Adopting to the New Economic Environment: The Case of Azerbaijan
When the U.S. economy entered into a recession in 2001, the Federal Reserve responded to the slowdown in economic activity by reducing the federal funds rate to historically low levels. In early 2001, the effective federal funds rate was higher than 5%. However, by the end of the year the rate was below 2%. The Federal Reserve continued to decrease the federal funds rate and by the end of 2003 the interest rates were at 1% which has not been seen since 1954. During the same time the Federal Reserve has also increased the money supply by more than 20%. These efforts paid off and during the period 2003-2006, the average real GDP growth in U.S. was higher than 3%. Â
This excessive monetary easing by the Federal Reserve was a turning point for commodity prices, in particular for energy prices. During 1990s, oil prices were relatively stable around 20 dollars. The prices only showed a sharp decline 1998 due to the Asian crisis. However, the oil prices recovered quickly and reached to 24 dollars in 2001. The accommodative monetary policy adopted by the Federal Reserve had generated an upward pressure on oil prices that can be explained by two reasons. First of all, the expansionary monetary policy had stimulated the economic growth not only in U.S., but all over the world. The boom in global economic activity has in turn increased the demand for oil and has created an upward trend in oil prices. Secondly, the low level of dollar interest rates had led to a depreciation of the U.S. dollar and the EUR/USD exchange rate has increased from 0.859 to 1.560 between 2001 and 2008. The weakening of the U.S. dollar has also put an upward pressure in oil prices and other commodity prices. As a result of these two impacts, oil prices had increased from 25 dollars to 150 dollars between 2002 and 2008. However, the prices showed a sharp decline in 2009 due to global financial crisis and had dropped to 40 dollars. The response of Federal Reserve to the crisis was more aggressive compared to the one in 2001. They reduced the interest rates to zero and printed more than 2 trillion dollars in three yearsâ€™ time. The extensive quantitative easing program generated another round of rally in oil prices and prices reached to three digit levels again in 2011 and stayed at these levels until the sharp decline that has been in the second half of 2014.
The decade long high prices in oil has significantly changed the macroeconomic dynamics both for energy exporting and energy importing countries. Energy exporting countries like Russia, Azerbaijan, and Kazakhstan etc. have experienced a rapid increase in their GDP per capita and they have accumulated large amounts of current account surpluses. On the other hand, countries like Turkey, India, and South Africa etc. that are largely dependent on imported energy have faced a large increase in their trade deficits.
The recent decline in oil prices and the possibility that these low prices may continue for a long period of time have the potential to change the long-term macroeconomic dynamics in exporting countries. Learning how to live with low oil prices and adopting appropriate economic policies is going to be a priority for these countries over the next two or three years in order to be able to deal with this new economic environment. In this paper we will look at this issue from the perspective of Azerbaijan and will discuss the necessary policies that will help the Azerbaijani economy in terms of achieving long-term sustainable growth in the case of low oil prices.
The rest of the paper is organized as follows. Section 2 gives a brief discussion about the recent decline in oil prices and gives a perspective for the future prices. Section 3 presents a brief economic outlook for Azerbaijan. Section 4 discusses the viable economic policies for Azerbaijan in this new episode of low oil prices and Section 5 concludes.
Outlook for Oil Prices
The 50% decline in crude oil prices in the second half of 2014 was certainly an unexpected event for the players in the energy markets. There has been a significant amount of study in the academic literature in terms of understanding interaction between oil prices, financial markets, and macroeconomic cycle. Although the 2014 oil bust is a new issue, there has been some research about the possible causes of this sharp decline in prices. Baffes, Kose, Ohnsorge, and Stocker (2015) focus on potential causes and consequences of the recent decline in oil prices and they cite five reasons that could explain the fall in prices. Significant increase in unconventional oil production mainly coming from the U.S., weakening global demand, change in OPEC policy, mitigation of geopolitical risks, and appreciation of U.S. dollar were mentioned as the main drivers of the bust in oil prices. Tokic (2015) analyzes the causes and consequences of this recent decline in prices and investigates whether the prices behaved efficiently during this period. He finds that oil market fundamentals do not confirm the bust in prices and the decline in EUR/USD exchange rate has generated another episode of oil price inefficiency.
In the past there has been five other periods in which oil prices have experienced a decline similar to the one that was seen in 2014. Four of these episodes were seen when the global economy were in a stagnation and oil demand significantly weakened. 1990-91 and 2001 U.S. recessions, 1997-98 Asian crisis, and 2008-09 global financial crisis are the four periods in which oil prices had declined by more than 30% in less than a year. The decline in oil prices in 2014 is not similar to these episodes as the world economy is not facing a recession. 1985-86 is the other period during which oil prices had experienced a sharp decline in a relatively short period of time and according to Baffes et al. (2015) the 2014 oil bust has some similar aspects to this episode. Â No one denies that the increase in unconventional oil production mainly coming from U.S. has the main responsibility for the excess supply in oil markets. According to BP statistics, after the global financial crisis in 2009, the total world production of oil has increased by 7.5 million barrels per day (mb/d) and more than 50% of the increase in total production has come from U.S. This aspect of the recent bust in oil prices is similar to the one that is observed in 1985-86. High prices that were observed in early 1970s had led to an increase in oil supply from the North Sea and the Gulf of Mexico and these sources added 6 mb/d to the global supply during the period 1973-83. This period was then followed by a sharp decline in prices.
The second similar aspect between the declines in prices in 2014 and 1985-86 could be attributed to the change in OPEC policy. When oil prices reached a peak in 1979, OPEC decided to reduce its supply to preserve high prices and the total OPEC supply decreased from 30 mb/d to 16 mb/d during the period from 1979 to 1985.
As can be seen in Figure 3 during this period oil supply from North Sea and Mexico continued to increase and both the real and nominal oil prices decreased. The decline in OPEC supply and the increase in the supply of other sources reduced the share of OPEC in global oil production from 45.4% to 27.6% during the same period. OPEC responded to the declining prices by increasing the supply and the total OPEC oil production had again reached to 30 mb/d by late 1990s. This policy change by OPEC had partially contributed to the low oil prices that continued for more than a decade.
When one takes into account the 2014 oil bust, the expectation that these low prices will continue for a long period of time could be partly attributed to the OPEC policy change in November 2014. After the sharp decline in prices there was an expectation that OPEC will take an action to support the prices. However, in its November meeting OPEC has announced that 30 mb/d production level that was agreed on December 2011 will be preserved. This statement implies that OPEC will no longer change the supply in order to eliminate the excess supply in the market. The action of OPEC in early 1980s proved that this type of policy only leads to a decline in the market share of OPEC and does not help the equilibrium price. Therefore, it seems that OPEC will continue to keep its current production levels and it will take some time before the oil market comes into a new equilibrium.
Besides the similarities between the decline in oil prices in 2014 and the fall in prices that was observed in 1985-86, there are some other factors that are expected to put a downward pressure on oil prices in the medium term. First of all, it is commonly accepted that the appreciation of U.S. dollar has been partly responsible for the decline in oil prices. Taking into account the economic growth outlook divergence between U.S. and the Euro Area, the EUR/USD exchange rate is expected to stay under pressure and this will generate a negative environment not only for oil, but for other commodities as well. Secondly, the demand side of the oil market will continue to be weak and it will take some time for the excess supply in the market to disappear. Over the last decade the global oil consumption has increased by 9 mb/d and almost half of that increase has come from China. The double digit economic growth rates that have been observed in China over the last ten years have become the engine of the increase in demand in all commodities. However, the recent developments in Chinese economy reveal that the economic growth rate in the next couple of years will be less than the ones that were observed in the last ten years. The slowdown in economic activity implies that in the future the rate of increase in global demand will be less than the one that is observed in the past and this will put a downward pressure on oil prices.
Economic Outlook for Azerbaijan
The early years of independence was characterized by a high degree of macroeconomic instability for Azerbaijani economy. During the period between 1991-1995 real GDP per capita declined by 60% and it took about a decade for the real GDP per capita to reach again to its level in 1991.
Macroeconomic environment was characterized by large budget deficits and excessive monetary growth in the early years of independence. While the share of government expenditure in GDP was only 17.7% in 1992, this figure reached 30.1% only in one year. Increased government expenditures were mainly financed by printing more money and as a result the money supply grew by 826% in 1993 and 1116% in 1994. This excessive money growth had led to a hyperinflation and inflation remained above 1000% in 1993 and 1994 and it only declined to 412% in 1995. Although other former Soviet Republics faced similar macroeconomic instability during the same period, Azerbaijan experienced a worse depression due to the Armenian occupation of Nagorno-Karabakh and seven other regions.
Obviously, the macroeconomic environment in the early years of independence was not sustainable and Azerbaijan initiated an IMF stabilization program in the beginning of 1995. The main aim of the program was to ensure price stability by adopting a tight monetary policy and reducing budget deficit. The program was successfully implemented by the government and the inflation rate dropped down to 19.8% in 1996 and stayed at single digits until 2007. After five consecutive years of decline, real GDP per capita increased by 2.8% in 1996 and had realized a steady increase until 2011.
Year 2005 was an important turning point for the Azerbaijani economy. While the average growth rate in real GDP per capita was 7.4% during the period from 1995 to 2004, the number has increased to 9.5% for the period between 2005 and 2014. Â Two developments have significantly contributed to the rapid economic growth that has been experienced in Azerbaijan over the last decade. First of all, as explained in Section I, the rally that has been observed in oil markets after 2002 has significantly increased oil revenues for Azerbaijan and the oil and gas sector has become the engine of the economic growth. Second important development was the implementation of Baku-Tbilisi-Ceyhan (BTC) pipeline. The BTC pipeline has significantly increased the oil export potential of Azerbaijan and five yearsâ€™ time the oil exports almost tripled and reached to 1 million barrels per day.
The increase in oil prices and the development of oil export potential have substantially changed the macroeconomic environment for Azerbaijan after 2005. Oil and gas exports had led to a rapid improvement in trade balance and the country started running a large amount of current account surplus. In 2005, current account surplus was only 167 million dollars, which translated into 1.3% of GDP. In three yearsâ€™ time current account surplus increased to 16.5 billion dollars and the ratio of the surplus to GDP reached to 33.7%.
Large amounts of foreign currency inflow implied by the current account surplus generated a prolonged period of appreciation for domestic currency. During the period of 2006-2009 in which oil output had made a significant jump, domestic currency appreciated 12.5% against USD. The appreciation of national currency continued after 2009 albeit at a slower pace. Although inflation rate increased to double digit levels in 2007 and 2008, the appreciation of domestic currency has also generated a downward pressure on prices and the average inflation rate during the period 2009-2014 was realized as 3.2%.
Oil and gas revenues have also initiated a process of rapid increase in foreign currency reserves of Central Bank of Azerbaijan (CBA) and State Oil Fund of Azerbaijan (SOFAZ). During the period of 2008-2014 the total strategic foreign exchange reserves of CBA and SOFAZ almost tripled and increased from 17.4 billion dollars to 50.9 billion dollars.
The increase in oil prices and exports has also opened a space for fiscal expansion in Azerbaijan. In 2005, only 7.3% of state budget revenue was coming from the transfers from oil fund. Since then the transfers to the state budget has steadily increased and by the end of 2014 more than half of the state budget is composed of transfers from SOFAZ. These transfers were in fact necessary for the large amount of infrastructure investment that the country needed. Besides that a large amount of money has been spent for people who were displaced from their homes after the Armenian occupation of Nagorno-Karabakh and seven other regions. According to the 2014 annual report of SOFAZ, since 2012 more than 1 billion dollars were spent for internally displaced people.
Despite the large dependence on oil and gas revenues, Azerbaijani economy has been quite successful in terms of achieving economic diversification. Since 2011 the share of non-oil sector in GDP has been steadily increasing and in 2014, about 61% of GDP has come from the non-oil sector.
The numbers reveal that Azerbaijan has been quite successful over the last decade in terms of achieving macroeconomic stability. However, as explained above a new economic environment has emerged for energy exporting countries and a different set of macroeconomic policies should be adopted in order to tackle with this situation.
A New Episode of Low Oil Prices
In this section we will focus on macroeconomic policies that Azerbaijan should adopt in a new economic environment that is circumscribed by low oil prices. While microeconomic reforms that would complement these macroeconomic policies are very important in terms of supporting long-term economic growth that should be a topic of discussion for another paper.
The decline in oil prices and the perspective that these low prices may continue for a considerable period of time creates two important problems and macroeconomic policies should focus on healing these problems. The first problem is about the potential increase in budget deficit. As it was explained above since 2010 more than half of the state budget revenues have come from transfers from the oil fund. The decline in oil prices will certainly limit the ability of the oil fund in terms of supporting the state budget. If necessary measures are not undertaken on the expenditure side, then there is the risk that budget deficit may increase and may put an upward pressure on interest rates and inflation.
For the first time since 2005, the state budget is running a deficit and this gives us a sign that the decline in oil prices is already creating some downside risks for the fiscal balances. Therefore, there should be a serious overview of state expenditures and those that are not economically vital should be delayed for a couple of years. That is a tight fiscal stance should be the main aspect of macroeconomic policy over the medium term.
Besides the tight stance in fiscal policy, there should be more emphasis on fund management in this new macroeconomic environment. As there will be a less amount of inflow to the state oil fund, the management of existing amount and obtaining a higher rate of return has become much more important after the recent decline in oil prices.
The second problem that needs to be considered due to the decline in oil prices is related with the developments in balance of payments. As it was analyzed in Section III, high oil prices and the increase in production has led Azerbaijan to give large amount of current account surplus over the last decade. However, recent numbers reveal that the decline in oil prices has significantly deteriorated the balance of payments figures for Azerbaijan since the last quarter of 2014. In fact, in the second quarter of 2015 Azerbaijan has realized a current account deficit which has not been seen over the last decade. The deterioration in the current account balance may bring the economy into a more fragile position and this is another problem that the authorities should tackle with in the medium term if the oil prices remain low.
The deterioration in the current account balance means less supply of foreign currency and this certainly puts a downward pressure on domestic currency. In fact, since the beginning of 2015, domestic currency has been subject to 30% depreciation against U.S. dollar. Besides that such a large amount of devaluation occurred despite the fact that foreign exchange reserves of the CBA has declined by more than 6 billion dollars over the first half of 2015.
The downward pressure on domestic currency will continue unless the market sees some improvement in current account balance. Therefore, macroeconomic policies should also be directed towards improving the current account balance again. First of all, the decline in domestic currency will help to restore current account balance by reducing imports. We should also take into account that taking 2000 as the base year the domestic currency is still overvalued in real terms and therefore there might be a further depreciation of national currency. Instead of intervening in the foreign exchange market which only leads to a loss of substantial amount of reserves, the CBA should allow the currency to reach its new equilibrium level. There is certainly a new macroeconomic environment and economic parameters including the exchange rate should adopt themselves to this new episode.
The rapid decline in oil prices that has been observed in the second half of 2014 has certainly changed the macroeconomic picture both for energy exporting and importing countries. The perspective that these low prices may continue for a long period of time generates a necessity for exporting countries to adopt this new macroeconomic environment.
In this paper, we looked at the issue from the perspective of Azerbaijan who has a large dependence on oil and gas revenues. It is seen that a long period of low oil prices may generate downside risks for fiscal balances and balance of payments figures. Therefore, in this new episode of low oil prices macroeconomic policies should focus on ensuring fiscal discipline and restoring the deterioration in balance of payments.
Â Â Â Â Â Â Â Â Â Â Â References
Baffes, J., Kose, A., Ohnsorge, F., Stocker, M., (2015). â€œThe Great Plunge in Oil Prices: Causes, Consequences, and Policy Responsesâ€, World Bank Policy Research Note.
Barsky, R.B., Kilian, L., (2004). â€œOil and the macroeconomy since 1970sâ€, Journal of Economic Perspectives, 18(4), 115-134.
Defina, R.H., Taylor, H.E., (1993). â€œMonetary policy and oil price shocks: empirical implications of alternative responsesâ€, Applied Economics, 25(6), 777.
Hamilton, J.D., (1983). â€œOil and the macroeconomy since World War IIâ€, Journal of Political Economy, 91(2), 228-248.
Hamilton, J.D., (2003). â€œWhat is an oil shock?â€, Journal of Econometrics, 113(2), 363.
Mork, K.A., (1989). â€œOil and the macroeconomy when price goes up and down: an extension of Hamiltonâ€™s resultsâ€, Journal of Political Economy, 97(3), 740.
Soucek, M., Todorova, N., (2013). â€œEconomic significance of oil price changes on Russian and Chinese stock marketsâ€, Applied Financial Economics, 23(7), 561-571.
Tokic, D., (2015). â€œThe 2014 oil bust: Causes and consequencesâ€, Energy Policy, 85, 162-169.
 Turkey has partly benefited from the increase in the purchasing power of energy eexporting countries due to the rising exports to these countries. However, the net impact on current account balance was still negative.
 Hamilton (1983, 2009), Mork (1989), Barsky and Kilian (2004), Defina and Taylor (1993), and Soucek and Todorova (2013) are some examples in the academic literatÃ¼re.