Boosting Economic Growth in Azerbaijan Through Economic Diversification

Introduction

Upon gaining independence from the Soviet Union in 1991, the Republic of Azerbaijan inherited a destitute economy and crippled infrastructure. The economies of the Republic were interconnected and once the states became independent, their economies suffered from a recession. Azerbaijan experienced the worst side effects of the recession along with other European transition countries[1]. According to the World Bank statistics, in five years, real income per capita evaporated over 60% falling from 8,500 USD in 1990 to 3320 USD in 1995[2]. In comparison, Kazakhstan’s fall in real per capita GDP was around 35% and 41% in Russia. To make matters worse, Azerbaijan was in war with Armenia over claims to the Nagorno-Karabakh region. Armenia occupied almost one-fifth of the total area of country thus infringing Azerbaijan’s territorial integrity. Breakdown of the economic and political system coupled with the war with Armenia threatened the country’s newly gained independence. When Heydar Aliyev came to power in 1993, his primary goal was to reconcile the nation and lay a foundation of prosperity in order to ensure the nation would have a future.

After achieving national solidarity and ceasefire at the battle-ground, Aliyev was able to focus on economic problems. Azerbaijan undertook a wide-range of economic reforms in order to restructure the centrally planned economy into a competitive free market economy. These reforms included trade liberalization, privatization, de-monopolisation, and establishment of fully functioning market establishments. At the time, major industrial plants had almost stopped production because either the lack in capital stock or from the breakdown of economic ties with other former Soviet Republics.  The  country lacked financial resources to develop the national economy and had a difficult time creating a favourable environment for foreign investment. Since Azerbaijan was endowed with rich hydrocarbon resources, oil (and gas) policies played a crucial role in the economic development of the country. The country’s economic policies were based on oil strategies laid out by H. Aliyev. This strategy also constituted the basis for Azerbaijan’s future economic policies. Azerbaijan attracted huge multinational oil companies in the development of hydrocarbon resources, which contributed to the country’s economic recovery.

In a short period of time, Azerbaijan succeeded in the stabilizing the economy. While inflation rate jumped to 1662% in 1994, it was reduced to 20% in 1996. In the same year, economic growth rate was positive for the first time since 1988 and Azerbaijan entered to a new phase of economic recovery. Thanks to effective oil strategy, real per capita income in 2006 exceeded the level it was in 1990. By the end of 2014, real per capita income in Azerbaijan rose to above 16700 USD. This is almost a fivefold increase from its lowest value during the transition period. In comparison, real per head income increase was only around twofold in Russia and threefold in Kazakhstan from their respective lowest values.

While Azerbaijan achieved macroeconomic stability and economic growth during the 2000s, the country now needs to diversify its national economy and develop the non-oil sector in order to attain sustainable growth in the future. This will allow them to catch-up with developed countries in terms of real per-capita income within next 15-20 years, the country must sustain on average a %9-10 growth rate per annum during the next two decades[3]. Such an economic feat requires major reforms in the country as well as the adoption of sound industrialization policies. We believe that the successful and considered oil strategy laid out by Heydar Aliyev can serve as the basis of a successful industrial policy, and if adopted to promote non-oil industrial sectors, it can boost the national economy and ensure sustainable economic growth.

In this note, we will briefly discuss economic policies to diversify the national economy and obtain sustainable growth. After providing a brief overview of economic developments during the transition period, we will then consider macroeconomic policies, i.e., monetary and fiscal policies to enhance economic growth. Next, we will address industrial policies to promote and develop the non-oil sector. Finally, we will discuss other issues , such as education, training, science, and the judiciary system, which will enhance sustainable growth.

Brief Overview of Economic Developments in Azerbaijan

Figure 1 below presents graph of real PPP per capita GDP in Azerbaijan. The early years of their independence was marked by a drastic economic collapse. The average decline of real income was 23% per year and the inflation rate was above 1000% during the first three years of independence. Therefore, economic policies aimed to reverse the economic recession and fight hyperinflation. Azerbaijan launched an IMF-backed stabilisation program in the beginning of 1995 [4]. The programs objectives were to stabilize prices quickly, creating an environment of low inflation conducive to a resumption of economic growth, and initiate a comprehensive structural reform. Under this program the government was extremely successful in achieving macroeconomic stability through the reduction of fiscal deficits and implementation of a tight monetary and credit policy. Inflation rate was reduced to 20% by the end of 1996 from 1662% in 1994. Economic growth turned to positive in 1996 as well for the first time during the transition period.

Azerbaijan continued to implement sound fiscal and monetary policies after the end of the IMF-backed stabilization policy in 1996. Combined with single-digit inflation rate or even deflation average, growth rate was 9.5% through 1997 to 2004 [5]. Beginning in 2005, Azerbaijan entered into a new phase of economic growth with the oil sector playing a critical role. An oil boom created an economic boom in the country. The economy grew on average 28.6% per year from 2005 to 2007. Although economic growth slowed after oil boom after 2007, average growth rate remained at 5% per annum during this period.

graph1

Figure 2 below depicts the stance of monetary and fiscal policies in Azerbaijan during the transition period. While Azerbaijan implemented tight macroeconomic policies during from 1995 to 2005, expansionary policies were needed in order to deal with the economic problems that had accumulated.  Economic growth brought about fiscal expansion. Azerbaijan had inherited a collapsed economy and dilapidated infrastructure. Furthermore, as a result of the Armenian occupation of Nagorno-Karabakh and seven surrounding regions, about one million people were displaced from their native lands and Azerbaijan was left with a severe humanitarian crisis. Significant portions of the initial oil revenues were used to provide internally displaced persons with living standards worthy of human dignity. In addition, the country had to modernise infrastructure that had been neglected for the last two decades beginning in the mid-1980s. Building adequate infrastructure required huge investments. As a result, public expenditures rose significantly starting from 2005.

Azerbaijan has implemented tight monetary policies until the mid-2000s. After reducing inflation rate to 3.7% in 1997, the country experienced deflation for the next two years. Inflation was kept at one-digit levels until 2007. The national currency was allowed to depreciate until 2004. In 2005, huge oil revenues and fiscal expansion caused the national currency to depreciate significantly. The national currency, Manat, appreciated an average of 4% from 2005 to 2009. Despite appreciation of the national currency, inflation rate rose to 16.7% in 2007 and then to 20.8% in 2008 as a consequence of increasing public expenditures. Central bank switched to an explicit exchange rate , which targeted policies to keep inflation under control. The nominal exchange rate was kept relatively stable until the recent depreciation in February 2015. Monetary policy during this period was accommodative, rather proactive.

Stance of monetary and fiscal policies

Figure 3 below presents GDP in the oil and non-oil sectors since 1995. The oil boom and large investments into public infrastructure have significantly altered the structure of the national economy. While the oil sector (mining and extraction industry) accounted for around 10.2% of GDP in 1995, the share of this sector jumped to 53.7% in 2007. However, the non-oil sector began to increase rapidly in 2006, and enjoyed two-digit growth rates for the following years. As a result, shares of oil GDP fell to 34.6% by the end of 2014.

Composition of GDP, constant national currency

Growth in the non-oil sector was mainly investment-driven rather than productivity-driven[6]. Huge infrastructure investments and accumulative public expenditures have led to a so-called “spending-effect”, i.e. increase in demand for production in the non-tradable (construction and services) sector at the expense of tradable (manufacturing industry, agriculture, forestry and fishing) sector [7]. Expansions in the oil and non-tradable sectors have caused productive resources to migrate to these sectors. As a result, the non-tradable goods sector grew more rapidly than the tradable goods sector. In fact, annual compounded growth rates of the service sector and construction sector were 9.2% and 16.5% per annum, respectively, during the last two decades. On the other hand, production of tradable goods grew at around 2.8% per year during the period from 1995 to 2015 [8]. Consequently, the share of manufacturing industry in GDP fell to 4.8% in 2014 from 11.5% in 1995. The share of construction and trade sectors were 12.5% and 7.9%, respectively, in 2014.

graph4

Table 1 below provides relative shares of selected sectors in GDP for the selected years. The table reveals that the oil sector gradually lost its importance in the national economy after culmination in 2007. Increase in non-oil GDP was mainly driven by the growth of non-tradable sectors, like construction and services, whereas the tradable sector lost its relative importance in the GDP. Although the tradable sector also grew significantly during 2000s, growth in the non-tradable sector surpassed the tradable sector. In fact, the agriculture sector and manufacturing industry enjoyed two-digit growth rates through most of this period.

table1

The appreciation of the national currency could have played an important role in suppression of the tradable sector. Rapid increases in the price of non-tradable goods caused the national currency to appreciate in the face of falling nominal exchange rates. In fact, real effective exchange rate index for the non-oil sector was 73.8 in 2004, before the oil boom. By the beginning of 2015, effective exchange rate appreciated by almost 98%, in real terms rising to 146.3. Even after devaluation of the national currency in February 2015, real exchange rate for the non-oil sector fell to 111.3 by June 2015. This suggests that the national currency is more than 50% appreciated in comparison to 2004.

Appreciation of the national currency was also reflected in the foreign trade activities of the country. Growing incomes during the period of the economic boom stimulated domestic demand. However, domestic production could not increase enough to meet the growing demand, which resulted in a drastic increase in imports. The trade deficit in the non-oil goods was around USD 357 million in 2001and rose to USD 6.26 billion by 2014 [9].

A brief analysis of the economic developments in Azerbaijan during their transition period suggests that the economic policies have been quite successful in achieving macroeconomic stability and economic growth thus far. The non-oil sector also enjoyed high growth during this period, as a result of which the share of oil sector was reduced to 34.6% by the end of 2014. However, the tradable sector lagged behind the non-tradable sector, which reiterates how important diversification is to the stabilization of the national economy. Henceforth, the government needs to promote the tradable sector to order to attain sustainable growth in the future. Below we will discuss the necessary policies needed to achieve sustainable growth in Azerbaijan.

 

Macroeconomic policies to promote economic growth

In this section we will discuss appropriate macroeconomic policies for enhancing economic growth in Azerbaijan. We will focus on how monetary and fiscal policies should be conducted to promote economic growth.

Framework for Monetary Policy

The Central Bank of Republic of Azerbaijan (CBAR) has been implementing intermediate targeting policies, i.e., either monetary targeting or exchange rate targeting. Under the monetary targeting system, the central bank moved its instruments to control monetary aggregates. The CBAR implemented this targeting policy under the IMF-backed stabilisation program, which launched in 1995. Under the exchange rate targeting regime, on the other hand, the central bank targets nominal exchange rates via direct interventions and/or interest rate changes. Central banks may either peg the nominal exchange rate or allow depreciation and/or appreciation of the national currency at desired levels, the CBAR followed this rule during 2000s.

Intermediate targeting regimes have been challenged in economic theory [10]. The ability of intermediate targeting policies to function effectively is dependent on the empirical relationship of the targeted intermediate variables to the goal variables, such as inflation and economic stability. Relatively high dollarization of the national economy as well as lack of strong and direct causal effects from monetary aggregates to final targets, such as economic growth and inflation rate, render monetary targeting inefficient targeting rule for the monetary policy. This is true in Azerbaijan’s case where economic growth in the non-oil sector has been mainly driven by investment expenditures, especially government infrastructure investments. Furthermore, it has been found that the money supply has had a limited effect on the inflation rate in Azerbaijan [11]. Exchange rate targeting regimes also have severe drawbacks as they leave little room, if any, for central banks to respond to domestic and external shocks. The exchange rate targeting regime in Azerbaijan caused the significant real appreciation of the national currency and loss of competitiveness of the tradable non-oil sector. Therefore, given the need to promote the tradable sector and diversify the national economy, an exchange rate targeting regime is not an adequate policy regime for Azerbaijan.

It could be argued that depreciation of national currency may promote exports and penalize imports, hence lead to development of the industrial sector [12]. However, international trade responds to real, not  nominal, exchange rates [13]. Although central banks can effectively target nominal exchange rates under certain circumstances, they lose the ability to control the inflation rate under exchange rate targeting policies. As domestic price level is as important as nominal exchange rate in determination of real exchange rates, the central bank’s ability to promote exports via continual depreciation of national currency is limited. Depreciation of nominal exchange rates may lead to a higher inflation rate, which in turn renders the nominal exchange rate as an inefficient tool for promoting exports. Furthermore, higher inflation rates are detrimental to low-income households. The social costs of promoting exports via depreciation are high, making them politically undesirable.

Perhaps, the most adequate monetary regime for Azerbaijan is inflation targeting regime. In fact, many developed and developing countries have adopted explicit inflation targeting as a strategy for conducting monetary policy [14]. Under this regime, central banks use policy tools to bring expectations of inflation to economic agents closer to the declared inflation target. While inflation targets are usually determined together with the governments, central banks have instrument independence, which allow them to set their own instruments. This regime provides central banks with the flexibility to respond to unexpected domestic and international shocks.

Although inflation targeting is a monetary policy regime under which central banks are responsible for achieving inflation targets, almost all of the central banks that adopted this strategy implement “nominal income targeting” policies in actual practice [15]. Under this regime, central banks target both the economic growth and inflation rate. Especially in periods of economic recession, central banks place a greater emphasis on the stability of economic growth rather than the inflation rate. Inflation targeting also eliminates macroeconomic uncertainties, which are detrimental both for inflation and economic growth [16]. Therefore, by creating a stable and predictable economic environment, inflation targeting indirectly promotes investment and hence, economic growth.

The above arguments and Azerbaijan’s experience using exchange rate targeting policies suggest that inflation targeting is the most appropriate monetary policy strategy for Azerbaijan. Hence, the CBAR should abandon exchange rate targeting, adopt implicit inflation targeting policy and switch to an explicit inflation-targeting regime as soon as the market conditions are established [17].

Framework for Fiscal Policy

As we briefly mentioned before, Azerbaijan inherited a collapsed economy and dilapidated infrastructure from the Soviet Union. In addition, the Armenian occupation of Nagorno-Karabakh and seven surrounding regions, almost one million people were displaced from their native lands creating a humanitarian crisis for Azerbaijan. Investments in social and productive infrastructure almost slowed to a halt because of the economic recession and lack of financial sources. Consequently, households and industries suffered from an inadequate supply of public services and utilities.

These situations have caused Azerbaijan invest extensively into infrastructure since mid-2000s. Rapid increase in transfers from the State Oil Fund (SOFAZ), starting in 2008, enabled the government to increase public infrastructure investments drastically. Transfers from SOFAZ constituted for 9.7% of total budget revenues in 2007. The share of transfers from the fund in total budget revenues rose to 35.3% in the next year and further to 47.6% in 2009. The share of transfers peaked in 2013, reaching 58.2% in 2013 [18]. The transfers from the fund allowed the government to increase their expenditures. While government expenditures constituted for less than 20% of GDP before 2005, the share of public expenditures increased considerably in 2006 and reached 32.9% of GDP by 2013 [19].

Infrastructure investments held the lion’s share in total government expenditures. These urgent investments were necessary to build adequate infrastructure for secure and reliable provision of public goods and services. Hence, the non-tradable sector attracted most of the public investments [20].

Azerbaijan needs to reconsider its fiscal policy in order to promote the development of the tradable non-oil sector. Since Azerbaijan has already succeeded in building an adequate infrastructure for normal functioning economy, transfers from the SOFAZ can now be curtailed significantly. The government must adopt some “fiscal policy rules” through imposing tight rules to both transfers from SOFAZ and public expenditures. For example, the government may gradually reduce transfers from the SOFAZ to under 10% of total budget revenues [21]. Prior to 2008, the shares of transfers from the oil fund were at one-digit levels , 2006 being the only exception. The government may also limit transfers from the fund for a given year to half of total revenues of the SOFAZ in that year. Such a limitation of transfers from the SOFAZ will help to prevent the fall of accumulated oil wealth, which is of vital importance for Azerbaijan. This will also reduce dependence of the budget, and hence public expenditures on the oil sector. As public expenditures are a significant part of the total expenditures in any economy, including Azerbaijan’s, government expenditures makes up to one third of the GDP, any reductions will help prevent vulnerabilities in the national economy after global oil shocks.

Government expenditures must also be significantly reduced. Limiting transfers from the SOFAZ will inevitably reduce total revenues and hence, the expenditures of the government. These necessary cuts to public investment expenditures, current expenditure and defence expenses cannot be readily created. Subsidies to public goods and services as well as to public enterprises need to be lifted. Investments in the non-oil tradable sector as well as investments that have significant positive effect on the total productivity must be given top priority. Azerbaijan may adopt practices similar to Norway’s, which will develop the strong framework for fostering successful public investment outcomes [22]. In particular, the government must carefully analyse socio-economic costs and benefits to public investment projects, paying special attention to the assessment of relevance and effects of investments on increasing productivity and competitiveness in the tradable non-oil sector. Perhaps, all investment projects that have limited the direct effects on the development of the tradable sector should be postponed or cancelled.

Budget will probably run into deficits after limiting transfers from the SOFAZ. Therefore, instead of increasing other revenues and rising tariffs or tax rates, the government must adopt debt financing of the budget deficit. In any case, budget deficits must be limited and not exceed 2-3% of the GDP. The government may consider issuing debt instruments, such as bonds and treasury bills, in domestic financial markets. Priority must be given to government bonds, like long-term financing instruments. Issuance of public debt instruments will also contribute to development of the domestic financial markets, and hence, foster private savings.

Industrial Policies to Promote the Non-oil Sector

Both the monetary and fiscal policies in modern economies aim to establish a favourable macroeconomic environment for economic agents, i.e., for businesses and households. Long-run economic growth requires investments in capital stock, both human and physical. Though, macroeconomic policies have only a limited, if any, effect on business investments. Monetary and fiscal policy authorities may reduce real and nominal uncertainties by achieving macroeconomic stability. This naturally reduces the costs of doing business. However, macroeconomic uncertainties are not the only hindrance to business investments. Therefore, governments must take other measures to reduce the actual costs of investment and stimulate business investments in order to achieve desired growth rates.

Business investment’s desire to obtain economic profit, simply defined, as the sales revenues above costs. Although, certain circumstances, policy authorities have almost no power to affect sales revenues. Naturally, governments may guarantee the purchase of goods at an agreed price and/or quantity. However, price setting and/or public procurement have distortionary effects for many commodities. In addition, it is nearly impossible to guarantee public procurement of all goods in liberal economies. Therefore, governments in developed economies are restrained from guaranteeing public procurements. Instead, industrialized countries provide significant incentives to industries. For example, Japan, Korea, China, Germany, the Czech Republic and many other European countries provide attractive investment incentives through special forms of regulatory measures, tax reduction, subsidies, and cash grants [23]. Such policies have been successful in attracting investments through reducing set-up and operation costs significantly. Azerbaijan must also consider such incentives for business investments in the development of the non-oil tradable sector. In essence, Azerbaijan must provide more attractive incentives than other countries.

Another related issue for attracting investments is the prevailing business environment. Generally, the agreed legal and regulatory framework determines a business investment [24]. Regulatory frameworks determine how easily a business’ activities can be conducted, making them  important than economic factors in the creation of business investments. Time and efforts required to fulfil regulatory requirements for conducting business activities have greater effects on business decisions. These “invisible” factors hold more weight in investment decisions than “visible” economic factors, like interest rates, taxes, tariffs, inflation and growth rates, as well as macroeconomic policies [25]. In fact, it has been documented that the cost of invisible factors are greater than the cost of observable determinants of business activity [26]. Hence, creating a favourable business environment may be the most important precondition for promoting investments.

Through the application of these policies, Azerbaijan has attracted enormous foreign direct investments (FDI) in the development of hydrocarbon resources. Therefore, the adoption of the oil strategy laid down by the Azerbaijan’s then president, Heydar Aliyev, for development of the non-oil tradable sector will yield a desirable level of economic diversification. Azerbaijan has created favourable conditions for international oil companies (IOC) in order to develop the country’s hydrocarbon resources. Product sharing agreements (PSA) have been widely used as contractual arrangements for development of hydrocarbon resources in Azerbaijan [27]. PSAs provide a sustainable and attractive legal framework that attracted enormous FDI inflows to the oil sector of the country. Establishing such a legal framework for investments in the non-oil industries is key to development of the non-oil tradable sector in Azerbaijan [28].

Azerbaijan has implemented massive reforms to create a favourable business environment. In fact, the World Bank recognized Azerbaijan as the “number one reformer” in 2009 for their reforms in 2007/2008. Azerbaijan has since maintained its status as one of the top country reformers in the world. Unfortunately, the Soviet’s legacy is holding the country back from achieving its full potential. Therefore, while continuing to perform structural reforms in the administrative and judicial system, Azerbaijan needs to adopt a special industrial development policy to attract investments and promote non-oil tradable sector.

The simplest way to accomplish this is through the establishment of free economic and/or industrial zones (FEZ or FIZ) and to provide a PSA-type legal and regulatory framework for business investments in these zones. The FEZ law adopted by Azerbaijan provides a “special legal regime” that would govern the activities of FEZ. This law has been drafted within framework of existing institutional arrangements but does not provide the same level of flexibility offered by a PSA regime [29]. The government must consider establishing free industrial zones to promote the development of the non-oil tradable sector. In order to make FIZ attractive for both domestic and international investors, the government must provide the same legal and regulatory framework , which they provide to the oil sector. Azerbaijan can not attract huge investments in the oil sector without this legal framework. A “special legal regime” must cover all aspects of regulatory framework, including, but not limited to paperwork, tax procedures, import-export procedures, settlement of disputes and applicable law. The government must also support the formation and development of industrial clusters and agglomerates in the FIZs. Formation of such clusters and agglomerations will enhance the competitiveness of industries by effectively reducing costs and increasing productivity.

Azerbaijan has to provide worthwhile incentives for investments in the non-oil tradable sector, especially for large-scale capital and knowledge intensive investments. As mentioned before, most of the industrialized countries offer attractive incentives for business investments. For example, Korea grants up to 50% cash incentives for FDIs, as well as tax credits up to half of total investments for 10 years. Azerbaijan may also provide cash grants for investments in the non-oil tradable sectors at varying rates. High-tech and knowledge-intensive industries need to have top priority in promoting industries. For instance, Azerbaijan may grant 50% cash incentives for both domestic and foreign investments in the high-tech industries. Other industries may be granted 20-30% cash investments, depending on the value-added produced in that industry. Azerbaijan must also offer exemption from profit tax up to 5-10 years and tax credits depending on the amount of investments and sectors. In addition, Azerbaijan must also provide investment credits at subsidized rates or subsidize interest payments for investments.

Cash grants will reduce the effective cost of investment for businesses, thus stimulating investments through increasing expected profits. Government support may be vital for capital-intensive industries because investments bear high risk due to economic uncertainties. Therefore, the government must work to eliminate the associated risks of investments by reducing the actual cost of both the set-up and operation. Cash grants and tax privileges. such as tax credits and holidays, have been proven to be effective tools for reducing the actual costs of business activities. Alternatively, the government may invest in these ventures through a special investment agency or fund. Therefore, the government should consider establishing a special investment fund for investing in strategic industries. However, the share of the government in any business must be limited is such a way that the government cannot interfere with the conduction of business. In addition, the government must set prudential procedures for incentives and investments in strategic industries. In particular, the government must conduct a sound cost-benefit analysis of investment projects, paying special attention to the contribution of the investment to development of the non-oil tradable sector, as well as to overall productivity and competitiveness of the economy.

In addition to special incentives for large-scale investments, Azerbaijan must also support small and medium sized enterprises (SME) and agricultural farms. While large-scale industries will boost national economy, reduce dependence on oil in exports and budget revenues, these industries are generally more capital and less labour intensive. Most industrialized countries give even more attractive incentives for SMEs. In particular, they provide tax holidays, tax credits and exemptions, interest rate free credits, cash grants, as well as subsidies for employment of the youth[30]. Azerbaijan also needs to generate sufficient job places for the young generation. Therefore, Azerbaijan must provide similar cash and tax incentives for all SMEs engaged in the non-oil tradable sector. In addition to fostering employment, promoting SMEs will also help to obtain balance and sustainable economic growth in the country.

Several countries subsidize energy inputs in order to promote domestic production[31], while some countries provide export incentives [32]. However, such promotion policies cannot be successful by themselves. Subsidizing inputs only alter the input decisions of producers rather than reducing their actual costs and increasing their competitiveness. In addition, subsidies on energy inputs cause producers to adopt energy intensive production technologies , which eliminate any motivation to adopt more productive technologies. Similarly, is is proven that imposing higher tariffs on imported goods is insufficient for promoting domestic industries by discouraging the adoption of more efficient production technologies. Export incentives without effective promotion of domestic production leads to import dependence[33]. Therefore, Azerbaijan must avoid subsidizing inputs and instead provide effective support to investments that contribute to productivity gains. In fact, although investments in Azerbaijan have risen significantly since the 2000s but have not brought about any productivity gains [34]. Although Azerbaijan is endowed with rich energy resources, the government should take appropriate measures to achieve energy efficiency within their economy.

Azerbaijan must also refrain from supporting domestic industries using only the tariffs policy in foreign trade. While such policies may contribute to the development of the non-oil sector in the short run, protecting domestic production via higher tariffs on imports may turn out to be more costly in the long run. Azerbaijan must adopt selective tariffs policy for international trade that will effectively protect domestic production. This requires imposing lower import tariffs on raw materials but higher tariffs on intermediate and finished goods. However, tariffs policy must be considered only as complementary, but not a primary, policy tool to promote domestic production. Subsidizing productivity increasing technologies is likely to be the most efficient tool in improving competitiveness against domestic producers [35].

Other Related Issues in Achieving Economic Diversification and Sustainable Economic Growth

Azerbaijan needs to establish a favourable business environment in order to achieve a sustainable economic growth. This entails establishing well-functioning market institutions, as well as ensuring availability of resources, both physical and human, needed in the production process.

Azerbaijan has been conducting massive market reforms since the mid-2000s. As previously stated, Azerbaijan was recognized by the World Bank in 2009 as the number-one reformer in the world. Azerbaijan has remained as a top-ten reformer in the world rankings. Recently, Azerbaijan introduced ground-breaking services such as “ASAN xidmət” or “Vahid pəncərə” that have significantly reduced paperwork for citizens and entrepreneurs. Such reforms must be continued in the future so that all paperwork and bureaucratic procedures reduce the burden on citizens and businesses.

Out of 144 countries, Azerbaijan was ranked 38th by The World Economic Forum for Global Competitiveness Index in 2014 and 2015 . Azerbaijan has been successful in mitigating the burdens of administrative business procedures across several sectors. For example, Azerbaijan is amongst top countries in areas like business start-ups, lack of burdens within government regulation, strength in investor protection, strong macroeconomic environment, fair hiring and firing practices, and the capacity to attract new talent. However, the country lags behind others in areas such as strength in auditing and reporting standards, an efficient judicial system, usefulness of anti-monopoly policies, the sound structure of banks, intensity of local competition, and the burden of customs procedures. The actual reforms during the last decade suggest the government is determined to reform the system and establish well-functioning institutions. Therefore, the government must give priority to reforms that would lessen burden on business activities so as to create a favourable environment development of the non-oil tradable sector. For example, the government may consider creating a system similar to “Vahid pəncərə” for customs procedures. The government must also reform tax systems to international standards. In particular, adopting international financial and reporting standards and increasing efficiency of tax-collection procedures would further improve business activities. In addition, the government must reform the judiciary system, with special focus on business related issues such as enforcing contracts, resolving insolvency, and settling of all-type of business disputes.

The government must also create a fair and competitive environment for business activities. Anti-monopoly and competition policies must be adopted and further reforms must be implemented to protect competition in the financial and goods markets. The government recently declared the privatization of the International Bank of Azerbaijan. This shift will help increase competition in financial markets, thus increasing entrepreneurs’ access to cheap financial resources. The government must also take additional measures to ensure financial soundness and competitiveness through the adoption of international standards, such as the Basel criteria. These measures would ensure both financial soundness, as well as market liquidity. The government may also consider offering special incentives for development of financial markets to improve businesses’ access to financial resources. For example, tax exemption for interest-bearing instruments and earnings from operations with equities may be considered. In addition, the government must adopt a strategy for development of the stock exchange.

In regards to ensuring fair competition in the goods and services markets, the government must adopt and implement an effective anti-monopoly policy. Current anti-monopoly legislation must be improved and an independent anti-monopoly agency needs to be established. This agency must monitor all activities of both public and private enterprises and take the proper measures to prevent any action of enterprises which prevent fair competition in the markets. Furthermore, the government must undertake all reforms aimed at ensuring fair competition, as well as promoting new entrances into markets. Specifically, vertically integrated public enterprises must be unbundled. For example, airports, ground services, air traffic management and related activities must be separated from air transport activities, thus enabling fair competition in these markets. Similarly, power generation, transmission, distribution and trade must be separated and entrance of new power generation and trade firms must be promoted.

Reforming the economic and administrative system cannot be done overnight. Establishing a business-friendly administrative and judiciary system takes time . Therefore, the government may consider establishing a business-promotion agency that will help both domestic entrepreneurs and foreign investors in dealing with bureaucratic issues. Most industrialized countries have a form of business facilitation divisions or agencies. For example, Korea Trade-Investment Promotion agency offers a wide-range assistance for foreign investments, including legal advice, provision of office space, secretarial assistance, assistance in paperwork, in addition to quite attractive investment incentives . A similar business-promotion agency in Azerbaijan may provide technical and legal assistance in all issues related to business activities, both to domestic and foreign entrepreneurs, and protect their rights in relations with governmental bodies. In addition, this agency may conduct special trainings for SMEs and entrepreneurs.

Another challenging issue for Azerbaijan is the availability of a high-quality workforce, particularly specialized in technical areas. Although school enrolment is high, the quality of education, both at secondary and tertiary levels, in Azerbaijan is insufficient in the development of industry . The government of Azerbaijan realizes the importance of education and has been implementing an education program for Azerbaijani youth to study abroad. Each year, hundreds of Azerbaijani students are sent to leading universities all around the world for undergraduate and graduate education. However, industries also require mid-level technical staff as well. Therefore, Azerbaijan must establish vocational schools that would prepare technical industry personnel. The scientific content of goods has risen drastically during the last two decades, and “knowledge-intensive” goods and production technologies gained importance . Hence, Azerbaijan must develop an education and science policy for achieving sustainable future economic growth. This policy must also cover the development of scientific research centres in Azerbaijan, as well as fostering collaboration between industries, universities and other research institutions, thus increasing the research-innovation-development capacity of the country. The government must consider offering quite attractive cash grants for such activities. Many industrialized countries offer up to 50% cash grants for research-innovation-development projects . Azerbaijan must also offer similar grants of equal or greater value to promote such activities.

Conclusions and Policy Recommendations

Azerbaijan has been prosperous in achieving economic growth and macroeconomic stability during the transition period. The period of economic growth within the country was impressive, resulting a five-fold increase in per capita income level just in a few years. The non-oil sector has also grown steadily, thus contributing to overall economic growth. However, Azerbaijan needs to further diversify its economy in order to achieve sustainable economic growth in the future.. For this purpose, the country must undergo massive reforms. Below we summarize our recommendations to this end:

1. The Central Bank must abandon exchange rate targeting policies, let the national currency to float freely, and adopt an inflation-targeting policy regime.
2. The government must adopt a “fiscal policy rule”, reducing transfers to the budget from the state oil fund and limiting non-oil budget deficits, as well as establishing an effective control over budget expenditures. Given the prevailing conditions, Azerbaijan cannot cut current defence and public expenditures. However, government must significantly reduce investments into the non-tradable sector and give priority to the non-oil tradable sector. The government must also implement efficient control over public investments, with special focus on the effects of investments on productivity gains in the non-oil tradable sector.
3. Macroeconomic stabilities, as well enforcing monetary and fiscal policies, are only complementary tools for promoting the development of the non-oil tradable sector. The government must adopt an industrialization policy and implement massive reforms to achieve economic diversification.
4. Azerbaijan must reform administrative, judiciary and education systems in order to establish a business-friendly environment. For example, “ASAN xidmət” and “Vahid pəncərə”-type systems have been successful and should be expanded to cover all areas. However, implementing such reforms and establishing well-functioning institutions takes time. While implementing these reforms and reducing bureaucratic burden on business activities, Azerbaijan must also consider alternative tools for promoting the non-oil tradable sector.
5. Establishing free economic and industrial zones and providing a PSA-type legal and regulatory framework to these special zones could be helpful in promoting investments in the non-oil tradable sectors. Similar legal frameworks have been successful in attracting huge investments into the oil industry.
6. Many industrial and transition countries offer appealing investment incentives. Azerbaijan must offer competitive incentives to attract investments into their non-oil industries. The country must grant cash incentives, tax holidays and credits, free-of-charge allocation of land, interest-free credits and similar incentives for large-scale investments in the non-oil tradable sector.
7. Small- and medium-sized enterprises and farmers must be offered more incentives.
8. The government must restrain from subsidizing inputs and instead subsidize investments in productive and efficiency-increasing investments.
9. Foreign trade tariffs must be adjusted to support domestic production. In particular, tariffs on raw materials should be reduced but increased for intermediate and final products. However, tariff policy must be considered as a supplementary, but not primary policy tool for promoting domestic production.
10. The government must promote scientific research and university-industry collaboration by offering incentives, like large cash grants. In addition, the government must also establish vocational schools in order to educate technical personnel.
11. The government must establish an independent anti-monopoly agency and promote entrance of new firms into markets. Vertically integrated public enterprises must be unbundled and entrance of new firms should be promoted. The government may consider promoting of new entrances into highly monopolistic by offering attractive incentives to new firms.
12. The government may also consider establishing a special business-promotion agency that would provide technical and legal assistance to domestic and foreign entrepreneurs.

Endnotes:

[1] See, for example, Fischer and Sahay (2000), Telatar and Hasanov (2009).

[2] World Development Indicators, 2014. The income level is measured as GDP (Gross Domestic Product) per capita at constant 2011 international dollars using PPP (Purchasing Power Parity) methodology.

[3] Currently real per capita income in Austria, for example, is about 43.905 Dollars. Assuming that growth rate will be 2% per annum on average, real income will rise to 59.091 during the next 15 years. This implies that Azerbaijan must attain %8.79 per capita income growth rate per year so that to catch-up Austria by 2030.

[4] IMF Press Release No 95/24. https://www.imf.org/external/np/sec/pr/1995/pr9524.htm.

[5] World Development Indicators, 2014.

[6] Sabiroglu and Bashirli (2012).

[7] See, for example, Hasanov (2013).

[8] Rate of change was computed as compounded rate of change ( ) during the period from 1995 to 2014 using the formula  where  is the value at the end of the period (2014),  is the value at the beginning

[9] Central Bank of Republic of Azerbaijan.

[10] See, for example, Bernanke and Mishkin (1997), Mishkin and Posen (1997), Obstfeld and Rogoff (1995), Svensson (1997, 1999), inter alia.

[11] See, for example, Telatar and Hasanov (2012).

[12] Aşıkoğlu and Uçtum (1992).

[13] Taylor (2003), Telatar and Hasanov (2009).

[14] See, for example, Mishkin and Posen (1997).

[15] Nominal income targeting was first discussed by Mead (1978). See also Bernanke and Mishkin (1997), Mishkin and Posen (1997) and Svensson (1999).

[16] See for example, Friedman (1977), Fountas et al. (2006), Hasanov and Omay (2011)

[17] For conditions of explicit inflation targeting see for example, Mead (1978), Bernanke and Mishkin (1997) and Mishkin and Posen (1997).

[18] SOFAZ (2014).

[19] State Statistical Committee.

[20] Hasanov (2013).

[21] SOFAZ (2014).

[22] See, for example, Albino-War et al. (2014).

[23] See, for example, Benacek (2010) and Hasanov (2015).

[24] See, for example, AcemoÄŸlu et. al. (2001), Lim (2014), World Bank (2014).

[25] See, for example, Hasanov (2015), Lim (2014), World Bank (2014)

[26] ECORYS (2009), Francois et al. (2013) and Hasanov (2015)

[27] IOCs also entered into joint-ventures with SOCAR. However, PSAs have been widely used for major oilfield development and exploitation contracts.  See also discussions in Ciarreta and Nasirov (2012).

[28] Ziyadov (2012) has also offered a PSA-type framework for development of the non-oil sector in Azerbaijan.

[29] Ziyadov (2012).

[30] Hasanov (2015).

[31] For example, most of the Central European countries provide electricity and gas at fees below actual costs. See, for example, Hasanov (2014).

[32] For example, Turkey has been implementing various export promoting policies since 1980s. See, for example, Müslümov et al. (2003).

[33] This is exactly the case Turkey has been experiencing during the last three decades. See, for example, Hasanov (2015).[34] Sabiroglu and Bashirli (2012).[35] In fact, most industrialized countries subsidize high-tech investments rather protecting them simply with trade tariffs. See, for example, Hasanov (2015).[36] See, for example, Schwab and Sala-i-Martín (2014). See also The World Bank (2014).

[37] See, for example, Fischer and Sahay (2000) for a more detailed discussion about this issue.

[38] KOTRA, 2013.

[39] “Global Competitiveness Index 2014-2015”, Schwab and Sala-i-Martín (2014).

[40] Deloitte, (2010) and World Economic Forum, (2013).

[41] See, for example, Hasanov (2015) and references therein.

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