1. The George Washington University School of Business Department of Finance Fakhri Ismayilov, PhD Long-term Fiscal Sustainability in Azerbaijan: Current issues and Post-crisis Challenges Fulbright Scholar

2.  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

3.  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 Theme 3

4.  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)“. 4 The main purpose of the paper

5. The structure of budget revenues In recent years, an average of 60% of the budget expenditure is financed through oil revenues. 5 Oil revenueNon-oil revenue Budget revenue,% Oil price and budget expenditure Budget expend.growth,% Oil price

6. 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) 6 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,%

7. Economic growth 20042005200620072008 GDP, %10.226.434.525.010.8 Oil sector, %3.066.363.136.87.0 Non-oil sector, % 13.68.311.811.415.7 GDP per capita, $ 10601600250839065404 7 Government expenditure has a significant impact on economic growth. Aggregate demand,% (non-oil sector) Public demandPrivate demand

8. Non-oil budget deficit and exchange market 8 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 supplyNet demand of exc.market Net central bank intervention

9. 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. 9 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.scAnnual inflation, right sc.

10. 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.PIOil 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

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

12. Regulation of the non-oil fiscal deficit – Model for the use of oil revenues AIOC SOCAR OIL FUND Consolidate Budget The remaining profit Financing of non-oil fiscal deficit Transfer Profit oil 12 Taxes Permanent income

13. The mechanism of using oil revenues on the basis of PI 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 Spend Saving 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) 13

14. 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

15. 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 agents have 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

16. 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-term Budget Framework

17. What are the key design issues? CharacteristicRationaleGood PracticeBad 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

18. Fiscal, Budgetary and Expenditure MTF The 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). LevelProjections MTEF MTBF MTFF GDP projections Inflation projections Aggregated Expenditure Projections Aggregated Income Projections Expend. Projections by Administrative Unit Expend. Projections by Function Disaggregated Income Projections Expend. Projections by Program Results Projections

19. Macro-Fiscal Framework on a basis of MTF Flexible IT regime Anchor: Non-oil fiscal deficit Expen diture projec tion Sector limits Medium term strategic priorities Macroeconomic framework Organization limits MTF 19 Revenue projection

20. Thank you for your attention!