Heiner Klemm in Baku -

All the natural resource rich countries in Central and Eastern Europe are trying to diversify their economies, but with the twin ills of massive petrodollar inflows and a largely bucolic population, Azerbaijan probably has the hardest task on its hands. The state's answer has been to target investments that would diversify the economy away from the extractive industries as quickly as possible.

Of all the CIS countries, state spending on economic diversification has been growing the fastest in Azerbaijan. Thanks to huge oil revenues, the state runs a healthy budget surplus. But if this money is excluded from the government's income, then the state actually ran a budget deficit of 32.6% of GDP in 2006.

To reengineer the economy, which grew at a blistering rate of 24.7% in 2007, the government needs to pull off the trick of making the most effective use of its "black gold." BP estimates Azerbaijan's proven oil reserves at 7bn barrels at the end of 2005, or 0.6% of the world's reserves, which is comparable to the proven reserves held by Oman or Sudan. Azerbaijan also has proven gas reserves of around 1.4 trillion cubic metres (cm), making it a top-five global producer. Most of future output growth will be driven by the giant Shah Deniz gas field, which began commercial gas production in December 2006 and is estimated to hold recoverable gas reserves of 420bn cm, making it one of the world's largest gas discoveries of the past 20 years.

According to analysts, the country's oil production is expected to peak at around 63m tonnes per year in 2009-2010, followed by a gradual decline from 2011-2012. The next peak in Azerbaijan's oil and gas sector will come in 2012 when the second phase of development of the Shah Deniz gas field comes on stream, with forecast annual gas production of between 30bn and 40bn cm.

The oil sector accounts for about three-quarters of industrial production, so it's not surprising the investment profile has been very lopsided until now. The completion of key energy export pipelines in 2005-2006 marked a significant milestone in Azerbaijan's economic development. With the Baku-Tblisi-Ceyhan (BTC) oil pipeline starting deliveries in mid-2006, the necessary infrastructure is in place for Azerbaijan to become a major oil exporter.

But while oil production ballooned in 2006, non-oil industrial production was up by only 7.5%, while agricultural production grew by only 1%, according to the European Bank for Reconstruction and Development (EBRD).

Azerbaijan Investment Company

Azerbaijan's track record on implementing structural reforms has been pretty mixed. According to the EBRD, it has made good progress with price liberalization and the privatization of small-scale enterprises compared with other transition countries. However, now the big-ticket investments into the oil industry are well in hand, the government is turning its full attention to the non-energy sectors. Last year, the government grasped the nettle and launched a battery of programmes designed to promote the traditional sectors of the economy.

Leading the charge is the Azerbaijan Investment Company (AIC), which was set up by presidential decree last year with $100m in capital. A state-owned agency, the AIC works like a domestic development bank. "This was a very important step to encourage and support the non-oil sector," says Anar Akhunov, the AIC's director. "The company is limited to committing a maximum of 20% of its capital in any one project and cannot take a majority stake. The plan is to promote and support private business and eventually exit via an IPO, management buyout or sale to a strategic investor."

Akhunov says the AIC is actively looking for foreign partners to come in as co-investors on projects in a variety of sectors like agriculture, telecommunications, and textiles, amongst others. He is also looking for investors in the AIC's bonds which will be issued to finance more development work.

At the same time, the government recently signed off on laws to create Special Economic Zones (SEZ) that will provide tax breaks and other incentives to companies setting up in targeted industries.

Other initiatives include the National Fund to Support small- and medium-sized enterprises (SMEs), an export promotion agency, and a state mortgage fund to provide financing for banks lending to homebuyers.

All these programmes are being led by the state, but the government has tried to force the private sector to reform by making use of market forces. For example, last year energy tariffs were tripled to force Azerbaijanis firms to curb their wasteful use of energy, and now the state is preparing to open up the power sector to foreign investors. "The strategy is to open the power sector to foreign strategic investors. There is a pilot project to set up an independent power station, which will take time to do. These sorts of changes often face resistance to the restructuring the power sector, but the work has stared," says Aygen Yazikogul, the head of the EBRD's office in Azerbaijan, which has so far committed a total of $1bn in investments to the country.

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