factors affecting the economic development of azerbaijan

157

Factors affecting the economic development of

Azerbaijan

Musayeva Fargana Phd, Leading Researcher of the Institute of

Economics of Azerbaijan National Academy of Sciences

Abstract: Economic development of a country reflects the overall economic outlook of a country and

each country can utilize the existing opportunities for faster economic development by better

planning and a systematic approach. In this regard, it is important to study factors affecting the

economic development of any country and since it plays a key role in advancement of society, it has

attracted numerous researchers' attention. Therefore, the main aim of this study is to investigate the

factors affecting the economic development of Azerbaijan during the years of 1990-2015 as well as

examining the short and long-run correlation of variables based on ARDL method. The obtained

results indicate the positive impact of health expenditure and negative impact of population growth

both in short and long run. Foreign investment has a negative impact in the short run, but the

financial development and research and development expenditure have positive impact in the short

run; while the rate of foreign investment and trade openness have a positive significant impact in

the long run. Furthermore, the results suggest the relatively good speed of adjustment towards long-

run equilibrium of variables.

Keywords: Economic development, Azerbaijan, ARDL method, production growth

1- Introduction

Nowadays, the concept of development is a very important concept based on which the countries of

world are classified into three categories: developed, developing and underdeveloped countries.

Economic development issues had been introduced in European countries during the seventeenth

and eighteenth centuries. Due to the pressure of industrialization and technological development in

these countries along with dominance of market in weak colonial countries in a short time, the gap

between advanced and backward poles were deepened and two groups of countries were created in

the world: Developed and underdeveloped countries. By the end of World War II and creation of

public order in the world (along with independence of numerous colonial countries), this gap was

highlighted and various nations confronted with the fundamental question of "why are some of the

world population are living in poverty and absolute hunger and others in welfare?" Since then, the

development ideas and theories have been created in the world. Despite the fact that the growth had

been considered as the development, we should now distinguish between economic growth and

development (Salimifar, 2003). In all definitions, the economic growth is as a quantitative

phenomenon of changes in national production and can be positive or negative; and in the case that

there are not any changes, the economic growth will be zero. However, the development concept is

wider than growth and includes the change in production and reallocation of resources and

Factors affecting the economic development of Azerbaijan

Fargana / Argos Special Issue 2016-part 2/pp.157-168

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workforce. The definition of economic development pays attention to concept of expansion and

improvement of economic status in countries. Economic development is not limited only to growth

and covers the issues related to poverty, justice, urbanization, migration, unemployment, income

distribution and other social indices at wider level (Tavallaei, 2014). Therefore, according to the wide

concept of development and coverage of several issues, it is important to pay attention to it and

investigate the effective concepts which can play essential roles in economic policy of countries, so

that planning for identification of economic growth structure and efforts to increase it is one of the

economic development requirements; and some experts have considered it in line with justice

(Gaskari and Mistry, 2010). Therefore, this study aims at investigating the factors influencing the

economic development of Azerbaijan.

2- Theoretical principles

Development literally means gradual growth to become advanced, more powerful and even larger

(Oxford dictionary, 2001). Economic development refers to economic growth which is along with

fundamental changes in economy and increased production capacities ranging from physical, human

and social capacities. The quantitative growth of production will be achieved in economic

development, but the social institutions will be also changed along with it (Wikipedia). Therefore, the

economic growth is a quantitative concept, while the economic development is a qualitative concept.

Brookfield defines development as follows: Development should be defined based on progress

towards welfare goals such as reduction of poverty, unemployment and inequality. In addition to

improving production and income, the development includes the fundamental changes in

institutional, administrative- social structures, and also public views. I most of the cases, the

development even contains the public habits, customs and beliefs (Daneshvar, 2007). Therefore, the

variables are qualitatively considered in economic development, and thus they express the

qualitative changes of a society which can be manifested in growth. Therefore, the economic

development refers to qualitative changes in economic structure of a society and those fundamental

changes which affect gross domestic product. According to a general definition, the development is a

process under which the cultural beliefs, and social, economic and political institutions are

fundamentally changed in order to be coordinated with new well-known capacities and it promotes

the public welfare process (Azimi, 2003). According to another definition, economic development is a

process which increases the real per capita income of a country over a long period. The important

point is that the economic development should not be reduced to economic growth, but the other

factors such as quality of life, life expectancy, increased productivity, social and economic equality,

reduced poverty, improved attitudes, and advanced factors and techniques of production according to

environmental protection should be taken into account in addition to growth (Meier, 1999).

The first economic ideas have been emerged since the eighteenth century and by fast growth of

industries in the West. The basic schools of economic development are as follows:

Adam Smith's theory (1723-1790): Smith was one of the most optimistic classical economists known

as the "father of economics". Smith and other classical economists (such as Ricardo and Malthus)

considered the "earth", "labor" and "capital" as the factors of production. The concepts such as

invisible hand of "division of labor", "capital accumulation" and "market expansion" form the

skeleton of his theory in economic development.



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Malthus's Theory (1766-1823): Malthus was more famous for his population theory; however, he had

accurate theories about economic issues such as market saturation and economic crises.

Ricardo's theory (1772-1823): He developed the classical school by Smith by adoption of Malthus's

theory. Smith emphasized on "production", while Ricardo focused on "income distribution" topic, and

later neoclassics (his students) concentrated on "efficiency". His two famous theories were "law of

diminishing returns" and "comparative advantage". In law of diminishing returns, he believes that

the economic growth in a capitalist society is achieved thanks to cost-effective food which means low-

wage industrial workers and higher profits for capitalists, increasing the possibility of capital

accumulation in industry, producing more and finally increased total economic revenue. According to

Ricardo, the increased agricultural productivity (compared to industry) is the basic foundation of

economic growth. By the help of "opportunity cost" concept, Ricardo concludes in theory of

comparative advantage that the countries should not (according to previous economists) solely

concentrate on production of goods in which they have absolute advantage (in comparison to other

countries), but they also act based on comparative advantage by considering the replacement cost of

a product with another product.

Classical growth model: The classical economic growth model will arise according to classical

economists' views. From their perspective, the development of capitalist economies is a competition

between technological progress and population growth and it has the technology advance on the

priority for a period, but it will end one day (or face with recession) and thus the economy will be

declining. In short, there is not any real progress in this model. However, the growth models offered

by classical economists promise the stop of economic progress in these countries in the long run when

the per capita income will not be grown any longer.

Karl Marx's theory (1818-1883): Unlike Smith, Malthus and Ricardo, Marx did not consider the

capitalism unchangeable. According to him, the capitalism is as one of the production methods which

is began with primitive commune, and then enters the slavery stage and finally leads to feudal

production in communities. He believes that the capitalism is the fourth stage of current production

methods in the world and will eventually collapse. This collapse will not be due to the recession, but

also for social reasons, and eventually the world will reach a final stage called the communism.

Marx's economic capitalism growth model: According to Marx, each production method (primitive

commune, slavery and feudalism, capitalism, socialism and communism) has two major

characteristics called the "productive forces" and "relations of production". The productive forces

refer to technical structure of production (such as the level and rate of change of technology and tools

of production, and natural resources). According to fundamental point of Marx's view, the capitalists

continue the capital accumulation to earn higher profits, but ultimately, the increase or decrease

benefits has a strong dependence on level of value added, not the rate of population growth or low-

quality agricultural lands.

Schumpeter's theory (1950-1870): According to Joseph Schumpeter, the capitalism machine is able to

produce high rates of economic growth in addition to compensation of its social losses. Mathematical

model of his theory has three difference with classical and Marx models: Introduction of interest rate



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and its importance; separation of different types of investment (particularly in the field of

innovation); and emphasis on centrality of entrepreneurship for economic growth.

Lewis-Fei-Ranis development model (LFR): Arthur Lewis's model (1954) was the first and foremost

development model which implicitly at least focused on rural-urban migration process, and was later

formulated and developed by John Fei and Gustav Ranis (1961). This model was known as the

general development process theory of "labor surplus" in the third world countries during the 1950s

and 1960s. In this model, the economy consists of two sectors: First, traditional sector (current rural

section), which is characterized by very low productivity (even zero) and labor "surplus". Second, the

industrial sector (intra-urban sector) which has high productivity; and the labor is gradually

absorbed to it from rural sector. This model focuses on the process of labor transfer and employment

growth in industrial sector (modern) and is due to the development and growth of its production.

(Motavasseli, 2003). The examples of economic development indices or level of development are as

follows (Salimifar, 2003):

A. Per capita income: The per capita income is obtained from dividing the national income of a

country (GDP) by its population. In different countries, this simple and evaluable index is usually

compared with per capita income of developed countries.

B. Purchasing power parity (PPP): The PPP is used since the per capita income is calculated

according to local prices of countries, and the prices of goods and service are not the same in different

world countries. In this method, the production rate of various goods in any country is multiplied by

global prices of those goods; and their GDP and per capita income are calculated after necessary

adjustments.

C. Stable income index (GNA, SSI): The effort to overcome the deficiencies of per capita income and

paying attention to "sustainable development" rather than "economic development" has led to

measurement of stable income index. In this method, the environmental costs of production and

economic growth are also considered in national accounts (either as compensation or as improved

resources and environment) and then the rate of growth and development is obtained.

D. Combined indices of development: Since the early 1980s, some economists suggested the use of

combined indices rather than relying on a single index for measuring and comparing economic

development between countries. For instance, the weighted combined index introduced by

McGranahan (1973) based on 18 main indices (73 sub-indices) (the Human Development Index was

then introduced).

E. Human Development Index (HDI): This index was introduced by the United Nations in 1991 and

is calculated based on these indices: The real per capita income (based on purchasing power parity

index), life expectancy (at birth) and access to education (which is a function of adult literacy rate

and the average years of going to school) (Salimifar, 2003).

In addition to the above-mentioned cases, the extent of poverty, employment rate, the change in

economic structure, decentralization and increased participation rate, access to healthcare facilities



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and access to education facilities are among the most important indices of development

measurement (Tavallaei, 2014).

3- Review of research literature

The development and its determinants have been investigated in numerous studies. Obviously, the

review of empirical studies along with theoretical issues helps to identify the appropriate variables

as well as developing the optimal model. Knight, Dillanueva and Loagza (2013) studied the

importance of human resources and public investment in growth of countries using panel data and

cross-country data and time series for 98 developed and developing countries during 1960-1985.

They have concluded that entering the degree of freedom of foreign trade and level of infrastructure

economic costs in growth model estimation equation increases the effect of public investment on

growth process and thus enhances the investment efficiency which is achieved in the light of

commercial regime liberation and change in infrastructures. Furthermore, this study indicates that

the trade restrictions such as increased tariffs on imports of capital and intermediate goods have

negative impact on growth.

James Raymo's study (1995) is another conducted study on the role of human capital in economic

growth in 1995. In this study, he measures the human capital role in GDP or economic growth using

data of 1970-1991. Based on obtained results, the education expenditure spent on education and the

labor's average years of school have had significant positive impact on economic growth of Japan as

two indices of human capital.

Fernandez et al. (2001) studied the model uncertainty in growth regression through Bayesian model

averaging on a sample of 140 countries and rated the determinants of growth in a period of 1992-

1960.

Wang, Hu and Yu (2007) studied the correlation between educational measures and economic growth

in China. Comparing the R&D expenditure efficiency in Hebei Province of with seven other provinces

of China, they sought to find ways to improve the performance of research and education on

economic growth. They measured the effects of research and education on economic growth of China

through data of 532 large and medium-sized enterprises in Hebei Province and based on data

envelopment analysis (DEA).

In a study on the impact of using the higher education graduates on economic growth of Iran,

Almasi, Soheyli & Sepahban (2010) introduced the growth as an endogenous variable which was the

function of investment in human, physical capital, etc. The results of this study indicate that the

impact of human capital on growth variable is more than physical capital.

In a study based on time series of large industrial factories, Dejband (2005) estimated the large-scale

production function and growth model. The obtained results indicate that the research and

educational capital accumulation in all estimated models at the macro level is among the most

important factors of economic growth in Iran. The confirmed human capital, research and physical



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capital in all models indicate the priority of both human capital and research to physical capital in

its models.

In a research entitled "The determinants of economic growth in different countries", Jalalabadi and

Bahrami (2010) studied the impact of variables affecting the economic growth in 7 theories of

economic growth for 79 countries in two groups of total countries and non-developed countries (52

countries) during the period of 1970-2006. Based on obtained results, the factors affecting the

economic growth of different countries can be different. On this basis, various theories of economic

growth do not have the same impact on their economic growth for different groups of countries based

on the impact of alternative variables.

In a research entitle "The factors affecting economic growth of Iran" An approach to Bayesian

approach with definition of uncertainty in growth function", Kafaei and Jozi (2013) determine the

factors affecting the economic growth of Iran. According to results, from total of 18 explanatory

variables, only three variables namely the oil income, human capital and private investment are

important factors affecting the economic growth of Iran.

In a latest study on this field, Ostadi (2016) studies the determinants of economic growth according

to effects of subsidy reform plan and increased energy prices. According to obtained findings, the

value-added of different economic sectors has a significant positive effect on GDP and economic

growth, but the governmental expenditure has a negative and significant correlation with them. The

increased governmental involvement in economy reduces the cost of private investment and growth

by algebraic substitution phenomenon and replacement of public sector with private sector. Based on

results of this study, the prices of energy carriers have significant negative impact on them.

4- Materials and methods

According to the literature and based on conducted studies on this field, the following model is used

to examine factors affecting the economic development in Azerbaijan during 1995-2015 based on

models by Lucas (1988) and Raymo (1995):

Where, the applied variables and type of calculation are as follows:

Rg: Rate of production growth;

OPEN: Trade openness;

FDI: Foreign direct investment;

EXH: Expenditure of health to total expenditure;

RPO: Rate of population growth;

FIN: Ratio of domestic credit granted to private sector compared to GDP;

RD: Research and development expenditure compared to GDP;

ε is the error term and i index indicates the surveyed period. It should be noted that all required

figures are extracted from information published by the World Bank.

When the sample size is small, the use of OLS for estimating the long-run correlation due to non-

considered short-run dynamic interactions between variables will not provide the unbiased estimate



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(Tashkini, 2005). Given that the studied period covers the years of 1995- 2015, it is suggested

applying a models which considers the short-run dynamics in order to estimate the model coefficients

more accurately because of small number of observations (due to the lack of available figures) for

investigating the factors affecting the economic development. In this regard, ARDL model is selected

and it is estimated by Microfit software.

5- Results and findings

5-1- Evaluation of variable statics

The evaluation of variable statics of time series model is the first step to estimate this model.

Therefore, Augmented Dickey-Fuller Test is used to investigate the statics of time series; and the

summary of test results for each studied variable is presented in the following table and indicates

the statics of all studied variables. Among all variables except for foreign direct investment (FDI),

which has static level, all other variables are static in the first-order difference.

Table 1: Static test of studied variables according to Augmented Dickey-Fuller Test

Variable

name

Dickey-

Fuller

test

MacKinnon critical

values Probability Intercept Process Result

1% 5% 10%

RG -3.42 -3.83 -3.02 -2.65 0.0229 It has It does not

have I (1)

EXED -7.664 -4.12 -3.14 -2.71 0.0001 It has It does not

have I (1)

OPEN -3.06 -2.69 -1.96 -1.69 0.0041 It does

not have

It does not

have I (1)

FDI -3.35 -3.83 -3.02 -2.65 0.02 It has It does not

have I (0)

EXH -5.58 -3.85 -3.04 -2.66 0.0003 It has It does not

have I (1)

RPO -4.44 -3.85 -3.04 -2.66 0.0031 It has It does not

have I (1)

FIN -5.07 -3.88 -3.05 -2.66 0.0010 It has It does not

have I (1)

RD -4.15 -3.92 -3.06 -2.67 0.0064 It has It does not

have I ( 1 )

Source: Research authors

5-2- Results of estimated ARDL model

Here, the target model is estimated through autoregressive distributed lag model (ARDL). Before

investigating the long-run correlation between variables of model, it is necessary to test the long-

term convergence between available variables because the total coefficient of lagged dependent

variable should be smaller than 1 so that the dynamic model of autoregressive distributed lag model

will have convergence towards the long-run equilibrium (∑ ̂ .



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The results of estimating the short-run dynamic equation through Microfit software are shown in the

following table. Given the annual data of this study and since there is a low number of studied data,

Schwarz Bayesian Information Criterion (SBIC) is used to determine the optimal lag, so that the loss

of too much degree of freedom is prevented; hence, the lag number criterion is selected for model

variables. The test for existence or lack of long-run correlation can be done based on these results.

Based on what is shown in table, since the coefficient of dependent variable (RG) is less than 1, the

studied model is close to long-run equilibrium model. Furthermore, the results indicate the

significant impact of all studied variables except for trade openness. Furthermore, the significance of

f-statistic at the level of 99% requires the significance of whole model, and the coefficient of

determination equal to 0.98 refers to high explanatory power of model.

Table 2: Results of estimated dynamic model

Autoregressive Distributed Lag Estimates

ARDL(1,0,1,1,1,1,1) selected based on Schwarz Bayesian Criterion

*******************************************************************************

Dependent variable is RG

16 observations used for estimation from 1998 to 2013

*******************************************************************************

Regressor Coefficient Standard Error T-Ratio[Prob]

RG(-1) -.44722 .21659 -2.0648[.031]

OPEN .055438 .37689 .14709[.892]

FDI -1.0636 .39176 -2.7149[.073]

FDI(-1) 1.1372 .24631 4.6169[.019]

EXH 95.9139 23.2380 4.1275[.026]

EXH(-1) 51.3726 13.9626 3.6793[.035]

RPO -30.5010 6.6748 -4.5696[.020]

RPO(-1) 25.9475 5.6655 4.5799[.020]

FIN .063652 .48995 .12992[.005]

FIN(-1) 1.0040 1.1985 .83770[.464]

RD 154.4107 113.0968 1.3653[.026]

RD(-1) -231.0781 65.0006 -3.5550[.038]

C 171.2515 50.7866 3.3720[.043]

*******************************************************************************

R-Squared .98078 R-Bar-Squared .90390

S.E. of Regression 2.8365 F-stat. F( 12, 3) 12.7579[.030]

Mean of Dependent Variable 11.8406 S.D. of Dependent Variable 9.1501

Residual Sum of Squares 24.1367 Equation Log-likelihood -25.9922

Akaike Info. Criterion -38.9922 Schwarz Bayesian Criterion -44.0140

DW-statistic 3.2467 Durbin's h-statistic -4.9927[.000]

*******************************************************************************

Source: Research authors

The co-integration between variables should be ensured after estimation of ARDL equation. As

mentioned, if the sum of lagged coefficients related to dependent variable is smaller than 1, the

dynamic model will tend towards long-term equilibrium model. The following hypothesis test should

be done to test the long-term co-integration test in autoregressive distributed lag model:



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The required value of t-statistic for doing the above-mentioned test is calculated as follows:

Where, SE is the standard deviation of variable i coefficient.

After calculation of the above-mentioned statistics, we should compare it with critical quantity by

Banerjee, Dolado & Mester (1992). If the t-statistic is greater than critical value, the H0, or the lack

of convergence is rejected and the long-run correlation between variables of model is confirmed.

Therefore, the long-run equilibrium correlation between variables of model can be studied by

rejecting the H0 and this provides the basis for use of error correction model in which the short-term

fluctuations of variables are connected to long-run equilibrium values.

The t-statistic quantity for doing the above-mentioned test is calculated as follows:

Since the absolute value of calculated statistics is higher than critical value by Banerjee, Dolado &

Mester, the null hypothesis based on the long-run correlation in favor of alternative hypothesis (long-

run correlation) is rejected, and there will be a long-run correlation. This result is obtained through

F-statistic of output. Therefore, the long-run correlation is also estimated and its result is presented

in the following table and indicates the positive and significant impact of trade openness, the

positive and significant impact of foreign direct investment, the positive impact of health

expenditure, and negative significant impact of population growth. However, the financial

development and R&D expenditure have not shown any significant effect.

Table 3: Results of long-run estimation of model

Estimated Long Run Coefficients using the ARDL Approach


*******************************************************************************

Dependent variable is RG


*******************************************************************************


OPEN .038306 .26117 .14667[.003]

FDI .050850 .22359 .22742[.035]

EXH 101.7722 22.2345 4.5772[.020]

RPO -3.1464 3.6212 -.86889[.049]

FIN .73773 .77220 .95535[.410]

RD -52.9758 50.9685 -1.0394[.375]

C 118.3316 27.6357 4.2818[.023]

*******************************************************************************



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In accordance with any long-run correlation, there is an error correction model (ECM) which

connects the short-term fluctuations of variables to their long-run equilibrium values. The error

correction model is used to combine the short and long-run correction. The existence of cointegration

relationships between a set of economic variables provides the statistical basis for use of error

correction models. Error correction model connects the short-run fluctuations of variables to their

long-run equilibrium values. To adjust the error correlation model, we just need to put the error

terms of cointegration regression for estimation of long-run coefficients with a time lag as an

explanatory variable together with the first order difference of other variables of model, and then

estimate the coefficients of model by Ordinary Least Squares (OLS). The results of estimating the

error correction equilibrium for investigating how the short-run fluctuations of studied variables

lead to long-run equilibrium are presented in the following table. The coefficient related to ECM (-1),

which indicates the process adjustment speed of non-equilibrium, is taken into account in this model

as an important issue. In other words, the ECM coefficient indicates what percentage of target

variables are put in direction of their long-run procedure in any year.

Therefore, all coefficients of error correction model except for financial development and R&D

expenditure are significant with a probability of more than 90%. Error correction coefficient is also

estimated equal to 1.44 and it is statistically significant. The negative coefficient indicates that the

non-equilibrium move towards equilibrium in the long-run. The value of this coefficient indicates

that 84% of non-equilibrium of a period (year) is mitigated (adjusted) in the next period. This figure

indicates that the adjustment towards equilibrium is done with fairly good speed.

Table 4: Results of estimating the error correction model (ECM)

Error Correction Representation for the Selected ARDL Model


*******************************************************************************

Dependent variable is dRG


*******************************************************************************


dOPEN .055438 .37689 .14709[.017]

dFDI -1.0636 .39176 -2.7149[.026]

dEXH 95.9139 23.2380 4.1275[.003]

dRPO -30.5010 6.6748 -4.5696[.002]

dFIN .063652 .48995 .12992[.900]

dRD 154.4107 113.0968 1.3653[.209]

dC 171.2515 50.7866 3.3720[.010]

ecm(-1) -0.8472 .21659 -6.6817[.000]

6- Summary and conclusion

In general, according to this section, this research considers the comprehensive variables in order to

study the factors affecting the economic growth and development in Azerbaijan. Therefore, the

following variables are considered for estimating their impact on GDP growth (Gt) during 1995-2015:

The trade openness (OPEN) is the first studied variable. Despite the fact that this variable has not

shown any significant impact in the short run, it has significant positive impact on growth in the

long run. This is consistent with results of research by Samimi et al (2009) and Dani (2007).



167

The foreign direct investment (FDI) is the second studied variable. The obtained results indicate the

negative impact of this variable in the short run and its positive impact in the long run. The positive

long-run effect of this variable is consistent with results of research by Alipour and Ghadkachi

(2011), Liang, Qi et al (2005) and Kottaridi and Stengos (2010).

The ratio of health expenditure (EXH) to gross domestic product is the third variable; and the

obtained results indicate a significant positive influence of this variable on economic growth. This

result is consistent with results of research by Raeispour and Pajouyan (2013).

The rate of population growth (RPO) is another variable which is examined in this research for its

impact on growth. The results indicate its significant negative impact on economic growth. This

result is consistent with results of research by Bakhshi et al (2011).

Financial development variable (FIN), which is considered as the ratio of domestic credit granted to

private sector to GDP (DCP), is one of the most important studied variables. Based on the obtained

results, despite the fact that this variable has a positive significant impact in the short run, it does

not have any significant impact in the long-run. The obtained result about the short-run impact of

financial development variable is consistent with research by Salmani and Amiri (2009).

The last studied variable is related to ratio of R&D expenditure on production, and the results

indicate a significant positive correlation in the short-run and its insignificance in the long-run. The

significant and positive result of this variable in the short run is consistent with result of research by

Daghighi-Asli et al (2013).

The results of VECM model estimation indicate that the speed of short-run error equilibrium

towards the long-run equilibrium is equal to 0.84 and it is significant at the level of 5%. This

indicates the fairly good speed of equilibrium towards the long-run equilibrium.

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