Azerbaijan: Stabilized And Stepping Up

Azerbaijan has turned a corner and is diversifying away from oil dependency.

Although Azerbaijan is by far the wealthiest nation in the Caucasus region, its prosperity springs largely from oil-and-gas export revenues; so the country was hard hit when international prices collapsed in 2015. During the crisis that followed, overall GDP fell to roughly half the 2014 peak. The local currency, the manat, was devalued and some banks were closed.

Yet that exchange-rate management, combined with relatively prudent fiscal policies, contained the crisis. The experience also jolted the government into pushing for a more diversified economy, launching a spate of initiatives to promote non-oil sectors and regional development outside the capital, Baku, where at present, “perhaps 90% of the country’s wealth and business activity is still concentrated,” notes Movlan Pashayev, PwC’s country managing partner in Azerbaijan.

Legacy issues of distressed assets remain. But with the recovery of energy prices over the past year, Azerbaijan seems to have turned the corner. “The economy is currently on a growth path,” says Ivana Duarte, head of the European Bank for Reconstruction and Development (EBRD)’s resident office in Azerbaijan. EBRD economists anticipate GDP growth rising from 2.5% this year to 3.5% in 2019. The consensus viewpoint, according to FocusEconomics, forecasts growth at 2.4% next year—though naturally, much depends on future oil prices.

Duarte says that moves have been made to diversify the economy away from energy, with notable success in growing tourism, agribusiness, manufacturing and services. She notes that the EBRD is supporting small and medium-size enterprises (SMEs) in these sectors and helping to meet strong demand from smaller businesses for local-currency loans.

Indeed, during the six months to July, Azerbaijan’s non-oil sectors grew much faster than the economy as a whole. Nihad Ahmed, an economist at FocusEconomics, says that “investments by the state oil fund SOFAZ, and more capital lured in from foreign investors, have helped propel non-oil GDP growth this year.” The sovereign wealth fund is investing outside the sector by which it is funded, to ensure the nation’s future after hydrocarbons are depleted.

Transportation infrastructure ranks high among the strategic priorities. Authorities want to build a North-South corridor connecting Russia, Azerbaijan and Iran, thus opening up an overland freight route between Europe and South Asia. A new port, railways and roads are being built to fulfil President Ilham Aliyev’s aim to create a regional transport and logistics hub.

“The best results so far have been the opening of Baku Port, some 30 miles southwest of the capital,” Pashayev comments. “This new port serves as a hub for Eurasian-Silk Road commerce and looks like it will utilize the full potential of its status as a free economic zone.” He further points out that investments in Baku airport will make it a hub for cargo shipment.

One priority for non-oil investment is power infrastructure, for both generation and distribution—including an upgrade of the electricity grid to ensure that recent blackouts are not repeated. There has also been a push to upgrade telecom capabilities, though Pashayev believes there is potential to further open the market for private investments. Agriculture is more liberalized, open to both local and foreign investors. “Together with the new transport infrastructure,” he says, “this helps spread economic activity away from the capital.”

But the key area where many see a need for further reforms and liberalization is the financial sector. Gubad Ibadoghlu, senior analyst at Azerbaijan’s Economic Research Center, points to the dominance of a few local banks with close ties to the country’s political elite, weak models of corporate management, and the absence of basic infrastructure such as bank branches or ATMs in rural areas. These factors form an ecosystem that is rife with inefficiencies and leaves many citizens unbanked.

“Opening up the financial sector to foreign investment—especially the insurance market, where only joint ventures with local companies are permitted—should be part of a broader process of deregulation,” Ibadoghlu says. “New players would provide access, for both SMEs and households, to alternative financial instruments such as guarantees, leasing and factoring.”

Alternative sources of corporate funding, currently dominated by a few banks, would also help boost the broader economy. But these are still early days. “We are commencing to work with the local stock exchange, with the intention to assist the development of capital markets,” says Duarte.

There is also the question of what to do with the distressed assets left in the wake of the recent crisis, most of which have already been offloaded to a “bad” bank, according to Pashayev. “Now there needs to be greater clarity on what happens next and the valuation of those assets,” he adds. “More transparency and efficiencies would make them more appealing to foreign investors.”

Despite the desire to diversify the economy and attract more investors into non-oil sectors, most of the $15 billion of foreign investment that the government anticipates receiving this year will go into oil-and-gas-related businesses. “Dollarization of the economy remains high,” Ibadoghlu explains. “Oil prices will continue to play a dominant role in shaping inflation expectations, the exchange rate and money supply.”

The recently signed treaty settling the international status of the Caspian Sea should facilitate construction of new pipelines, thereby enhancing Azerbaijan’s role as a transit country linking European markets to Central Asia’s huge reserves of oil and gas. The proposed Trans-Caspian Pipeline would transport natural gas from Turkmenistan, linking up with the Southern Gas Corridor to carry it onward to Europe. Other joint projects with Kazakhstan include an undersea oil transportation pipeline from Aktau to Baku.

More immediately, however, Azerbaijan is facing a gas-supply crunch because domestic demand is growing faster than new supply; and it could use additional supply from Turkmenistan. This demand could be met, says Kate Mallinson, managing director at political-risk consultancy Prism, by building a smaller pipeline from Turkmen blocs in the Caspian direct to Azerbaijan.

Oil prices aside, the indirect impacts on Azerbaijan of US-sanctions-induced economic woes in neighboring Iran and Turkey could blow the recovery off course.

According to EBRD economists, any such negative spillover should be manageable for the economy of Azerbaijan because “conservative macroeconomic policies in recent years have allowed it to maintain sizable foreign exchange liquidity buffers and to put the economy on a more sustainable footing.” Regional turbulence on Azerbaijan’s oil revenues should be limited, they believe, absent a major change in price.

PwC’s Pashayev adds, “Azerbaijan has a much tighter fiscal policy [than Turkey or Iran]; and with some controls on the exchange rate, the currency remains stable.” He points out that “Indeed, this stability has led to an influx of money from neighboring countries, so that the local property market has become somewhat heated.”

Optimism remains high in Baku, as demonstrated by its bid to host Expo 2025. It is one of just three cities seeking to host this world’s fair. The others are Yekaterinburg, Russia; and Osaka, Japan. The successful city, to be announced in November, will be in the spotlight. Azerbaijanis would surely gain from the boost to the tourist industry. Are they ready for this close-up?