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C O N F I D E N T I A L SECTION 01 OF 05 BAKU 000407 
 
SIPDIS 
 
SIPDIS 
 
E.O. 12958: DECL: 03/16/2016 
TAGS: ECON EFIN EAID ETRD PREL PGOV AJ
SUBJECT: MANAGING AZERBAIJAN,S LOOMING ECONOMIC STORM 
 
 
Classified By: Ambassador Reno L. Harnish III per 1.4 (b,d). 
 
¶1. (C) SUMMARY: Azerbaijan faces a massive economic challenge 
over the near-term.  With oil revenue projected to reach USD 
42 billion by 2010, Azerbaijan has the opportunity to 
transform from a cash-poor developing nation into an 
economically confident regional leader.  While the GOAJ in 
theory has the right tools in place to make this transition, 
we see troubling signs that the GOAJ is moving in the wrong 
direction.  Quick GOAJ action is needed in its economic 
decision-making structure, anti-inflationary measures and 
banking reform.  Over the medium-term, the GOAJ also must 
take action on the business climate, anticorruption measures 
and increasing citizen oversight of GOAJ activities. 
Continued, high-level engagement by the U.S. and the 
international community will be key to convincing the GOAJ to 
take these hard steps.  END SUMMARY 
 
EXPANDING ECONOMY PRESENTS DIFFICULT CHALLENGES 
--------------------------------------------- -- 
 
¶2. (C) Azerbaijan,s rapidly expanding economy poses a 
massive challenge tQhe GOAJ.  With oil revenue projectQto 
reach USD 42 billion by 2010, Azerbaijan must apply a 
balanced approach to fiscal and budgetary policy that 
maintains macroeconomic stability while allowing sustainable 
capital investment and infrastructure development.  While the 
GOAJ in theory has many of the right tools in place to manage 
this transition -- including an internationally audited State 
Oil Fund and an economic reform program -- we see increasing, 
troubling signs that the GOAJ is moving in the wrong 
direction.  With a whopping 70 percent increase in the state 
budgQor 2006, there is a real danger that the combination 
of weak monetary tools and sharply increased public 
expenditures as petro-dollars flood into a weak economic 
environment could lead to higher inflation and the potential 
for economic and political instability. 
 
¶3. (C) The GOAJ has yet to show sufficient respect for the 
economic and financial perils that can come with an economy 
reliant on oil, i.e. Dutch Disease.  The onset of Dutch 
Disease would only worsen Azerbaijan,s already large poverty 
problem, with 40 percent of the population currently under 
the poverty line.  While the international community 
continues to be engaged on economic issues, our ability to 
maintain pressure on the GOAJ to continue reforms, control 
inflation, and diversify the economy will decrease as GOAJ 
revenues increase.  The GOAJ already has not hesitated to 
break off negotiations with IFIs if the lending conditions 
prove too stringent or the conditions of the financing do not 
meet the government,s satisfaction.  IFIs are also worried 
that anti-reform elements appear to be gaining the upper hand 
within GOAJ economic decision-making circles. 
 
¶4. (C) Azerbaijan,s economic policy drift over the last 
decade could be remedied by GOAJ action in its economic 
decision-making structure, renewed attention to 
anti-inflationary measures and banking reform.  Over the 
medium-term, the GOAJ also must take action on the business 
climate, anticorruption measures, trade and increasing 
citizen activism and oversight of GOAJ activities.  All of 
these measures are necessary to prevent the onset of Dutch 
Disease. 
 
¶5. (C) The U.S. is deeply engaged in promoting economic and 
legal reform through our assistance programs and, on a policy 
level, through regular dialogue via the Revenue Management 
Group and the Joint Economic Task Force.  Given the urgency 
of economic reform and its key role in preserving stability 
in Azerbaijan, sustained, higher-level dialogue on these 
issues over the coming year will be critical to protecting 
our interests in this strategically important, energy-rich 
Muslim country in the heart of the Greater Middle East.  The 
U.S. and U.K. ambassadors lead the locally-formed Revenue 
Management Group (RMG), a high-level group of international 
donors that carries significant political and economic clout 
within the GOAJ.  A key priority of the RMG is to increase 
GOAJ awareness of revenue management and economic reform. 
Members of the RMG work to coordinate directly the various 
economic reform and assistance efforts of USAID and the IFIs 
as well as provide strategic guidance to high-level GOAJ 
officials on economic and fiscal policy items.  In 
coordination with the RMG, the U.S.-Azerbaijan Joint Economic 
 
BAKU 00000407  002 OF 005 
 
 
Task Force provides a valuable mechanism for U.S. and 
Azerbaijan economic decision makers to discuss bilateral 
economic priorities and goals.  The November 2005 meeting, 
which included the Minister of Finance, Minister of Economic 
Development and the Chairman of the National Bank, brought 
together the key GOAJ officials that directly affect economic 
policy decisions.  Continuing the active participation of 
senior U.S. and GOAJ is critical to encourage the GOAJ to 
follow a more reformist path. 
 
COORDINATION OF U.S. ASSISTANCE GOALS 
------------------------------------- 
 
¶6. (C) Using the U.S. Azerbaijan assistance strategy 
statement as a road-map, the U.S., in conjunction with the 
international donor community, will continue its efforts to 
lead the GOAJ towards reform and sustainable development. 
U.S. assistance objectives in Azerbaijan will focus on 
growing and developing competitive private enterprises, 
supporting a more representative, participatory and better 
functioning democracy and expanding the use of quality health 
care services and practices.  The U.S. leads all 
international donors in Azerbaijan striving to transform 
Azerbaijan's economic growth and potential into economic 
prosperity for all its citizens.  U.S. assistance targets 
improving the efficiency and accountability of public 
expenditures, improving access to credit and improving the 
business environment as well as working with the most 
vulnerable segment of the population.  Working to combat 
corruption, improve fiscal policy, develop the financial 
sector and business environment as well as working with 
grass-roots non-governmental organizations provides one of 
the most effective manners to reach underdeveloped 
Azerbaijanis in need.  Indeed, the U.S. needs to expand its 
assistance to NGOs, business associations and other civil 
society groups that are taking innovative steps to combat 
corruption, improve the business and investment climate, and 
expand government transparency. 
 
GOAJ NEEDS AN ECONOMIC ADVISORY BODY 
------------------------------------ 
 
¶7. (C) An easy, yet critical reform that the U.S. and the RMG 
have been pushing the GOAJ to adopt is a formalized economic 
advisory body to advise the President on economic issues. 
This body, comprised primarily of the Ministers of Economic 
Development and Finance, along with the Chairman of the 
National Bank, should take the lead in developing 
macroeconomic and budgetary policies.  Current economic and 
budgetary decision-making is disjointed, lacking in 
transparency, not properly informed and does not appear to 
include all the relevant actors.  More often than not, the 
key budgetary ministries and agencies, including the Ministry 
of Finance and Ministry of Economic Development, are not 
consulted on the budget and public investment program as 
dictated by Azerbaijani law.  Using existing U.S. assistance 
programs at the Ministry of Finance and the Ministry of 
Economic Development, and its role in the RMG, the U.S. will 
endeavor to convince the GOAJ of the importance of an 
economic advisory body before any detrimental economic 
effects occur in the economy.  Delivery of this message 
during high-level visits also would be helpful. 
 
BANKING REFORM 
-------------------- 
 
¶8. (C) Strengthening Azerbaijan,s banking sector is critical 
to prepare for the "Tsunami" of money coming from oil and gas 
revenues over the next decade.  The U.S. is already working 
with the National Bank of Azerbaijan to improve its banking 
supervision capabilities, but the GOAJ needs to do more to 
ensure that the National Bank plays a strong role in 
regulating and controlling the banking system.  Large 
state-owned banks, such as the International Bank of 
Azerbaijan, make it difficult for the well-managed mid-tier 
banks to be successful.  IBA,s market position also stifles 
competition and has limited the growth of banking products 
and services available to customers.  Additionally, the GOAJ, 
in coordination with the National Bank, needs to develop and 
nurture the stock market and growing securities market. 
 
¶9. (C) In addition to reforming the commercial banking 
sector, the GOAJ needs to take steps to strengthen the 
 
BAKU 00000407  003 OF 005 
 
 
overall role of the National Bank.  The National Bank,s job 
to combat inflation has been undercut by a 70 percent 
increase in public expenditures in 2006.  The GOAJ did not 
closely coordinate with the National Bank to determine 
economically safe levels of government expenditures prior to 
drafting the budget.  As a result, many economic and 
financial observers are expecting much higher inflation in 
the second half of 2006 and early 2007.  In addition, the 
ability of the National Bank to effectively control inflation 
using monetary policy is limited and the National Bank risks 
damaging the non-oil sector with further appreciation of the 
manat.  Senior U.S. economic policy makers need to warn GOAJ 
officials about the growing potential for a banking crisis 
and uncontrolled inflation if the system is not strengthened. 
 Visits to the U.S. for educational purposes and meetings 
with senior officials at the Treasury Department and U.S. 
Federal Reserve also would be useful. 
 
IMPROVING THE BUSINESS CLIMATE & INCREASING U.S. INVESTMENT 
--------------------------------------------- -------------- 
 
¶10. (C) Improving the business and investment climate is 
another goal that will promote Azerbaijan,s sustainable 
development.  Increasing competition in the economy will 
translate to decreasing costs for consumers and increasing 
opportunities for Azerbaijani entrepreneurs and international 
companies.  Court reform aimed at eliminating corruption in 
the judiciary and an emphasis on enforcement of contracts and 
judgments are important elements of improving business 
climate.  In addition, the USG should push the GOAJ to 
implement the changes in legislation and practice already 
recommended by the AmCham in its December 2005 White Paper, 
which was presented to President Aliyev.  Many of the changes 
suggested in this document would improve the business climate 
for foreign and local enterprises, and would reinforce a USG 
message that government's policies must be linked into 
feedback by civic groups, be they economic or social.  Senior 
level engagement in this area would be helpful. 
 
¶11. (C) The structured privatization of select public 
interests, including the national airline AZAL, the 
International Bank of Azerbaijan, and elements of State Oil 
Company (SOCAR) would begin to open the domestic market to an 
infusion of international investment, technology and 
know-how.  Senior U.S. visitors need to push GOAJ officials 
to take the hard decisions now to improve the business and 
investment climate.  One payoff for the GOAJ,s efforts would 
certainly be increased U.S. investment in the non-oil sector. 
 As in many developing countries, privatization of key state 
companies and sectoral reforms will prove intensely 
difficult.  In Azerbaijan, international financial 
institutions have attempted to table several initiatives to 
privatize key companies only to have their efforts die a slow 
death due to government inactivity.  In addition, efforts to 
diversify the banking sector have been thwarted.  By again 
leading the privatization efforts with the RMG and 
international community, the U.S. will open up additional 
markets to U.S. goods and services while strengthening the 
Azerbaijani economy. 
 
WTO ACCESSION 
------------------ 
 
¶12. (C) In the near-term, the GOAJ would like to join the 
World Trade Organization.  Azerbaijan,s interest may offer 
an opportunity to push for reforms while holding out a carrot 
in WTO membership.  Active engagement by U.S. trade officials 
on WTO membership may offer an incentive for the GOAJ to push 
for necessary reforms if it believes its efforts will be 
rewarded.  Any WTO reforms would have an immediate positive 
effect on the business and investment climate and would 
signal Azerbaijan,s willingness to move towards a more 
market economy.  Currrently, Azerbaijan has a fourth working 
party meeting scheduled for March 30 in Geneva.  All of the 
preparatory documents have been sent to the WTO.  While some 
weaknesses persist in the documents, Post's USTDA-funded 
accession advisor believes that the documents will allow for 
progress in the working party meetings.  Separately, Post has 
learned that USTR has agreed to begin bilateral negotiations 
on tariffs, an important step.  Azerbaijan may be planning 
other bilateral negotiations on the margins of the working 
party, perhaps with Turkey and Georgia, as well.  While the 
pace of accession is up to Azerbaijan, Post's target of 2008 
 
BAKU 00000407  004 OF 005 
 
 
remains a real possibility. 
 
REDOUBLING INTERNATIONAL ANTI-CORRUPTION EFFORTS 
--------------------------------------------- --- 
 
¶13. (C) Combating corruption in all its forms and supporting 
rule of law go hand-in-hand with improving the investment and 
business climate.  Corruption and non-competition practices 
through state monopolies and monopolization in many sectors 
of the economy by political-economic elite remain serious 
threats to economic growth and democratic stability in 
Azerbaijan.  The Parliament and the government have passed 
laws to combat corruption but on-the-ground inaction by 
government officials have made most laws ineffective. 
 
¶14. (C) The U.S. will continue to be actively engaged with 
the GOAJ to improve its record on combating corruption.  The 
government has not made a high profile arrest due to 
corruption and most corruption charges against government 
officials or individuals are politically motivated.  The 
government will need to do more to elevate the attention it 
gives to this problem, and take real action against egregious 
violators.  Senior U.S. policy makers need to highlight this 
point to the GOAJ and push for more government action.  The 
lack of transparency and accountability in public 
expenditures and abuse of government offices for personal 
gain are having a very negative effect on the growth of 
investment.  The government has also used its various 
services, for example tax department auditors, for political 
purposes. 
 
¶15. (C) Key to combating corruption is the strengthening of 
the state institutions that ensure the accountability and 
transparency of public expenditures such as capital 
expenditures, treasury operations, international controls in 
budget agencies, the supreme state auditor and the state 
procurement agency, all of which are deplorably weak and 
under-resourced.  This effort will prove additionally 
difficult, as the government,s Anti-Corruption Commission 
chief, Ramiz Mehdiyev, has been widely rumored to be 
associated with corrupt activities, such as using political 
influence to benefit personally.  Ironically, this person is 
also one of the few political actors that can improve 
Azerbaijan's anti-corruption record. 
 
AGRICULTURE'S ROLE IN POVERTY REDUCTION 
--------------------------------------- 
 
¶16. (C) Agriculture remains Azerbaijan's second largest 
sector after oil and gas, and is perhaps the best hope for 
medium-term poverty reduction in the rural regions.  However, 
development of the agricultural sector is hampered by a 
clumsy bureaucracy that at times appears unable to facilitate 
worthy development projects, as well as the legacy of a land 
privatization program that all but ensured no farmer received 
enough land to be commercially-viable.  U.S. assistance is 
active is the commercial agriculture sector with projects 
focusing on improving the business practices of pocessors 
and exporters and bringing farmers moreinto the marketing 
chain.  Post has high hopes tat three commercial farm pilot 
projects by U.S. irrigation firm Valmont will catch the full 
attention of the GOAJ.  With GOAJ support, Valmont's 
methodology has the potential to develop value-added 
agriculture in the regions and assist poverty reduction.  At 
the same time, such a success would open a large market for 
U.S. exports. 
 
ROLE OF CONSTRUCTIVE CITIZEN ACTIVISM 
------------------------------------- 
 
¶17. (C) Coupled with international efforts to strengthen the 
economy, improve the investment climate and fight corruption, 
is the important role Azerbaijani citizens could play in 
demanding greater government accountability and transparency. 
 Increased citizen awareness about the government,s use of 
the country,s natural resources appears to be a good 
starting point to push for full government transparency. 
Already some civil society activists are studying ideas to 
establish mechanisms to oversee governmental budgetary 
expenditures.  These groups have experience working with the 
State Oil Fund within the Extractive Industries Transparency 
Initiative and will require some backing and support from the 
international donor community.  International efforts to 
 
BAKU 00000407  005 OF 005 
 
 
increase transparency and government accountability will be 
enhanced when Azerbaijanis add their voices to the mix. 
 
COMMENT 
------- 
 
¶18. (C) In the short-term, Azerbaijan's wealth will continue 
to grow as more oil and gas is extracted from the Caspian and 
shipped through new pipelines to Western markets.  This 
wealth presents unique challenges to a country as poor and 
loosely regulated as Azerbaijan.  The potential for economic 
mismanagement and widespread corruption by 
government-connected elites will increase.  The U.S., in 
close coordination with the international donor community, 
will continue its efforts to lead the GOAJ towards reform and 
sustainable development.  Whether Azerbaijan is a success or 
failure over the next decade will be influenced by the amount 
of pressure the U.S. and the international donor community 
can apply to secure reforms that will lead to a stable and 
prosperous development.  In addition, Azerbaijan,s 
leadership will need to be held accountable for the proper 
administration of the country,s wealth and sustainable 
development.  A strong political will to enact hard reforms, 
along with active U.S. engagement, will be necessary in order 
for Azerbaijan to be securely on the path to an economically 
stable country. 
HARNISH