Azerbaijan banks on a Dutch Disease cure

By bne IntelliNews June 8, 2007

Ben Aris in Kazan -

Robust economic growth is nothing unusual in the emerging markets of Southeast Europe, but when trying to describe Azerbaijan's 34% GDP growth last year there is not more to say other than Azerbaijan has the fastest growing economy in the world - with bells on.

Mikayil Jabborov, deputy minister for Economic Development and head of the Azerbaijani Investment Company (AIC), chose to simply describe his country's growth as "phenomenal" at the Azerbaijani country session during the EBRD annual meeting in May.

Home to the world's third-largest oil deposits after the Middle East and Russia, hydrocarbons are responsible for most of this growth. The oil sector accounted for three-quarters of industrial production and 93% all exports in 2006, while non-oil industrial production was up by only 7.5%, and agricultural production grew by only 1%, according to the EBRD.

The top-heavy economy, still largely under the control of the state, and rising oil prices have given Azerbaijan a bad case of the Dutch Disease, where incoming petrodollars is sending the value of the local currency, the manat, skyward and stoking inflation to an extent that it's making the rest of the country's industry uncompetitive.

Inflation was running at 16.6% in the first quarter of 2007, up from 11.4% at the end of 2006, and has been increasing every year for the last three. The state is making the problem worse by pouring money into new infrastructure projects, with the state spending up 80% at the start of this year year-on-year. Analysts say the government's hopes to bring the rate down to 9% by the end of this year are likely to fail.

"Azerbaijan has weak institutions but a strong state," says Ed Parker, head of the rating agency Fitch's sovereign ratings team. "There is a weak judiciary and a difficult business environment. At the same time the huge inflow of petrodollars means the currency is appreciating rapidly, which is making life even more difficult for the private sector. It is encouraging that the government has move to diversify the economy, but the government has find the right balance between meeting the investment needs and running a tighter fiscal policy."

Still, the government is not blind to the problems and all this spending is designed to rapidly diversify the economy. The government has rolled out a raft of initiatives to help the anaemic small and medium-sized enterprise segment with initiatives such as Special Economic Zones and the state-owned Azerbaijan Investment Company, a sort of domestic EBRD-cum private equity firm with $100m in capital.

More immediate relief is being provided from a Stabilisation Fund into which excess oil revenues flow, which goes some way to sterilising the inflows; the oil fund has grown from $1.5bn at the end of 2005 to $10bn at the end of last year.

Banking interest

State spending on infrastructure is only one side of the coin; for SMEs to flourish they need money and probably the most encouraging development in the last few years has been a financial sector lift-off.

Like everywhere else in the region, Azerbaijan's banking sector saw assets soar, rising by 60% last year alone. Most of the country's 44 banks are concentrated in the capital Baku, but in 2006 they began to move into the regions as growth of retail banking draws them into the open market and competition.

The government has also introduce a swath of reforms to push development along. There are too many banks in this small country of 8m people so last year the central doubled the minimum capital requirements for banks to $10m hoping to spark a wave of consolidations.

"The idea was to try and push banks towards consolidation via mergers, but all that happened was all 44 banks met the increased capital requirements," says Elchin Gadimor, chairman of Rabitabank, the 14th largest bank in the country. "The thing is that all Azerbaijan's banks are growing so fast, no one is ready to sell out yet."

The bank sector is dominated by the state-owned International Bank of Azerbaijan (IBA), which has capital of about $2bn, over six-times more than the second largest bank in the country. But this behemoth is increasingly seeing its once virtual monopoly being whittled away by the burgeoning commercial banks: IBA's share of the total credit portfolio has fallen from 80% a few years ago to 45% now.

The state is starting its privatisation of the banking sector and the first to go under gavel will be Capital Bank, the third largest bank in the country which has a large retail network. The government will sell off half the bank in a series of five auctions for 10% chunks of its capital and is hoping to attract strategic foreign investors for the know-how that they can bring.

As public confidence in the banking sector increases, a lot of "mattress money" has been deposited in the banks, providing the main source of banking capital. Confidence will be further boosted in January when a deposit insurance scheme comes into effect, that guarantees the first $4,000 of depositors' money against bankruptcy. With a retail-credit-to-GDP ratio of only 10%, against the 40-50% rate in industrialised countries, the bank sector clearly still has a lot of growing left to do.

With so much potential upside, foreign banks are circling the market and are expected to enter soon. Russia's VTB, Kazakhstan's Bank TuranAlem and France's Societe Generale are all taking a hard look at the market now.

"Each of these banks are by them selves bigger than the whole of Azerbaijan's banking sector, so the local banks will be under tremendous pressure if they come in," says Gadimor.

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