Azerbaijan: Country outlook

COUNTRY VIEW

ECONOMIST INTELLIGENCE UNIT
PUBLICATION DATE: September 07, 2005

OVERVIEW: Although the Economist Intelligence Unit’s baseline forecast
assumes that the president, Ilham Aliyev, will continue to consolidate
his authority and remain in power over the forecast period, there is
still a small risk that an aggressive attempt to restructure the
political scene could antagonise members of the ruling elite, leading
them to challenge his authority. There is also likely to be unrest
surrounding the forthcoming parliamentary election. The economy is
expected to continue to grow rapidly, owing to external investment in
the energy sector and rising energy production. Real GDP growth is
forecast to reach 20% in 2005, owing to a substantial increase in oil
output, and will accelerate to 25% year on year in 2006, as gas
production begins to rise in tandem with oil volumes. As there are only
limited sterilisation tools available, the authorities will allow a
slight nominal appreciation of the currency against the US dollar, which
will keep inflation in check. The current-account deficit is forecast to
swing into substantial surplus in 2006, as oil production is ramped up.

Domestic politics: The political scene will be dominated in the short
term by the approach of the parliamentary election, which will be held
on November 6th 2005. Although Mr Aliyev is likely to survive
politically the tensions that will build as the election approaches, he
will probably emerge weakened from the process. Largely thanks to a
changed international context, the opposition is thus expected to be
stronger and more influential after the election. It has become
increasingly clear that the government’s long-standing strategy of
manipulating elections and excluding the opposition from power is less
viable than before. International pressure for increased political
liberalisation, particularly from Azerbaijan’s most important ally, the
US, has increased considerably in recent months, and the government is
now more likely to shy away from the sort of blatant electoral
manipulation seen in the past.

International relations: One development that is increasingly affecting
Azerbaijan’s foreign policy is the greater stress by the US government
on the promotion of democracy. In the past the US was willing to work
with the semi-authoritarian leadership in Azerbaijan, since it was
preferable to the chaos that dominated the country in the years
immediately following independence. Although this policy has now
changed, the difficulty for the US will be to judge the amount of
pressure that it will be able to exert on Azerbaijan’s leadership
without triggering an upheaval. The new US policy will also create
problems for Mr Aliyev. He will find it harder now to fulfil one of the
main objectives of Azerbaijan’s foreign policy–namely, promoting closer
ties with the US, with the goal of fending off interference from its
larger neighbours, Russia and Iran, and avoiding the animosity of
smaller countries in the region, such as Armenia and Turkmenistan.

Policy trends: Economic policy will focus on the challenge of
maintaining macroeconomic stability during a period of rapid economic
growth. The fiscal stance will be loosened slightly, so that spending
increases on welfare projects to alleviate poverty and to stave off
potential social unrest. A tightening of monetary policy is therefore
likely to be required. The level of official debt, both domestic and
foreign, will remain low, but the issuance of domestic debt will
increase as a way of mopping up any excess liquidity linked to by
hard-currency inflows. However, inflation is still likely to be higher
than in recent years, because of the limited number of policy tools at
the disposal of the Azerbaijan National Bank (ANB, the central bank),
and because the bank will be reluctant to let the exchange rate
appreciate significantly. In the event that the authority of Mr Aliyev,
comes under serious challenge, this would result in a bout of political
instability, and even limited reforms would be put on hold. However,
every effort would be made to ensure that the operating environment for
oil companies remained favourable.

International assumptions: As a result of the ongoing strength of oil
demand and our long-standing forecast for a slowdown in the growth of
supplies from both Russia and other non-OPEC producers, we expect prices
for dated Brent Blend to average US$55.5/barrel in 2005. This price
projection includes a risk premium to reflect the growing concerns over
global spare capacity in crude oil and tight refined capacity. As OPEC
production gradually rises, global stocks will continue to build
(particularly once the US driving season ends), and we expect prices to
ease slowly from current highs. However, prices will be subject to
occasional sharp increases. Geopolitical concerns and price expectations
will encourage consumers to continue to make forward purchases, as well
as to stock up in anticipation of uncertainties and perceived tightness
ahead. By 2006 we expect an annual average price of US$53.5/b for Brent.

Economic growth: A surge in oil production at the Azeri-Chirag-Guneshli
(ACG) oilfields, which began in February, pushed up real GDP growth to
18.9% year on year in the first seven months of 2005, compared with 9.4%
in the year-earlier period. We expect the economy to expand by 20% year
on year in 2005, reflecting strong growth in oil production and
extremely high oil prices. Growth will accelerate to 25% year on year in
2006, owing to the completion of the first phase of development of the
Shah Deniz gasfield and further rises in oil output. Economic expansion
will also be supported by continued large-scale inflows of foreign
direct investment (FDI) into the oil and gas sector, which is undergoing
a rapid and intensive phase of development. Capital investment in
January-July 2005 reached Manat14.8trn (US$3.1bn), up by nearly 10% year
on year. Capital investment now accounts for about 50% of GDP.
Hydrocarbons development and production will drive economic growth over
the forecast period. However, strong growth will be limited to oil and
related sectors, such as communications, and hotels and catering, with
the contribution to GDP of the broader non-oil economy set to decline
gradually.

Inflation: High FDI inflows related to hydrocarbons development pushed
up consumer price inflation to 15.7% year on year in April, but the
ANB’s decision to raise interest rates in subsequent months slowed
inflation to 12.8% year on year by July. Hard-currency inflows, combined
with additional inflows related to the rapid growth in oil exports (not
all of which will be sterilised by channelling them in the overseas oil
fund), will continue to exert inflationary pressures, although seasonal
declines in food prices will temper month-on-month consumer price
inflation. Average annual consumer price inflation is expected to be 12%
in 2005, and will fall to 8.5% in 2006 as monetary policy tightens
further. Decelerating inflation will be helped from the second half of
2006 by a decrease in FDI as hydrocarbons activity enters a less
intensive phase of development, and as some export earnings are diverted
into the SOFAZ oil fund.

Exchange rates: Although the government sterilises part of the oil
windfall by depositing foreign currency in its overseas oil fund,
hard-currency inflows are still affecting the economy and boosting the
money supply. The ANB will allow the manat to appreciate slightly in
nominal terms over the forecast period, in order to restrain the
expansion of the money supply and contain consumer price inflation. The
recent rise in interest rates will not help to prevent further real
appreciation, although the amount of speculative capital that is likely
to be attracted into domestic assets will be very small, given that
there are few attractive assets on offer. Some of the products of the
non-oil sector will be priced out of their export markets by the
stronger manat.

External sector: With the hydrocarbons sector at an intensive stage of
development until the middle of 2006, import spending will be extremely
high over this period. Foreign investment projects in Azerbaijan’s
hydrocarbons sector require substantial imports of capital goods and
services, since Azerbaijan’s industrial base is insufficiently developed
to service oil and gas investors. High oil prices in 2005 will ensure
that the current-account deficit decreases significantly, and it will
swing into substantial surplus 2006, when exports of crude oil and gas
surge. The first tanker of oil from Azerbaijan’s ACG oilfields will be
shipped to Western markets towards the end of 2005, while the export of
gas from the Shah Deniz field will begin from mid-2006. The external
deficit in 2005 will be entirely covered by FDI.

SOURCE: Country outlook