Azerbaijan is considering borrowing $4bn from international financial institutions (IFIs) to help balance its budget this year, but why would a country that sits on up to $39bn worth of combined reserves (held in the sovereign wealth fund Sofaz and the central bank) seek international help?

A team from the International Monetary Fund (IMF) and the World Bank (WB) is currently on a working visit in Baku to discuss loans worth $3bn and $1bn respectively. Finance Minister Samir Sharifov denied on January 28 that his government was in need of urgent financing, insisting that the IMF-WB visit would focus on ways to "improve management, liberalise the economy, and improve the business climate", according to Bloomberg.  

It is true that President Ilham Aliyev’s regime has been talking about using external borrowing to cover its 2016 budget deficit since at least September 2015, when the Ministry of Finance drafted the 2016 budget law and listed “privatisations, foreign and domestic borrowing, foreign grants, and the treasury" to cover the then-forecast $1.6bn budget deficit.

But things have changed for the worse since September, and the deficit will likely end up being at least double Baku's forecast. For starters, oil, which accounts for 90% of Azerbaijan's exports, some 70% of budget revenues and more than 30% of GDP, has declined by $20 a barrel to under $30 a barrel in the last five months. Meanwhile, the Central Bank of Azerbaijan (CBA) burned through $8bn worth of reserves in 2015 in a failed attempt to prop up the manat.

On December 21, with some $5bn left in its warchest, the central bank finally gave up the fight; the manat promptly devalued by 50%, sending prices of food staples skyrocketing. Faced with higher prices, and unemployment as high as 90% in some provinces, citizens began to protest, a highly uncharacteristic manner of expression in a country that Freedom House deems "not free".

In response, Aliyev’s regime promised a swathe of social reforms that it could not possibly afford at the current oil prices, revealing just how terrified it was of social instability. From capping the price of bread to increasing pensions and salaries for public servants and promising more jobs and regional development projects, Baku stopped at nothing to keep its electorate off the streets. It also appears to have scrapped early plans for a $5bn austerity programme aimed at reducing the size of its bureaucracy (an obvious way to save money, given that the government accounts for some 55% of total employment), and instead promised to create thousands more government jobs.

Aliyev’s opaque regime would normally turn to its very own rainy-day fund Sofaz to plug the budget holes, rather than accept the increased transparency and (real) economic reforms that the IFIs will ask for, so what has gone wrong this time?

The problem might be that Sofaz is simply not very liquid. Set up in 1998 to promote the "development of advanced areas and implementation of projects of social-economic importance", Sofaz boasted assets worth $34.7bn at end-2015, down from $37bn a year earlier.

Azerbaijan is a candidate country to the Extractive Industries Transparency Initiative (EITI) - it used to be a full member, but was downgraded in 2015 over Baku's human rights record - and Sofaz's reports should therefore be compliant with EITI standards. However, its yearly report for 2014, the most recent published, does not fully disclose where most of the fund's assets are stored.

Baku gives statistics about the distribution of assets - 87.5% of which were in fixed income, 6.5% in equity, 2.9% in real estate, and 3.1% in gold, as well as its sources of revenue, and programmes that it financed. More than 40% of its fixed income was invested in corporate bonds, while the remainder was spread among financial bonds (17%), agencies and international organisations (14%), short-term commercial paper (7%), securities (6%), and depots and cash (9%).

In line with its strategy to "obtain reasonable returns while minimising the probability of substantial losses", Sofaz spread its assets in various currencies, including the dollar (50%), euro (35%), pound (5%), ruble, and Turkish lira. Geographically, 51.7% of its assets were invested in MSCI-approved European bonds, 24% in North America, 13.5% in Asia, 1.2% in the Middle East and 3.2% in Latin America.

It also claims to have used a number of investment managers, including the World Bank Treasury ($223mn), Deutsche Bank Advisers ($99mn), UBS Asset Management ($664mn), and State Street Global Advisers ($662mn).

With less than $4bn in deposits and cash at end 2014 – a large part of which must have been used to cover the 2015 budget deficit and to intervene in the foreign exchange market to prop up the manat – Sofaz is simply probably not liquid enough to cover this year's budget deficit. bne IntelliNews asked Sofaz about the possibility of monetising some of their other investments but did not receive an answer in time for publication.

Sofaz could presumably sell some of the 87.5% in fixed income assets, but it might not want to if the IFIs provide loans at low interest rates, a source in Baku told bne Intellinews. That theory would hold if Sofaz' return on its portfolio was higher than the 1.5% it recorded in 2014, or the 1.4% average it posted for 2010-2014.

Some observers are also sceptical about Sofaz's investments, particularly those in real estate, speculating that Baku might have overvalued the cost of its investments in order for some corrupt officials to take a cut from the oil fund's investments. While that scenario is likely in light of the pervasive corruption in Azerbaijan, it is hard to prove.

Logical development

The key question is how much money will Azerbaijan actually need in 2016. Azerbaijan produces roughly 800,000 barrels of oil a day. If the oil price averages $37 a barrel in 2016, as the World Bank forecasts, and Azerbaijan sticks to the expenditure outlined in the 2016 budget law – which is doubtful because of the flurry of additional social benefits it has subsequently committed itself to – Baku would need to borrow at least $3bn to cover its most basic budget needs. This calculation assumes that Socar's oil production cost estimate of $20 a barrel is accurate.

However, it is only January, the price of oil remains significantly under $37 a barrel, and the cost of stability in Azerbaijan will likely increase during the remainder of the year, especially as banks start to close down and Baku finds itself having to reimburse customer deposits and write off bad loans, which are rampant in the banking sector.

Meanwhile, preventing further devaluation and inflation amidst pervasive mistrust of the national currency could cost CBA most of its remaining foreign exchange reserves this year, even after Baku imposed capital controls to prevent forex flight. So far in 2016, CBA has held forex auctions three times a week, during which it put $200mn up for grabs for local banks. At this rate, it is only a matter of time before the regulator runs out of reserves.

As such, $3bn appears to be the absolute minimum required at this point, and it is a "positive [development] that [Azerbaijani authorities] are getting the IMF in at a relatively early stage to try and manage through the on-going exchange rate and banking crisis driven by the drop in oil prices", Tim Ash of Nomura writes.

But he points out that for Aliyev, applying for IFI support has definite drawbacks. “The problem with IMF financing is that it would come with conditionality, in terms of really improving transparency in the banking sector, and more broadly in the economy...The Aliyev regime is not quite ready to fully let go of all the levers just yet, and likely thinks Sofaz still has plenty of domestic financing options," he wrote in a January 28 email comment. 

Yet insiders argue that Baku's commendably low debt to GDP ratio of 12.5% mean that, even if it reaches a deal with the IFI’s, they will not be able to force the Aliyev regime towards deep reforms, such as combating corruption, increasing transparency, enhancing economic diversification, and eliminating monopolies in sectors such as retail, agribusiness, and finance.

"This [loan] is not a bailout , because Azerbaijan has very low debt levels,” a Baku-based source told bne Intellinews. “It is just a loan. The IMF's leverage over a country with such a low debt to GDP level is limited. Besides, Baku has signed loan agreements with many institutions before, took the money and did what it pleased with it, disobeying the terms of the agreement," the source added.