The George Washington UniversitySchool of Business

Department of Finance

Fakhri Ismayilov, PhD

Long-term Fiscal Sustainability in Azerbaijan: Current issues and Post-crisis Challenges

Fulbright Scholar

Population: 9 million

Territory: 86 th.sq.km.

GDP of Azerbaijan (PPP based) is around 2/3 of total GDP of South Caucasus region

GDP per capita in 2009 5400 USD

Last periods of high economic growth rate achieved by a broad social dynamics and capital budget in the face of rising oil revenues.

Increasing dependence on oil revenues, the budget deficit in the state budget, in particular the non-oil budget deficit is important in terms of macroeconomic stability and sustainability of the budget issue.

The difference from other resource-rich and developing economies emanates from the fact that proven oil and gas reserves of Azerbaijan are short-lived to be depleted by mid-2025, which exacerbates the need to ensure longer-term fiscal sustainability.

The Importance of ThemeThe Importance of Theme

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Assess the current situation of fiscal deficit on a macroeconomic point of view,

The methodology for the calculation on the basis of international practice in determining the level of non-oil budget deficit;

To ensure the sustainability of the budget for a fixed volume of used oil revenues by the principle of Permanent Income Hypothesis methodology and determination of the limit of the optimal use of oil revenues;

Medium-term fiscal strategy evaluation and implementation opportunities in Azerbaijan;

Fiscal Policy Consolidation - “The New Procedures for the Preparation of the Sate Budget (within MTF)“.

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The main purpose of the paper

The structure of budget revenues

In recent years, an average of 60% of the budget expenditure is financed through oil revenues.

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Oil revenue Non-oil revenue

Budget revenue,% Oil price and budget expenditure

Budget expend.growth,%

Oil price

The level of non-oil budget deficit is defined…

Non-oil budget deficit = budget expenditure – non-oil budget revenue (budget revenue – oil revenue). (IMF methodology)Non-oil budget deficit = budget expenditure – non-oil budget revenue (budget revenue – oil revenue). (IMF methodology)

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Budget deficit,%

Budget deficit in share of GDP,%

Non-oil budget deficit in share of non-oil GDP,%

Twin deficit,%

Non-oil budget deficit in share of non-oil GDP,%

Non-oil CAB in share of non-oil GDP,%

Economic growth

2004 2005 2006 2007 2008

GDP, % 10.2 26.4 34.5 25.0 10.8

Oil sector, % 3.0 66.3 63.1 36.8 7.0

Non-oil sector, %

13.6 8.3 11.8 11.4 15.7

GDP per capita, $

1060 1600 2508 3906 5404

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Government expenditure has a significant impact on economic growth.

Aggregate demand,% (non-oil sector)

Public demandPrivate demand

Non-oil budget deficit and exchange market

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Quasi-fiscal deficit in the non-oil GDP increased by 2% to about 13% level.

Quasi-fiscal deficit

Quasi deficit, mln.azn

In share of budget expenditure, %, right sc.

In share of non-oil GDP, %, right sc.

Fiscal sector - foreign currency supply, mln.$

Currency supply Net demand of exc.market

Net central bank intervention

Effect of the non-oil budget deficit on macroeconomic stability

A 10% increase in budgetary expenditure of the money supply increase is 0.17% points.

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Oil revenues spent and non-oil budget deficit Money stock and annual inflation,%

Spent oil revenues, bln.$

Non-oil deficit/non-oil GDP,%,right sc. Money supply growth,left.sc Annual inflation, right sc.

Evaluation of the optimal level of oil revenues spent in terms of fiscal sustainability

Permanent Income Approach in IP*:

1. Total oil wealth from financial assets:

W = V + NPV (1)

W - the creation of oil wealth is expected to total financial assets (current value);

V - the current balance in the oil assets;

NPV - the expected total net present value of oil and gas revenues.

2. The expected total net present value of oil and gas revenues:

(2)

 

R - estimated oil revenues for each year during the period;

i - nominal interest rates in international financial markets;

n - number of years.

3. Limit the use of oil revenues within a year:

PI = r * W (3)

r – the real annual return on assets management of the oil (r = i - p);

W – the creation of oil wealth is expected to total financial assets (current value).

* - IP – international practice (IMF/FAD)10

Current expend.PI Oil revenue

The Goals of Long-term Fiscal Sustainability is:

• A fiscal trajectory must be constructed, so that in the coming years the current abundance of oil revenues can be covered with a fiscal budget when oil revenues will decline. • If the oil revenues are well spent on the optimal level, after 8-9 years oil reserve assets will be around $ 100 billion (in current prices). • To define Sustainable fiscal benchmark: Sustainable non-oil primary deficit = r/(1+r) * government wealth = r/(1+r) * (present value of oil revenue + financial assets–debt)

Reserve 100 bln.$

NPV

SOFAZ

Fiscal Sustainability and Managing O&G Revenue in Azerbaijan (general)

0

5000

10000

15000

20000

2007 2009 2011 2013 2015 2017 2019 2021 2023 2025

10000

30000

50000

70000

Crude Oil Production 000s Tons Gas Production BCM

Oil revenue PIH

Regulation of the non-oil fiscal deficit – Model for the use of oil revenues

AIOCAIOCSOCARSOCAR

OIL FUNDOIL FUND

Consolidate BudgetConsolidate Budget

The remaining profit

The remaining profit

Financing of non-oil fiscal deficit

Financing of non-oil fiscal deficit

Transfer

Transfer

Profit oilProfit oil

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TaxesTaxes

Permanent incomePermanent income

The mechanism of using oil revenues on the basis of PI

How to use the oil revenues?How to use the oil revenues?

Development purpose (stability and development)

Development purpose (stability and development)

Economy:

- economic growth

- economy diversification

- infrastructure

Economy:

- economic growth

- economy diversification

- infrastructure

Social:

- distribution of revenues

- social service and infrastructure

Social:

- distribution of revenues

- social service and infrastructure

Saving:

- storage revenues for future generations

- the payment of public debt

Saving:

- storage revenues for future generations

- the payment of public debt

SpendSpend SavingSaving

INVESTMENT EXPENSES:Positive point:- Economic development and diversification

Negative aspects:- Poor technical capacity- Fruitlessly projects- Inflation

INVESTMENT EXPENSES:Positive point:- Economic development and diversification

Negative aspects:- Poor technical capacity- Fruitlessly projects- Inflation

Consumption expenditures:

Positive point:- Short-term poverty reduction

Negative aspects:- Import dependency- Inflation- Loss of competitiveness- Dutch disease

Consumption expenditures:

Positive point:- Short-term poverty reduction

Negative aspects:- Import dependency- Inflation- Loss of competitiveness- Dutch disease

Permanent Income Principle:

Ending the oil wealth into financial wealth of unending

Permanent Income Principle:

Ending the oil wealth into financial wealth of unending

The principle of non-oil budget deficit (MTEF)The principle of non-oil budget deficit (MTEF)

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Adoption of a Medium-Term Fiscal Framework (MTFF)

Medium-term fiscal framework is a mechanism for setting multi-year objectives for one or more fiscal aggregates and ensuring that they are respected in budget formulation, approval and execution.

Linking annual budget to long-term policies and sustainability objectives – performance budgeting

Integrated medium-term macroeconomic projections Aggregate fiscal targets, target for the non-oil fiscal deficit based on

stabilization and sustainability goals Administrative capacity building – Public Financial Management Systems to

ensure the quality of spending

What do MTFFs try to achieve?Systemic problems in fiscal policy

a. Time-inconsistency

b. Short-sightedness

e. Asymmetric info

c. Collective action

d. Principal - agent

f. Exogenous shocks Sound policies are blown off course by unexpected events

Policymakers and budget agentshave different incentives

Policymakers hide consequences of their policies from the public

Policymakers favor sectional over collective interests

Policymakers’ ex ante intentions differ from their ex post incentives

Policymakers discount long-term consequences of current policies

What are their constituent parts?Key MTFF components

a. Time-inconsistency

b. Short-sightedness

e. Asymmetric info

c. Collective action

d. Principal - agent

f. Exogenous shocks f. Fiscal Risk Management

d. Budget Execution Controls

e. Transparency

c. Top-Down Budgeting

a. Fiscal Objective/Target/Rule

b. Medium-termBudget Framework

What are the key design issues?

Characteristic Rationale Good Practice Bad Practice

Medium-term horizon

• Separate fiscal policy and budget decisions

• Flexibility to deal with volatility or shocks

• Over the cycle (UK)• Over the Parliament

(NL)

• Annual deficit ceiling• Debt reduction path

Comprehensive in scope

• Limit scope for burden shifting

• General govt (SGP)• Public sector (UK, NZ)

• Budget• Central Govt

Binding on outturn

• Reduce optimism bias in forecasts

• Ensure deviations are made up in future

• “Debt brake” rule (Swiss)

• Maintain debt below 40% of GDP (UK)

• Aim for balance over the forecast horizon

• Real expenditure growth targets

Stable over time• Build public support• Raise reputational cost of

breaking the rule

• Procedural FRLs (Aus, NZ)

• Frequent revision to numerical rules

Precise & transparent

• Provide clear guide for policy-making

• Facilitate evaluation of compliance

• 1% surplus over the cycle (Sweden)

• Increase net worth over time

Fiscal, Budgetary and Expenditure MTFThe three major objectives sought by medium-term frameworks are macro-fiscal discipline and stability, strategic allocation of resources (allocation efficiency), and technical efficiency (reduce the waste of resources).

Level Projections

      

MTEF

    

MTBF

  

MTFF 

GDP projections

Inflation projections

Aggregated ExpenditureProjections

Aggregated IncomeProjections

  Expend. Projections byAdministrative Unit

Expend. Projections byFunction

Disaggregated IncomeProjections

  Expend. Projections byProgram

Results Projections

Macro-Fiscal Framework on a basis of MTF 

Flexible IT regime

Anchor:Non-oil fiscal deficit

Expenditure projection

Sector limits

Medium term strategic priorities

Macroeconomic framework

Organization limits

MTF

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Revenue

projection

Thank you for your attention!