Clare Nuttall in Almaty -

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After a long wait, foreign investors in Azerbaijan are reporting signs of a new political will to reform two key areas, fighting corruption and developing the local capital markets - both of which should help the oil-rich economy to diversify. The financial sector remains the easiest way for foreign investors to access the market, but other sectors including IT, tourism and agriculture also look promising.

One of the most important weaknesses that the government is trying to address is corruption, which has been a major limiting factor on both domestic and foreign investment. Transparency International put the country in 134th place on its ranking of 178 countries in October. On January 27, officials announced a no-tolerance policy for graft and several local investigations were launched, leading to dozens of state employees being fired, ranging from the head of Azerbaijan's penitentiary service to several officials from the powerful Ministry for State Emergencies.

Clearly, the launch of the new anti-corruption initiative was in response to the wave of protests in the Middle East and North Africa, and the fear in government circles that revolutionary fever could also sweep through Azerbaijan. The Azeri opposition has tried to emulate these efforts but so far with little success. Two recent protests organised via social networking sites were broken up almost as soon as they started, while a third, planned for April 16, was thwarted from the outset by the police and security forces.

Observers say that the anti-corruption campaign is proving to be more than just empty rhetoric. "The initial reaction was scepticism, but we have seen some progress already at lower levels of government," says Clemente Cappello, CEO of Caucasus and Central Asia-focused Sturgeon Capital. "President Aliyev has since taken a stand against the monopolies within the Azeri economy. It's not yet clear whether there will be real action in this area, but acknowledging the problem is the first step."

A second area that has long been of concern to investors is Azerbaijan's stock market. The domestic capital market is under-developed and, aside from the bond market, is lacking in activity. The technical changes that need to be made are relatively straightforward, and include changing some laws and removing the capital gains tax, but until recently the political will for reform had been lacking.

Now this too has changed. The World Bank on March 17 approved a $12m loan to support the Capital Markets Modernisation Project in Azerbaijan. This is intended to improve access to finance and contribute to faster economic growth of the non-oil economy. "The government is currently going through its internal approval process. We hope the agreement will be signed in May and the project will become effective soon after that," World Bank spokesperson Saida Bagirli tells bne.

Observers say these changes will undoubtedly help diversify the oil and gas-dominated economy, but even before that Azerbaijan was experiencing increasingly strong growth outside its energy sector.

Model country

The fastest-growing economy in the world in the mid-2000s, Azerbaijan was never going to sustain such growth, stemming as it did from such a low base. Even so, Azerbaijan managed to maintain steady growth throughout the crisis, and GDP was up by a healthy 5% in 2010. This is expected to decline to 2.8% in 2011 and 2.5% in 2012, according to the International Monetary Fund.

The latest IMF report from Azerbaijan points out that, "Non-oil economic growth was strong in 2010, largely spurred by high public investment spending." The European Bank for Reconstruction and Development (EBRD) also reports the potential of sectors outside of natural resources, forecasting 12-14% growth in the non-oil sector this year.

However, Azerbaijan remains an oil and gas related economy and is likely to remain so for the near future, says Cappello. "A lot of the growth in the coming years will come from gas projects. The country will be fine following this model for the next five to ten years; after that it is harder to say," he says. "The big question is whether Azerbaijan will become another Kazakhstan, or follow the Gulf state model. We are getting mixed messages at the moment."

Statistics also show some success in diversification. For example information and communications technology, or ICT, is being vaunted as the hot new sector, having grown an average of 30-35% a year during the last seven years. The sector attracted $1.5bn of investment over the last six years, 21% of which was from abroad, Azerbaijan's Deputy Minister of Communication and Information Technologies Elmar Valizadeh told a recent investment summit in Baku, APA reported.

"The government has launched a number of measures to promote the non-oil sector of the economy, including launching a fund to support banks' lending to SMEs," Samir Huseynov, chairman of the board at Texnikabank, tells bne. "We need to achieve growth outside the oil sector in order to avoid the 'Dutch Disease'. Azerbaijan is richly endowed with natural resources, but also has great potential for agriculture and tourism, the IT sector is growing, and manufacturing is picking up recently."

The financial sector is already the best way for international investors to get exposure to the Azeri market, according Sturgeon Capital's Cappello. The sector remains relatively untapped, apart from commitments by a couple of investment funds and international financial institutions such as the EBRD and the International Finance Corporation. Nor has the sector seen an influx of international banks, although more are expected. "The financial sector is a good place to get exposure to the Azeri market. It is an investor friendly sector, and as yet the level of external financing is low. There are good prospects for the sector, although with 42 banks in a small economy, some consolidation is expected," says Cappello.

Azerbaijan's financial sector compares favourably with that of Kazakhstan, which suffered terribly during the crisis. While Kazakh banks had rushed to borrow on international credit markets, exposing them to the crisis, their Azeri counterparts remained quietly dependent on local funding. This has resulted in a sector that is still relatively small compared with the size of the economy - the ratio of bank assets/GDP is just 26% - but without the overhang of bad debts that other countries' banking sectors are still struggling with. Texnikabank's Huseynov says that the proportion of foreign borrowing by Azerbaijan banks was only at 17-18% as of the end of last year. However, this situation is set to change in 2011, with several banks including Texnikabank, International Bank of Azerbaijan (IBA) and Pasha Bank considering tapping international capital markets.

Huseynov says there is considerable scope for expansion. "For Azerbaijani banks, there are two drivers for growth. First, the expansion of banks' funding bases, allowing them to increase lending. Second, the government strategies to encourage cashless transactions," he says.

Texnikabank has declared 2011 as the year of plastic cards, and is concentrating on projects for Visa and Mastercard. Meanwhile, Azerbaijan's largest bank, IBA, announced in April that it has launched a new scheme to allow drivers to pay their traffic fines by card through POS terminals being set up in State Traffic Police checkpoints and vehicles. IBA substantially expanded its electronic banking channels in 2010.