From: MihranK@aol.com
Subject: Boom and gloom

Boom and gloom

Mar 8th 2007
The Economist Intelligence Unit ViewsWire

Azerbaijan’s economy, drunk on oil, is suffering rapid inflation

Azerbaijan is the world’s fastest growing economy, thanks to an oil
boom, but it is already running into serious difficulty. A huge
expansion in budgetary spending has pushed inflation close to double
digits’in month-on-month terms’ and there are early but ominous signs
that the non-oil economy is losing competitiveness. The economy is
already showing signs of Dutch Disease’and the maintenance of
artificial monopolies throughout the economy will serve to exacerbate
the problem.

Azerbaijan is in the midst of a dizzying period of economic
expansion. Real GDP grew by 26.4% in 2005 and 34.5% in 2006, and is
forecast to grow by around 21% this year. The main driver of this is
the oil sector. The BP-led Azerbaijan International Operating Company
(AIOC) has been steadily ramping up production from the
Azeri-Chirag-Guneshli offshore complex and has now completed the
Baku-Tbilisi-Ceyhan oil pipeline, which lays the foundations for yet
higher output. Oil output grew by 41% in 2005 and 45% in 2006, and is
set for a similar performance this year.

The oil boom has fuelled other sectors of the economy. The non-oil
sector grew by 11% in 2006, propelled mainly by services. Baku, the
capital, is in the midst of a construction boom that is impressive
even by the standards of the transition region. Yet already distress
signals are apparent. In 2006 the government increased budgetary
spending by an astonishing 80%; a further 50% increase is anticipated
this year. At the start of 2007, the impact of the huge fiscal
stimulus began to tell on inflation. In annual average terms,
inflation was 8.3% in 2006 and ended the year at 11.4% year on
year. Doubt about the official number has spawned a number of
alternative indices, some of which suggest the 2006 inflation rate
could have been as high as 20%.

Even on the official measure, inflation is now surging. In January,
the rate was 16.8% year on year and 6.4% month on month. Again, some
private-sector economists grumble that the real rate is higher
still. According to one USAID-funded NGO, January inflation was 14.3%
month on month, which is more than double the official figure. Given
that the government raised a host of regulated prices on January
8th’electricity tariffs trebled, water charges more than doubled,
gasoline prices rose 50% and public transport costs increased by 30%’
the unofficial estimate seems perhaps more credible than the official
one.

Oil’s curse One of the dangers for Azerbaijan of rampant inflation is
that it will put pressure on the real effective exchange rate and thus
undermine the competitiveness of the non-oil economy. In any case, the
influx of petrodollars has in the past two years forced the
strengthening of the manat in nominal terms against the dollar. In
2005 it appreciated by 8% against the dollar, and by a further 5% in
2006. According to the head of the central bank, Elman Rustamov, the
2006 figure would have been significantly higher but for central bank
currency interventions to the tune of US$1bn.

Ostensibly, the growth of the non-oil economy in 2006 suggests there
is as yet little to worry about with regard to competitiveness. Yet
that growth rate is primarily due to the success of non-tradeables
such as construction, which are barely affected by exchange rate
appreciation. Azerbaijan’s tradeables, by contrast, are already
showing signs of strain. Agricultural output last year grew by just 1%
and output of staples such as cotton, rice and potatoes actually
contracted. In Baku’s markets, local fruit is beginning to lose ground
to Latin American competition; considering the cost of transport, this
is a very worrying development. Agriculture is on some measures the
most important part of the non-oil economy, as it is the largest
source of non-oil exports. In addition to exchange-rate problems,
agriculture is suffering from an outflow of labour, as the
construction boom sucks labour from the countryside into Baku and
other urban centres.

Elsewhere in the economy, there are clear signs of strain. In 2006,
for instance, tax receipts from the non-oil sector actually fell in
year-on-year terms ‘this despite a national headline growth rate of
over 30%. Agriculture is not the only sector that is losing ground in
the home market to importers. Also, now that power prices in
Azerbaijan are sharply rising, following Russia’s decision to hike gas
prices for its CIS customers, it will be interesting to see how the
energy-intensive metals sector, and particularly the country’s
aluminium enterprise, performs. Metals are the second largest source
of non-oil related exports after agriculture, with 2.3% of total
exports.

Wasting away Although Azerbaijan is at an early stage of its oil boom,
the signs of Dutch Disease’in essence, a loss of competitiveness in
the non-oil economy prompted by exchange-rate appreciation and other
factors’are particularly ominous. At this point, it is possible that
Azerbaijan will make the transition from a sizeable agricultural
exporter to a major importer in less than the 15 years it took fellow
Dutch Disease sufferer Nigeria.

In Azerbaijan’s case, several factors conspire to deepen and
accelerate the problems associated with Dutch Disease. First, its oil
boom will be relatively short-lived on current forecasts: oil
production will begin to decline in 2012. At least while oil receipts
are gushing into the state budget, Azerbaijan will be able to throw
money at some of the most obvious symptoms, as it is currently by
hiking wages and offering to subsidise fuel purchases for farmers.

Second, the country’s physical and financial infrastructure is
underdeveloped and/or dilapidated, and this puts the non-oil economy
at a huge disadvantage. The banking sector, for instance, scarcely
exists beyond the major cities; this makes life harder for the
country’s farmers as they seek to modernise and expand. Electricity
and water supplies outside the cities are also unreliable, and the
road network is underdeveloped and in a very poor state of repair. The
government’s fiscal boom will alleviate some of these issues,
particularly with regard to the physical infrastructure, although this
will not improve utilities and the financial sector.

Third, the country’s business environment is hazardous and getting
worse and this makes life close to impossible for the private
sector. The headline problems include: rampant corruption on the part
of state officials, particularly in the tax and customs departments,
as evidenced by Azerbaijan’s very poor rating in Transparency
International’s Corruption Perceptions Index; a court system that is
open to abuse, delivers verdicts at odds with the country’s legal code
and is often ignored by the authorities it relies upon for
enforcement; the maintenance of a number of artificial monopolies in
the country, including the import of basic commodities such as
bananas, run for the benefit of well-connected individuals; and a high
level of interference in the economy by government figures.

A self-serving elite This last problem is probably the most
threatening, as in its scale it is excessive even by the standards of
countries such as Russia, Ukraine and Kazakhstan, as well as
neighbouring Georgia and Armenia. Within the last two years, a number
of major enterprises have been subject to Yukos-style assaults by the
authorities. Downstream oil company Azpetrol, which was widely
considered to be the best-run company in the country, was taken over
around the time of the 2005 parliamentary election and its major
shareholders were jailed. Barmek, the Turkish-run power company, was
forced out soon after. These are merely the highest-profile examples
of a declining business environment. Although not reported in the
international media, since the second half of 2006 a stream of
Azerbaijani entrepreneurs have migrated to Georgia and Kazakhstan,
because they find the business climate more attractive.

The phenomenon of well-connected Azerbaijanis muscling in on
successful businesses has got noticeably worse since Ilham Aliyev
succeeded his father, Heydar, as president in 2003. At the time,
Western states hoped that Ilham would prove to be a modernising and
liberalising force in the country. Instead, perhaps because he has
been unable to fully control some senior members of the government,
the country’s political elite has encroached further into the private
sector. This magnifies the corrosive effects of Dutch Disease, and at
present it is more a matter of hope than expectation that the private
sector will be allowed sufficient space to develop.

Mr Aliyev’s government is quite aware of the phenomenon of Dutch
Disease, and has taken some sensible preventative steps. A large part
of the oil revenues are directed to a stabilisation fund, and
institutions are in place to support the development of the non-oil
economy. Yet the best chance for Azerbaijan to avoid the worst effects
of Dutch Disease rests on Mr Aliyev implementing measures that he is
politically unwilling or unable to take’namely to break up the
artificial monopolies, rein in budgetary spending, curb the business
empire-building of his inner circle, and promote anti-corruption and
the rule of law.