help, since main donor of the transitional countries USA excluded the Azerbaijani government from the list of recipients as a result of the Section 907 to the Freedom Support Act of 1992. Thus, the only hope for Azerbaijani reformers was the IMF and other international financial organizations, which altogether played an important role during the macroeconomic stabilization in Azerbaijan .

The post-Communist transition in Azerbaijan can be roughly divided into two stages: 1) first years of independence (1991 – 1994) – “state of nature” and 2) powerful autocratic regime and stabilization (after 1994) – “state of Heydar Aliyev”. After the brief overview of the main characteristics of the first stage, I will turn to the second stage when the reforms started.

The Pre-Reform Chaos and Feebleness of the Government

        The experience from post-communist transition suggests that transformation from a central planned system to the market path is accompanied by a worsening of production parameters, sharp increase in inflation, high speed depreciation of the national currency and worsening of the social conditions of the population. The break up of traditional economic relations established for decades and political cataclysms in the post-Soviet also aggravated these transitional problems.

            All these problems were characteristic for Azerbaijan . Moreover, it was engaged in the conflict and suffered from the military aggression. By the 1993 20% of the republic’s territory was occupied, the number of refugees and internally displaced persons reached almost one million people.

After resignation of the first President Ayaz Mutallibov in spring of 1992, the Popular Front of Azerbaijan (PFA) government head by the new President Abulfaz Elchibey attempted to accelerate reforms in 1992 to liberalize the economy. For this purpose, the Government took a decision to introduce the national currency - Manat, liberalized most prices, initiatedd financial sector reforms, and began developing the necessary legal and institutional framework.  In August 1992, Azerbaijan finally joined the IMF and started negotiations with this institution.

The presidency of Elchibey was a bright example of the fact that being a good orator and ideologist does not mean being a good head of state. Short period of the PFA rule was notable for unbalanced foreign policy, internal instability, economic collapse and hyperinflation.

In fact, the government was unable to implement any kind of economic reforms and suffered from the lack of financial support. Thus the volume of production decreased by 67% between 1990 – 1994, the average annual inflation rate was about 1600 – 1800%, and Manat was depreciating at a higher speed[3].

            One of the major shortcomings, along with decrease of GDP, and related to the National Bank’s activity was hasty money and credit emission. An increase in money supply, which did not accord with real economic situation and demand resulted in inflation and caused the paralysis of the financial system[4].

            During the given period the structure of the financial system was rather primitive and underdeveloped. The NBA’s activities in the field of money market in the condition of high inflation were limited by the speculative transactions related to interest rates and foreign exchange rates. Azerbaijan was also in Ruble zone until 1993 and it was depreciating too. Circulation of Ruble added the problems for the NBA in implementation of the exchange rates policy. Thus due to institutional weakness of the Government and failure of the NBA to create a sufficiently effective monetary and exchange rate policies, it was unable to control inflation and the exchange rate of Manat.

Setting Conditions for the Macroeconomic Stabilization in Azerbaijan

            Political conditions for the macroeconomic stabilization in Azerbaijan were achieved only after coming to power of Heydar Aliyev in June 1993. He made his comeback by taking advantage of a military rebel lead by Colonel Suret Huseynov against the rule of the PFA[5]. Having dealt with his main political opponents (including above-mentioned Suret Huseynov) Heydar Aliyev could establish and strengthen his rule.

Cease-fire in Karabakh and final agreement with multinational oil giants on oil fields in the Caspian sector of Azerbaijan and signing $7 billion contract in 1994 as a result also contributed to establishment of stable pre-conditions for launching the radical reforms.

      At the same time Azerbaijan accelerated negotiations with the IMF about funding the economic reforms in Azerbaijan . The government had not applied for any credits to IMF, but after the resignation of the NBA’s governor Qalib Aghayev, who was a fervent opponent of borrowing from the IMF and playing by their rules, there was a progress in the negotiations.

            Experts of the IMF prepared stabilization program, for which implementation US$ 46m was given in April of 1995. This was a beginning of the long and fruitful cooperation between the IMF and Azerbaijan (Aliyev 2002).

The first program's aimed to limit the decline in real GDP to 6 percent, reduce monthly inflation to about 2 percent by the end of the year, and limit the external current account deficit to below 10 percent of GDP and restore a sound external reserve position to the central bank.

The population tired of instability, chaos and military defeats mainly supported and trusted Heydar Aliyev seeing in him the person able to put things in order. The population remembered him as a wise and experienced leader, and this image was fixed in the minds of the people and “cultivated” through the state television. Thus the level of political capital for the implementation of radical reforms was rather high. And reforms started.

The Stabilization Reforms: Process and Main Actors

            Briefly and roughly one can argue that the macroeconomic stabilization in Azerbaijan was achieved by the coordinated measures of the NBA and the Government inspired by the IMF. But let us take a look at the details.

The first stabilizing measure by the NBA was declaration of Manat the single legal currency on the territory of Azerbaijan from January 1, 1994 in order to be able to pursue its independent monetary and exchange rate policies. Ruble was removed from the circulation. In addition, the National Bank finally got the right to control the foreign exchange reserves, which had been largely allocated to governmental needs from the Unified Foreign Exchange Fund (UFEF) managed by the President. Approving the annual credit plan by the Parliament each year in order to manage credit allocation was also suspended. As a result the NBA was holding all the trump cards for launching its monetary and exchange rate policies in the framework of the macroeconomic stabilization program.

The NBA started to implement rigid monetary policy from the second half of 1994. A main principle of this policy was to decrease inflation and strengthen the Manat’s rate through bringing the quantity of the broad money and emission of money and credits in accordance with the real demands of the national economy. Simultaneous strengthening of the fiscal policies through cutting the state budget expenditures made it possible to carry out coordinated monetary and fiscal policies in one strategic dimension – achieving macroeconomic stabilization. Another important component of macroeconomic stabilization was the policy of exchange rate. Stabilization of Manat in respect to US Dollar was conducive to stopping inflation in conditions of extreme dependence of the domestic market on critical imports and in prevention of a reduction in the population’s income.

The NBA used refinancing of the commercial banks as one of the instruments of macroeconomic stabilization. One of the main sources of hyperinflation in Azerbaijan was the huge volume of money emission for the purpose of the budget deficit financing in account of the NBA’s credits. Thus financing of the budget deficit by the NBA’s credits as a first step was brought to minimal level (2% of GDP) and later suspended at all.

            Another instrument was the interventions to the currency market. In order to achieve aims on the exchange rate policy, the NBA moved in the direction of creating infrastructure of the currency market as well as the creation of currency resources in accordance with the market demands. Starting from early 1995 the NBA was commissioned the competence of management Azerbaijan ’s official currency resources. As a result it became possible to implement a flexible exchange rate policy with the interventions, when necessary, namely with consideration of the situation in the currency market. The NBA, in fact, intervened very often and so-called “dirty floating” took place.

            Thus the real exchange rate of Manat in respect to the US Dollar was appreciating starting from 1995 till 1999, when monetary and exchange rate policies were loosened and Manat was allowed to fall slightly. You can see the dynamics of exchange rate of Manat in respect to US Dollar from the Figure 2 on the next page.

During the first year of reforms gross official reserves of the NBA rose from less than US$2m to US$16m[6]. This was mainly due to the IMF loans and the bonuses for contracts related to joint exploration and utilization of oil and gas filed as well as liberalization of foreign exchange regulation.

            After first positive signals from Azerbaijan the IMF approved credits (Stand-by[7] and STF Drawing) in November of 1995 totaling about US$132m to support the Government's 1995-96 economic reform program. Its aims were further reduction of inflation through tightening of monetary policy of the NBA, fiscal adjustment, with a reduction of the overall budget, structural reforms (restructuring the financial sector, rationalizing the price structure, achieving rapid progress in privatization, and initiating the enterprise restructuring process) as well as reforms of the system of social transfers.

            The problem of policy coordination between the NBA and the Government was not serious in the case of macroeconomic stabilization in Azerbaijan . The government in the person of the Ministry of Finance used budget mechanisms (taxation, state expenditures) and the NBA was applying the instruments of monetary and exchange rate policies. This happened as a result of the clearly defined (with the help of the IMF experts) major goal – stabilize economic situation.

            Price stability and low inflation are usual concerns of CBs. Contractionary policies might be a problem for governments since a median voter usually does not welcome such policies. However, the situation in Azerbaijan demanded nothing but rigid monetary contraction and tight fiscal policy, which was an essential part of macroeconomic stabilization program, and a median voter could not decide much through elections.

            The fiscal policy, which was implemented by the Government from the end of 1994, was rigid in terms of the social safety. However, it was the only way out from the deteriorated economic situation and huge budget deficit. This fiscal policy was based on tight controls on the expenditures and on accumulation of arrears. As already mentioned direct financing of the state budget was brought to minimum in order to escape inflationary consequences.

Since 1995 deficit was almost externally financed and this fact allowed the Government to accumulate domestic assets. Royalties and other bonuses from the oil companies helped a lot in financing the state budget deficit, which declined from 15 percent in 1993 to 4.3 percent of GDP in 1995, and then to 1.7 percent in 1997. Revenues from indirect taxes (VAT, excises and customs duties) also increased to 7.2 percent of GDP due to broadening of the VAT tax base through removing exemptions and duty free threshold for imported goods for personal use. At the same time tax enforcement was improved as well.

            In general, monetary and fiscal policies were rather coordinated and consistent. The reason is that the measures for macroeconomic stabilization that should have been implemented by both the Ministry of Finance and the NBA were prescribed by the same “doctors” – the IMF experts and controlled by the same institution – the office of the President head by the charismatic person of Heydar Aliyev.

Results and Consequences of Macroeconomic Stabilization in Azerbaijan

The monetary and exchange rate policies of the NBA and the Government’s fiscal policy played a crucial role during the process of macroeconomic stabilization in Azerbaijan . They could suppress inflation and ensure stability and internal convertibility of national currency.

            One of the main positive results of the exchange rate policy was formation of the relatively strong currency market, based on supply and demand. The NBA regulates a position of Manat through its interventions to the currency market. Although in principle there is a flexible exchange regime, the NBA, in practice, used its reserves to support Manat. It is also worth mentioning that Manat was the only CIS currency for which the nominal exchange rate strengthened against the US dollar during 1995 – 1998.

            The lowest rate of inflation among the transitional countries is another ground for special pride of the Government in general and the NBA in particular. During 1999 even deflation was achieved, but then inflation was allowed to rise slightly.

            However, there are several problems, which arising as a result of the monetary and exchange rate policies of the NBA. The measures, quite successful in tackling inflation and establishment of relatively stable macroeconomic situation after being continued even after the macroeconomic stability was achieved resulted in the lack of money in the economy. GDP growth now is much higher than growth of M2 aggregate. Broad money now is at the level of only 6% of GDP, while in practice it should be not less than 25%.

            A tight monetary policy aggravated the problems in the real sector. Given almost zero rate inflation the real interest rate for potential borrowers has been extremely high. This created liquidity problems for the real sector, which, first, reacted through barter activity, and after the prohibition of the barter – through wage and tax arrears. Another consequence was as highlighted by Singh and Laurila:

“Enterprises previously able to service debt through inflation no longer have the option – in an inflationary environment, debtors gain at the expense of creditors since inflation wipes away the real value of the debt; the reverse is true during a period of price stability. Without enforceable contracts and hard budget constraints, rises in inter-enterprise debt, or arrears in taxes or wages are a rational real sector response.”[8]

            The first measure that comes to one’s mind as a solution for this problem is a cheap money policy. But there is a problem, which would undermine any actions in the framework of such policy. The problem is that Azerbaijan economy is highly dollarized and only dollar credit’s cheapness could increase speed of economic growth[9]. The NBA can not print dollars and thus can not change the situation. The solution could be increase of confidence in Manat and banking system and increase of the deposits in Manat. Having more Manat deposits banks will be able to reduce interest rates for deposits. This might decrease the interest rates for both US dollar and Manat loans. But now there is weak credibility from the side of the public to the NBA’s policy and the banking system as a whole.

            The NBA suffers from the problem of credibility because of the lack of actual independence and the perceptions among the population that “the President decides everything”. This is not a problem of only the NBA, but all other institutions in Azerbaijan .  It is impossible to speak about any credibility when the prices and business activity fluctuate depending on the fluctuations of the health of 78 years old President Aliyev (or even rumors about his health).

            Why there is distrust to Manat if it is stable? The high level of dollarization in Azerbaijan suggests that the “victory” over inflation has not resulted in any significant rise of confidence in Manat[10]. The matter is that stability of Manat is provided through regular interventions of the NBA to the currency market, which are made using currency resources of the NBA. These reserves are quite impressive now (about US$ 1.2b: Source: NBA 2002)[11].

The main sources of the currency reserves have been external borrowing and especially the revenues from oil sector. But the oil sector can be “mixed blessing” and undermine the stability of Manat, e.g. through change in oil prices. The paradox is that oil richness of Azerbaijan has not had strong positive effect on its domestic currency[12].

The share of the oil industry in GDP increased from 16.4 percent in 1995 to about 40 percent in 2001, which would be great, if not the simultaneous fall of non-oil sectors’ share from 13.2 percent to 6.1 percent, respectively. Thus there is a threat of the so-called “Dutch disease”. The Dutch disease is expressed in “unbalanced growth among the petroleum sector, the nonpetroleum traded goods sector, and the expanding nontraded goods sector”[13]. As a result there is bias in development – services, transportation, construction and other non-tradeables grow at the expense of discouraging industrialization and agriculture as well as a danger of the local currency over-appreciation.

Presence of mineral resources can have some other negative consequences for the economy and the process of reforms, which are pointed out by Terry Linn Karl and can be applied to the case of Azerbaijan . These consequences are addiction to oil rents and development of the rentier mentality; knitting of political and economic power based upon the allocation of rents and decision making about distribution of financial resources: soft budget constraints, presence of “crony capitalism” etc; high level of non-economic expenditures and high absorption and corruption[14]. The newly established Oil Fund where all oil revenues are collected will help to avoid the perils of oil-richness through the better control over flows of the “oil money”. This money will be deposited in the several foreign banks for future generations. Only the President has the right to use these means by his decree in the public needs in case of emergency (at present there have been accumulated almost US$ 600m).

After fall of the world prices of oil and the crisis in Russia , the IMF suggested Azerbaijan to devalue rapidly the exchange rate of Manat and promised financial support for this action. The government and the NBA refused and could keep the same exchange rate until July of 1999, when after all Manat was led to depreciate for the first time since 1995[15]. Such strong adherence to the principles of price and exchange rate stability might be explained by the fact that low inflation as a symbol of successful macroeconomic stabilization has been one of the few achievements of the economic policy of the Government and thus should have been cherished.

Another explanation could be that an important source of the revenues of the ruling elite at that time was based on the import operations. Over-appreciated Manat was conducive to higher revenues from imports.

Nevertheless, Manat had to be depreciated and as admitted even by the NBA officials its real appreciation should be avoided. But some economists suggest that the further real depreciation is advisable (e.g. Laurila-Singh 2000, Soos 2001, Rzayev 2001).

Concluding Remarks

In general, macroeconomic stabilization in Azerbaijan has been successful. The problem is that other dimensions of market reforms: privatization, liberalization and especially institution-building have not been that successful. The pace of legislative and structural reforms has been slow and the degree of legal transition to a market economy has been one of the lowest among all transitional countries[16] and all we have is the continuous “successful macroeconomic stabilization”. The problem in case of Azerbaijan is development of the “bad institutions”: high level of corruption and state capture as well as flourishing “crony capitalism”.

        The successful stabilization and following impeding pace of the market reforms in Azerbaijan can be explained by the argument that at the initial stage strong executive power or even autocratic political regime unconstrained by free elections is preferable[17]. But when it comes to the point when situation is stabilized, and there is a need for consolidation, will a ruling elite stand the temptation to keep  and strengthen its own power and status quo? The case of Azerbaijan shows that it can not. After the macroeconomic and political stabilization the Government has not loosened its policies and has not tried to seek for consolidation with the opposition. At the same time economic reforms were also held back.

            Another actor – the IMF – has played an ambivalent role. It contributed to both: the success of macroeconomic reforms and hold back reforms after. In general, one has to admit that the IMF financed reform programs have been at the core of Azerbaijan international support. It has also encouraged and supported establishment of the so-called Oil Fund in which all revenues from oil are concentrated[18].

            It is obvious that political reasons for the relative success of the reforms in Azerbaijan have prevailed because of the geopolitical competition for dominance in the region and control over Caspian oil deposits and their transportation. Support of the stabilization program could be a reward to the Azerbaijani government by US in the person of IMF for its opposition to Russia and Iran . Such geopolitical issues make the IMF blind not to see corruption-friendly policies and or inconsistency of reforms as well as the problems with a democratic state building.

In fact, the macroeconomic stabilization in Azerbaijan became possible only as a result of consensus between the main actors. However, there is no such consensus about what to do next which means that the future of reforms in Azerbaijan is absolutely unpredictable.

Fuad B. Aliyev

Baku,  July 2002  

Bibliography

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