Using oil revenues effectively in Azerbaijan

The rapid increase in oil production and the rise in prices for this oil have ensured that Azerbaijan has posted the sixth consecutive year of double-digit growth.  GDP expanded by a record 34.5 percent in real terms in 2006 (the last year for which complete data are available), the highest growth rate in the world for the second year in a row.  Although oil and gas are responsible for most of this growth, non-hydrocarbon sectors of the economy are still growing fast as well, by 11.2 percent in the same year.  

Moreover, the medium-term outlook for the economy is positive, with GDP growth expected to continue to be at the double-digit level for the next few years, even though foreign direct investment is expected to decline as major oil and gas projects move into less intensive stages of development.  At least some of that decline, the Azerbaijan government plans to compensate for by increasing its spending on the economy.  But many in Baku are concerned that Azerbaijan's dependence on oil and gas sales could put the country at risk.  And they argue that Baku must develop the non-oil sector even more rapidly than it has done up to now. 

The challenge for Baku is to find a way to make use of the revenues from the sale of hydrocarbons to develop other parts of the economy, a challenge that until the post-1991 period Azerbaijan had little experience in dealing with.  The country now has an Oil Fund which collects much of the revenue and oversees its disbursement.  But deciding how to do so, and especially how to balance short-term versus long-term investments is one of the most difficult policy choices Azerbaijani officials now face. 

 

This fund was established eight years ago, but even now, there are no transparent resource management principles to ensure that the fund's managers serve the needs of the economy as a whole.  There is no general strategy and no criteria to measure the effectiveness of its investments.  That has led some to suggest that the Oil Fund should be disbanded because theoretically what it does could be done by others.  The central issue is whether the fund can give a privileged status to certain revenues and investments or whether some other agency might perform that function more effectively.  But many believe that the primary virtue of the fund is its ability to serve as a single institution that can at least partly sterilize the economy from the oil money and thus help the country avoid what some have called the oil curse, a problem that the Azerbaijan government has officially acknowledged.  

Just how important that is can be seen from the amounts of income and expenditure projected over the next six years, the period when Azerbaijani oil and gas production is likely to peak (see Table 1 in the PDF version). 

  

Thus, it is clear that oil and gas are short-term assets while the fund itself is a long-term one.  And consequently, the fund should behave as if there is no oil at all.  That is what the Norwegian Pension Fund has done, and Azerbaijan's Oil Fund must be at least as efficient in isolating oil revenues from society and using them efficiently at the same time.  Why at least?  Because, the fund may also generate money and that money can be partially accumulated in the fund.  Were there no Oil Fund, the economy would survive but not do nearly as well as it could with fund investments. 

The Fund's basic challenges are to decide whether to transfer money to the budget and how to use the money that it does not transfer.  The principles of the modern finance can be applied to develop the best investment strategy.  Diversity, of course, is the best way to lessen risks, but it works only if there is a realistic and prudent approach for each investment decision.  In addition, non-transparent management is likely to lead to satisfying behavior and inefficient decisions.  All of these principles can be derived from the experience of other oil and gas exporting countries.  

Table 2 (see the PDF version) compares the growth of expenditures in several countries.  “After the boom” is a relative terminology, since the countries in the list still produce oil, and here the boom refers to the rise in the production, but not to the production itself.   

  

Norway's approach is generally considered to have been the most successful in making use of oil money to develop the entire economy.  It established the Petroleum Fund, the prototype of the Oil Fund in Azerbaijan in which Oslo accumulated all the oil money.  This money was then invested in bonds and corporate equities to generate the more stable income independent on the rate of the current oil production in the country.  Later the fund's functions were integrated with the national insurance scheme, and the fund continued to function as the Pension Fund.  But even after this change in name, Oslo's strategy of sterilizing the economy form oil money remained in place. 

Most studies conclude that the budget in the oil-producing countries depend on the oil prices in the international market, thus the Oil Fund needs to include the stabilization function, i.e. filling the budget deficiencies in the recession years.  This paper argues, however, that it is not the oil price but overall oil revenues that matter (the latter includes many other factors, such as the amount of oil production) for the decisions between the budget and the fund, and that it is not the budget but overall income that depends on oil revenues; budget often as a result of political processes and decisions is linked to short-time oil revenues, but the fund can eliminate that link and make it dependent on the long-term and secure incomes. 

If that is recognized then it becomes obvious that the Oil Fund needs to develop instructions, guidelines and standards for portfolio investments and for transfers to the state budget.  Such a strategy will improve management, prevent the rise of populist policies, and reduce corruption.  And at the same time, this commitment to transparency will guarantee that the fund will help promote the sense of ownership among the broader population that will help to support the rise of democratic forms of governance.