VZCZCXRO2821
RR RUEHDBU
DE RUEHKB #0533/01 1220623
ZNY CCCCC ZZH
R 020623Z MAY 07
FM AMEMBASSY BAKU
TO RUEHC/SECSTATE WASHDC 2929
INFO RUCNCIS/CIS COLLECTIVE
RUEHAK/AMEMBASSY ANKARA 2108
RUCPDOC/DEPT OF COMMERCE WASHDC
RUEATRS/DEPT OF TREASURY WASHDC
RUEAIIA/CIA WASHINGTON DC

C O N F I D E N T I A L SECTION 01 OF 03 BAKU 000533 
 
SIPDIS 
 
SIPDIS 
 
E.O. 12958: DECL: 05/03/2017 
TAGS: ECON EFIN ETRD PREL KCOR EINV KCRM KJUS AJ
SUBJECT: AZERBAIJAN'S BOOMING ENERGY SECTOR HIDES DIFFICULT 
BUSINESS OPERATING ENVIRONMENT 
 
REF: (A) BAKU 474 (B) BAKU 505 
 
Classified By: AMBASSADOR ANNE E. DERSE PER REASONS 1.4 (B, D) 
 
¶1. (C) Summary:  Azerbaijan's stunning GDP growth of 34 
percent -- fueled largely by the energy sector -- is 
accompanied by severe corruption and weak rule of law, that 
since early 2006 appear to be having an increasingly negative 
impact on firms operating outside the protection of the 
energy sector's Production Sharing Agreements.  The Resident 
IMF Representative believes that many of the corruption 
problems stem from an increase in the Customs Service's 
demands for illegal payments, which is having a ripple effect 
in both tax collection and the banking sector.  Senior 
business representatives from Azerbaijan's largest foreign 
investments outside the energy sector report that they also 
increasingly suffer regular pressure from Government of 
Azerbaijan (GOAJ) officials -- many of whom have their own 
significant business interests -- seeking to gain shares in 
successful businesses at sweetheart rates.  The only way to 
avoid this pressure, the business representatives say, is to 
avoid taking on local partners, a strategy which also has a 
negative impact on Azerbaijan's economic development.  The 
negative trends in the business environment in Azerbaijan's 
non-energy sectors over the last year are a disturbing sign, 
and make it all the more imperative that the GOAJ take steps 
now to address the monopolies, corruption and weak rule of 
law that threaten to strangle the development of its 
non-energy sectors.  End summary. 
 
DIFFICULT BUSINESS ENVIRONMENT 
----------------------------- 
 
¶2. (C) With GDP growth of 34 percent in 2006, Azerbaijan has 
one of the fastest growing economies in the world.  On the 
surface, Baku looks like a capital in the midst of a boom, 
with construction, expensive European shops, and glitzy 
restaurants catering to expatriate oil workers and 
Azerbaijan's business elites mushrooming everywhere. 
Underlying this veneer, however, is a struggling non-energy 
sector that is being crippled by official bureaucracy, lack 
of capacity, corruption and weak rule of law that cloud the 
investment climate, creating a mean and difficult environment 
in which to do business.  Firms operating outside the 
protection of the Production Sharing Agreements, which carve 
out a special transparent, legal and regulatory environment 
for energy investment, struggle with a lack of rule of law, 
government accountability and transparency that inhibit 
investment and overall profits. 
 
¶3. (C) Discussions with several U.S. and non-U.S. businesses 
operating in Azerbaijan paint a bleak picture of the 
difficult business operating environment.  As the AmCham laid 
out candidly for A/S Sullivan and the Economic Partnership 
Commission delegation in February, the overall business mood 
of local businessmen and bankers is dour and reflects growing 
bearish sentiment for the future, unless the GOAJ takes 
dramatic action soon.  Many businessmen speculate that some 
government officials, many of whom also have significant 
commercial interests, are actively seeking to drive out 
competitors, foreign and domestic, in order to take over key 
economic markets and sectors therefore serving their personal 
interests at the expense of broad economic development. 
Since early 2006, in the view of many international 
observers, the overall business climate has progressively 
gotten worse as the level of corruption seemingly has 
exploded, leading the Managing Director of the Xirdalan 
Brewery to compare Azerbaijan to Zaire during Mobutu's reign. 
 (COMMENT: This businessmen, who is successfully engaged in a 
major U.S. investment here, worked in Zaire during Mobutu's 
reign in the 1990's.) 
 
¶4. (C) Many private sector businesses and international 
financial institution contacts, including the Executive Board 
Chairman of private bank UniBank and the IMF Resident 
Representative, mark January 2006 as the beginning of a new, 
worsened phase of government pressures and corruption.  In 
early 2006 Customs officers began demanding larger illegal 
payments to process goods in and out of Azerbaijan 
temporarily stopping all imports.  During 2006 most companies 
adapted their practices or used personal and commercial 
connections to solve customs problems.  According to the 
Chairman of UniBank, Customs officials have also reportedly 
demanded that businesses underreport the true level of 
imports, which in turn forces companies to underreport profit 
and income statements to the Ministry of Taxation.  The 
underreporting of imports also complicates banking and 
international working relationships for local companies as 
 
BAKU 00000533  002 OF 003 
 
 
they misrepresent the companies' true well-being. 
 
¶5. (C) By first quarter 2007, the Embassy's business contacts 
report that the private sector is beginning to feel the pain 
of the rising level of corruption.  The chairman of UniBank 
reported to EconOff that many small and medium enterprises 
have requested renegotiation of terms for current lines of 
credit and financing, citing their inability to meet 
repayment terms due to the difficult business environment. 
In addition, many non-energy sector businesses are putting on 
hold plans for investment in Azerbaijan due to the 
uncertainty of the investment climate.  One banker told 
EconOff of a client who has decided to redirect any future 
investments away from Baku and to Dubai due to the economic 
and political uncertainties in Azerbaijan.  Azerbaijani MP 
Chingiz Asadullayev, who is proud of his record as an 
independent businessman, told the Ambassador that 
increasingly, Azerbaijani business representatives are 
approaching him as an MP and expressing their frustration and 
desire for GOAJ action to halt corruption.  Several companies 
shared their individual stories, which follow below. 
 
GARADAGH CEMENT 
--------------- 
 
¶6. (C) The General Director of Garadagh Cement, a Swiss-owned 
cement factory in Baku and the largest in Azerbaijan, said 
that Ministry of Taxes authorities regularly visit his 
corporate offices to "review the books" looking for tax 
violations.  High-level tax inspectors reportedly offer to 
stop the tax inspections in return for Garadagh Cement 
setting them up as cement redistributors with cement provided 
at favorable rates.  Garadagh Cement ran into trouble during 
the late 1990s and early 2000 when its previous management 
team engaged in "questionable businesses practices" leading 
it to be "preyed upon" by several government ministries and 
agencies.  The General Director said that since the new 
management team arrived several years ago, the company has 
not engaged in any questionable practices but the Ministry of 
Taxes and other ministries continue to investigate its 
operations.  Inspectors from different ministries often pass 
each other in Garadagh offices, surprised to see one another 
there, according to Garadagh's General Director. 
 
¶7. (C) The booming construction sector makes cement a 
lucrative business.  The Prime Minister and Minister of 
Transportation are reputed to be among the largest cement 
dealers and mixers in Baku.  Azerbaijan's total annual cement 
market is 2.5 million tons per year with Garadagh Cement 
making only 1.3 million tons per year.  Additional cement is 
imported from Georgia and Russia.  Garadagh's General 
Director reported that the company is holding off on making 
large investment upgrades until the business climate is safer 
and the company's owners believe their investments will not 
be at risk of nationalization by the GOAJ.  In addition, 
possible investment by the Azerbaijan Investment Company has 
been delayed due to AIC's veto option on company management 
(Reftel A).  Garadagh is one of Azerbaijan's largest tax 
payers, with annual turnover of USD 90 million. 
 
BiH EASTERN XIRDALAN BREWERY 
---------------------------- 
 
¶8. (C) The President of BiH Eastern holdings, the owner and 
operator of the local Xirdalan brewery, Jean Paul Lanfranchi, 
told the Ambassador in a recent meeting that representatives 
from the Lenkaran governor's office and the Chairman of State 
Property Management Committee Chief Kerem Hassanov recently 
approached him and requested 50 percent ownership in the 
company's vineyard in the southern Azerbaijani town of 
Jalalibad.  The BiH President said he was taken aback at the 
"brazen approach."  He told the Ambassador that he will 
refuse any attempts by the officials to gain ownership in the 
vineyard, noting that he planned to raise this issue directly 
with President Aliyev.  He later told the Ambassador that he 
had raised the issue in a letter to the President and got an 
immediate telephone call from Minister of Economic 
Development Heydar Babayev.  The Xirdalan brewery is a major 
U.S. investment in Azerbaijan and one of the country's top 
ten tax payers and in 2006 produced 250,000 hectoliters of 
beer.  Citibank Venture Capital International Growth Fund 
owns approximately 92 percent of BiH Eastern holdings. 
 
REAL ESTATE MARKET 
------------------ 
 
¶9. (C) A local Turkish Cypriot real estate businessman with a 
British passport recently experienced the harshness of 
 
BAKU 00000533  003 OF 003 
 
 
operating in Azerbaijan first-hand.  A long-time investor in 
Azerbaijan and owner of several buildings housing 
international businesses (including BP, ExxonMobil, and some 
U.S. Embassy offices), this property developer had the 
construction on his new large office building stopped for 
more than a month by the Ministry of Emergency Situations on 
the grounds of a safety review.  The stoppage cost USD 15,000 
a day in labor costs and millions of dollars in lost rent. 
He told Econoff that representatives reportedly speaking on 
behalf of senior GOAJ officials, including Minister of 
Emergency Situations Heydarov, demanded a controlling stake 
of more than 50 percent ownership in the new building.  The 
businessman said that when he refused the offer, the Ministry 
of Emergency Situations, officially closed down the 
construction site.  In the end, the businessman negotiated a 
settlement that included selling some ownership in the new 
building.  Construction on the building complex has since 
resumed. 
 
BUSINESS BEST PRACTICES 
----------------------- 
 
¶10. (C) From various discussions, it would appear that one of 
the safest ways to operate in Azerbaijan is to never give in 
to official or non-official corruption no matter what the 
short-term gains.  In the long-term, the "system" will cease 
harassing the company, understanding that nothing can be 
done.  The Managing Director of the McDonald's chain in 
Azerbaijan told the Ambassador that since he is a U.S. 
company he has never given a bribe to facilitate the 
importation of goods or the location of a new McDonald's 
site.  In addition, he pre-pays his quarterly tax revenue to 
the Ministry of Taxes.  Since he operates only in the 
official sector, he has had less problems than other 
businesses even if he has "sacrificed short-term financial 
gains."  He opined that once a company gives in to the 
corrupt official or office, it is impossible to reverse 
course and correct the situation.  The vicious cycle spirals 
out of control as the illegal demands increase exponentially. 
 The McDonald's Managing Director highlighted the importance 
of businesses paying all legal and published taxes and 
customs duties.  An executive at Turkish-owned Ramstore 
strongly reiterated this theme of never giving in to 
corruption and paying all published taxes and duties. 
 
¶11. (C) The President of BiH Eastern and Xirdalan brewery 
also shared this view, stating that in order to operate in 
Azerbaijan it was important never to pay bribes, pay all 
taxes and never get "too big."  If a business becomes too 
big, too successful, he said it will attract "sharks" that 
will come to take a piece of the business.  He indicated that 
the operating environment in Georgia was equally difficult, 
noting that his brewery there has had problems with 
government officials who own a competing brewery. 
 
COMMENT 
------- 
 
¶12. (C) The long-term success of Azerbaijan depends upon the 
development of the non-oil private sector to promote economic 
growth and employment.  With energy resource exports set to 
decline by 2015-2020, the GOAJ will need a sound foundation 
for broad based sustainable growth to ensure economic and 
political stability.  Continued economic and political reform 
-- particularly changes that strengthen rule of law -- are 
essential to attract foreign and domestic investment outside 
the energy sector.  The GOAJ's recent statements regarding 
accession to the World Trade Organization are positive, as 
the WTO accession process could help facilitate the legal and 
regulatory changes needed to establish a transparent, 
market-oriented economy.  In addition, on May 1 President 
Aliyev ordered several key ministries to review their 
procedures and present recommendations on how to improve the 
business operating environment.  With inflation and some of 
the distorting effects of Azerbaijan's energy-based growth 
beginning to kick in (Reftel B), time is of the essence. 
Azerbaijan's successful economic reform and sustainable 
development is key to the country's stability and therefore 
important to U.S. interests; absent reform, Azerbaijan stands 
a real chance of becoming a failed petro-state, north of 
Iran, south of Russia and sitting on a key transit route for 
Caspian energy resources to the West.  In our own interests, 
it is essential that we continue to engage in all areas of 
our political and economic reform agenda, to promote 
Azerbaijan's sustainable development and transition to a 
market-oriented democracy. 
DERSE