Scholarly article on topic 'Fiscal sustainability and the State Oil Fund in Azerbaijan'

Fiscal sustainability and the State Oil Fund in Azerbaijan Academic research paper on "Economics and business"

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Abstract of research paper on Economics and business, author of scientific article — Kenan Aslanli

Abstract Azerbaijan, like many resource-rich countries, decided to set up a sovereign wealth fund in order to avoid income volatility, to achieve intergenerational equity and to transform resource wealth into more productive assets. Azerbaijan established the State Oil Fund of the Azerbaijan Republic (SOFAZ) in late 1999 to accumulate income from hydrocarbon exports. SOFAZ has gradually become the leading part of the country's public finance system. Azerbaijan was the first country to fulfill all requirements of the Extractive Industries Transparency Initiative (EITI), an international agreement to implement global standards of transparency in the resource extracting sectors. However, SOFAZ's contribution to an effective resource revenue management and long-run economic development is still questionable: transparency applies only to the income side of Azerbaijan's oil fund while the expenditure side remains opaque. Unlimited and unconditional transfers from SOFAZ to the state budget have threatened fiscal sustainability and the overall macroeconomic equilibrium.

Academic research paper on topic "Fiscal sustainability and the State Oil Fund in Azerbaijan"

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Fiscal sustainability and the State Oil Fund in Azerbaijan*

Kenan Aslanli*

Public Finance Monitoring Center, Beshir Seferoglu Street 122, AZ1009, Baku, Azerbaijan


Azerbaijan, like many resource-rich countries, decided to set up a sovereign wealth fund in order to avoid income volatility, to achieve intergenerational equity and to transform resource wealth into more productive assets. Azerbaijan established the State Oil Fund of the Azerbaijan Republic (SOFAZ) in late 1999 to accumulate income from hydrocarbon exports. SOFAZ has gradually become the leading part of the country's public finance system. Azerbaijan was the first country to fulfill all requirements of the Extractive Industries Transparency Initiative (EITI), an international agreement to implement global standards of transparency in the resource extracting sectors. However, SOFAZ's contribution to an effective resource revenue management and long-run economic development is still questionable: transparency applies only to the income side of Azerbaijan's oil fund while the expenditure side remains opaque. Unlimited and unconditional transfers from SOFAZ to the state budget have threatened fiscal sustainability and the overall macro-economic equilibrium.

Copyright © 2015, Asia-Pacific Research Center, Hanyang University. Production and

hosting by Elsevier Ltd. All rights reserved.


Article history: Received 27 August 2014 Accepted 11 March 2015 Available online 2 April 2015


Sovereign wealth funds Fiscal sustainability

State Oil Fund of the Azerbaijan Republic

1. Introduction

Resource-rich countries encounter specific challenges such as intergenerational equity of resource distribution, long-term macroeconomic stabilisation and fiscal sustainability. Institutional responses to the specific fiscal challenges in oil-exporting countries included conservative oil price assumptions in the budget, the establishment of oil stabilisation and savings funds and fiscal rules.

Oil and gas producing Azerbaijan, like many resource-rich countries, decided to set up a sovereign wealth fund (SWF) in order to respond to fiscal challenges, to avoid

* This work has been carried out as part of the research project on domestic discourses and foreign policy-making in the Caspian region with financial support from the Volkswagen Foundation (Germany).

* Tel.: +994 50 5813630.

E-mail address:

Peer review under responsibility of Asia-Pacific Research Center, Hanyang University.

income volatility, to achieve intergenerational equity and to transform resource wealth into more productive assets. To realise these goals the fiscal sustainability of such a SWF is of great importance. Fiscal sustainability is given when total public spending equals non-oil revenues plus the return on the present net value of future oil revenues. Oil-rich countries can achieve fiscal sustainability if they develop a fiscal system able to generate enough oil-related revenues to finance the non-oil budget deficit in the longrun.

Azerbaijan established the State Oil Fund of the Republic of Azerbaijan (SOFAZ) in late 1999 to accumulated income from its hydrocarbon exports. SOFAZ has gradually become the leading part of the country's public finance system. But the organizational set up is not the only pre-condition for fiscal sustainability, there is also a need for fiscal policy rules adequately responding to oil price shocks and resulting income volatility. In order to avoid spending inconsistencies and macroeconomic shocks on different production capacity, resource reserves, market price

1879-3665/Copyright © 2015, Asia-Pacific Research Center, Hanyang University. Production and hosting by Elsevier Ltd. All rights reserved.

fluctuations and erratic spending behaviour natural resource-rich countries have to apply diverse fiscal rules.

These fiscal rules play an essential role for the optimal distribution of natural resource revenues. Notwithstanding that the government of Azerbaijan officially adopted the 'constant real expenditures' principle in 2004, in reality unlimited and unconditional transfers from SOFAZ to the state budget have threatened fiscal sustainability, effective revenue management and the overall macroeconomic equilibrium. In recent years, reckless spending by the government and a procyclical fiscal pattern were major factors jeopardizing fiscal sustainability. The lack of effective management of the increasing oil and gas revenues is still one of the major challenges for the government. That is why the main hypothesis of this article is that SOFAZ's contribution to prudent fiscal policies depends on the overall quality of institutions and the public financial management system in Azerbaijan.

A sustainable fiscal policy must take into account the volatile nature of revenues for safeguarding the national economy and the state budget against external shocks and price fluctuations. The aim of this article is to analyse the spending behaviour of SOFAZ and the government in terms of fiscal sustainability throughout the almost 15 years of SOFAZ's existence. This article investigates quantitatively and qualitatively whether the government's spending of oil and gas revenues - especially through SOFAZ - promotes long-term fiscal sustainability. The article starts with a brief outline of main definitions and indicators of fiscal sus-tainability. It then explains the analytically distinct patterns of possible links between fiscal sustainability and SWFs. Different fiscal rules applied in oil-exporting countries like 'permanent income hypothesis', 'bird-in-hand' and oil price assumptions are analysed in regard to their relevance for Azerbaijan. A brief conclusion draws out the implications of the analysis for the future of revenue management policy and fiscal sustainability.

2. Definition and indicators of fiscal sustainability

Sturm, Gurtner & Alegre (2009: 18) describe fiscal sus-tainability for oil-exporting countries as the guarantee that in the 'post-oil period the same amount of public goods or level of expenditure can be provided as in the oil period without resorting to deficit financing of public expenditure.' They distinguish fiscal sustainability and intergener-ational equity, because 'if oil revenues are replaced by tax revenues, this would ensure fiscal sustainability but not necessarily intergenerational equity'. According to the OECD (2009: 86), fiscal sustainability 'encompasses government solvency, continued stable economic growth, stable taxes and intergenerational fairness'. In other word, sustainable fiscal policy is a policy that can be realized without any major changes in tax and spending patterns.1

The development of the primary balance of the state budget (i.e., the difference between primary revenue and primary expenses) is a useful indicator to evaluate fiscal sustainability. Another important indicator is the fiscal gap,

1 See also Schick, 2005.

defined as the 'permanent spending decrease or revenue increase that would be necessary at a point in time to ensure a specified debt-to-GDP constraint is met at the end of the projection horizon' (Bell, Blick, Parkyn, Rodway, & Vowles, 2010: 74).

Validating fiscal sustainability for resource-rich countries requires distinguishing between the resource and non-resource fiscal deficits. The size of the non-resource primary deficit and the rules for allocating current resource revenues from the SWF to the budget are very important for resource-rich countries. Fiscal sustainability analysis for these countries means exploring the influence of the non-resource primary fiscal deficit and SWF allocation rules on the distribution of public debt. In the case of Azerbaijan, the share of external debt stock in gross domestic product (GDP) declined while the share of SOFAZ's transfers to budget increased rapidly.

Generally, the problem of fiscal sustainability is especially severe in resource-rich countries because huge revenue inflows from the export of oil, gas or minerals can lead to an increased dependence on a highly volatile source of income creating two problems: (1) income volatility, and (2) exchange rate distortions by the inflow of resource revenues ('Dutch disease').2 Therefore, high spending of current resource income converts income volatility into highly volatile expenditure with very serious economic consequences.

Despite the fact that there is no commonly accepted unique model of fiscal rules about optimal spending behaviours of governments of resource-rich countries, different applied models have already been analysed and categorized empirically. Iacono (2012: 2) emphasizes that effective fiscal rules should be 'backed by a strong political will and complemented by administrative reforms, also strong costs of deviations from the fiscally responsible behavior'. Robinson, Torvik, and Verdier (2006: 448) point out that one outcome of a resource boom for the resource dependent economies could be 'highly dysfunctional state behavior, particularly large public sectors and unsustainable budgetary policies'.

There are a number of approaches on how to cope with natural resource revenues (cf. e.g., Economic Research Center, 2009). The most widely used approach to managing volatile resource revenues is the permanent income (PI) approach, under which a volatile revenue flow is used to finance a constant stream of expenditure. This approach states that governments should try to smooth out consumption over time in line with permanent income. As a

2 The term 'Dutch disease' broadly refers to the harmful consequences of large, but perhaps temporary, influx of foreign currency into an economy on exchange rates and eventually on trade balances, domestic production, and the availability and costs of credit. A large influx of foreign currency from natural resource exports can have serious repercussions on important segments of a country's economy, as the appreciation of the local currency diminishes the competitiveness of non-natural resource sectors, resulting in their contraction. Real exchange rate appreciation impedes economic diversification and increases dependence on volatile commodity markets, and thus there are likely to be significant adjustment costs in moving back to agriculture or into manufacturing following resource depletion or price slumps (Bornhorst, Gupta, & Thornton, 2009: 439; Davis & Tilton, 2005: 236).

result, government spending financed from oil income should be equal to the current annuity value of expected oil wealth (Segura, 2006). In this concept, after depletion of natural resources, the government will finance its future expenditure particularly based on the gaining from past savings. The main shortcoming of the PI approach is that it disregards future expenditure liabilities related to especially the ageing of population, i.e., increasing pension and health care costs.

That is why some resource-rich countries like Norway have opted for the real income approach — or 'bird-in-hand' approach — which allows consumption only of the resource revenues which have already been liquidated, i.e., the expenditure financed from resource income cannot exceed the investment income of the SWF. States that choose the real income approach convert the income from the sale of natural resources into financial assets and only spend the interest that emanates from these assets. As it has a restrictive nature, this track ensures that actual oil income is kept for the use of future generations. This spending rule is not directly linked to oil price fluctuations, as only the income earned on financial assets is spent. In this case government consumption will be influenced only by changes in accumulated financial assets, not by changes in the current value of revenues.

However, some studies argue that this approach 'is inappropriate for low-income countries [...] rich in natural resources, as it ignores that these countries are both capital and credit constrained' (Baunsgaard, Villafuerte, Poplawski-Ribeiro, & Richmond, 2012: 4).

The third approach adopted in some resource-rich postSoviet countries (e.g., Kazakhstan and Russia) is the long-term price rule where resource revenues are transferred from the SWF to the budget in an amount equal to the revenues generated above a specified long-term price; that is, a long-term price for the exported resources is determined and all export proceeds that exceed that price are transferred from the SWF to the state budget. However, this approach is not sustainable beyond the phase of oil and minerals production. Once resource revenues end, the economy may experience a severe negative shock and debt may increase to compensate for the lack of resource revenues (cf. e.g., Bauer, 2014).

Due to the limited availability of oil, gas, and minerals revenues, intergenerational fairness is a major issue for natural resource exporters. If the highly volatile nature of resource revenues were to translate into highly volatile spending levels and associated volatility of the real exchange rate, the impact would be like a tax on private investment, with negative consequences for economic growth (Van Wijnbergen & Budina, 2011: 662—663). Fiscal policy in most oil-exporting countries has been expansionary over the past years of high oil prices. Fiscal expansion has added to inflationary pressure, and monetary policy has been constrained in tackling inflation as a result of prevailing exchange rate regimes (Sturm et al., 2009: 18). According to Villafuerte and Lopez-Murphy (2010: 4) the degree of pro-cyclicality in fiscal policy is high for low-income countries and conversely low for high-income countries. Frankel (2010: 22) defines one of the crucial reasons for pro-cyclical spending that 'the

government cannot resist the temptation or political pressure to increase spending proportionately'. A widespread institutional solution in oil-exporting countries to promote fiscal sustainability and anti-cyclical fiscal policy is to set up a SWF. But the evidence suggests that SWFs can perform poorly due to low overall institutional quality in the respective country, imperfect diversification of the investment portfolio and poor corporate governance.

3. Fiscal sustainability and sovereign wealth funds (SWF)

SWFs are government-owned investment funds operating in private financial markets; some are funded from fiscal surpluses or foreign exchange reserves, while others are funded through borrowings from the market. Almost half of the existing SWFs operate as separate legal entities, while the rest exists as a dependent entity within the Ministry of Finance or the Central Bank of the respective country. The objectives of SWFs range from fiscal stabilisation to general savings for future generations to covering expected future pension expenditures. Stabilisation and savings funds are common among countries with large natural resource endowments because they are able to mitigate volatile world market prices as well as a fluctuating and/or declining resource production. Savings funds are concerned with intergenerational equity and transfers. Intergenerational equity focuses on benefiting the current and future generations as equally as possible from the country's natural wealth. This may be done by setting up an endowment type fund that converts a finite or extractive asset with an infinite string of financial cash flows to benefit the present and all future generations. In some economies, saving assets abroad in an SWF can assist in mitigating 'Dutch disease' symptoms and related macro-economic consequences. At times, stabilisation funds grow beyond what is needed for stabilisation purposes, especially when prices are amplified up an elongated period, and are consequently redesigned as stabilisation and savings funds.

The coordination of fund operations with the overall national fiscal policy has been difficult because SWFs have not only economic incentives, but also political ones. Funds' top managements have to evade serious fiscal risks for SWFs which will ensue if the government views their assets as free resources to be used ad hoc to cover various fiscal needs (cf. e.g., Public Finance Monitoring Center, Khazar University & Revenue Watch Institute, 2011). Sovereign wealth funds 'are least needed when institutions are strong; but they are least likely to work in precisely those institutionally weak environments where they appear to be most needed'. When policy-makers design natural resource revenue funds they should first consider 'the political incentives in their country, and attempt to design fund rules that not only approximate the optimal fiscal policy, but, more importantly, create political incentives (or at least mitigate political disincentives) for abiding by that policy' (Humphreys & Sandbu, 2007: 226, 227).

In light of this dilemma, the decision whether or not to establish a SWF — and what kind of fund to design — has to be made. A first position claims that SWFs are not

necessary; if the conditions that are required for the successful functioning of these funds exist, then resource revenues or fiscal surpluses can be managed without them within the budgetary process. The second position suggests that even if it is impossible to create ideal conditions, the existence of SWFs could prevent excessive spending. In particular, governance, transparency, and accountability remain important in the areas of macroeconomic development and the design and implementation of fiscal policy (especially in the context of public savings). SWFs can foster the control of revenue management and the prudent intergenerational and intra-generational allocation of the finite national wealth. In macroeconomic terms, strong governance and the provision of adequate transparency and accountability would foster fiscal sustainability of the respective countries, further enforcing their international positioning (Humphreys & Sandbu, 2007: 213).

In order to enable fiscal sustainability, transfers from the fund to the state budget should be guided by the principle of maintaining the real value of government wealth. Deposit and withdrawal rules should be defined by the laws that establish the arrangement. These rules need to be clearly specified, but should also provide some flexibility in case of adverse conditions. They should be defined in line with country needs, and it is important that countries clearly state what those rules are when the fund or account is set up and then abide by them. For instance, stabilisation fund arrangements or accounts are more likely to be needed on short notice, their withdrawals are somewhat more uncertain. For a savings account, the presumption is that withdrawals are predictable and not to be used soon; it should therefore be capitalized second (Ghura et al., 2012).

The asset allocation of the fund should begin with a conservative, very liquid and low-risk, investment portfolio, especially since at first investment expertise may not yet be fully developed. It is important to ensure that the asset allocation strategies of and between various portfolios is flexible enough to ensure that the withdrawals that may be needed for government's liquidity needs can be met without incurring penalising day-to-day borrowing or other financial costs. Withdrawals from stabilisation funds tend to be defined to meet specific budgetary or funding targets. Deposit and withdrawal rules need to be consistent with the objectives of each SWF and the country's use of the fiscal balances, and all expenses should be captured in the budget. Deposit and withdrawal rules are often detailed in the legislation establishing a fund. In trying to delink the fiscal stance from natural resource revenue volatility, the draft legislation setting up the SWF should link withdrawals from the fund to the medium-term fiscal framework (IMF, 2012).

The objectives of the fund need to be aligned with the long-term development vision of the resource-rich country. Integration of resource revenue management through SWFs with fiscal and monetary policy is critical to manage risks and avoid banking crises. Mobilizing fiscal space created by an SWF through public and private investment in the domestic economy is critical for long-term stability and development. Integration with the state budget is necessary to increase transparency and align revenue management with development strategy matters for SWFs.

4. The role of SOFAZ in fiscal sustainability

The State Oil Fund of Azerbaijan, SOFAZ, was established in 1999 and began operating in 2001 with an official, legally extra-budgetary fund status combining stabilization, sterilization and saving functions. SOFAZ's revenues include the proceeds from the sales of Azerbaijan's share in hydrocarbons, transit fees, bonus payments, and acreage fees, revenues from the management of the Fund's assets and other revenues, as detailed for the year 2013 in Table 2.

The Fund has three objectives: (1) preserve macroeco-nomic stability by decreasing Azerbaijan's dependence on oil revenues and stimulate the development of the non-oil sector; (2) accumulate and preserve revenues for future generations; and (3) finance major national projects for socio-economic development.3 Simultaneously, SOFAZ has worked on the implementation of the standards of the Extractive Industries Transparency Initiative (EITI) in Azerbaijan to promote regular reporting and an inclusive approach to transparency rules.4 A significant amount of information is available on the Fund's investments. SOFAZ limits investment risk through strict target asset allocation and a Supervisory Board oversees the Fund's activities on behalf of Azerbaijan's president.5

However, a lack of withdrawal rules, extra-budgetary spending directly by the Fund and a lack of independent oversight have become the Fund's most significant governance challenges.

Financing major national projects to support socioeconomic progress and ensuring intergenerational equality with regard to the country's resource wealth by accumulating and preserving oil and gas revenues for future generations are SOFAZ's main goals. With regard to the first goal, notwithstanding that these funds have been appropriated without parliamentary oversight and that spending is generally non-transparent, the objective has been more or less met. However, the second goal of ensuring the fair allocation of resource wealth across generations has been neglected so far. Priority has been given to spending revenues instead of accumulating or investing them for long-term growth (Tsani, Ahmadov, & Aslanli, 2010). During the years 2001-2013, inflows to the Fund totalled US$101 billion, with 36% representing savings and 64% spending. The Fund has played a considerable role in the process of maintaining fiscal stability. In 2013, transfers from the Fund accounted for 58% of total state budget revenues (State Oil Fund for the Republic of Azerbaijan, 2014: 30-31). As Table 1 indicates for several years in a row more than 90% of the Funds revenues have been transferred to the state budget, i.e., have been spent.

With that the government's rate of spending has violated the principle of saving a minimum of 25% of

3 See 'Mission, goals and philosophy', content/3, last accessed 23 January 2015.

4 Azerbaijan joined the EITI as early as 2004 and is actively working under this framework, which stresses the importance of transparency and accountability issues. Recent assessments have revealed that Azerbaijan is relatively compliant with all EITI principles and so the country became the first full EITI member (Aslanli, 2012: 239).

5 For a detailed description of SOFAZ see Aslanli, 2012.

Table 1

SOFAZ's transfers to the state budget.

Year Transfers to state budget (millions AZN) Growth dynamics Transfers as share in GDP Transfers as share of the state budget Transfers as share of SOFAZ's expenditures

2003 100 — 1.3% 8.2% 41.0%

2004 130 30.0% 1.5% 8.6% 77.0%

2005 150 15.4% 1.2% 7.2% 70.0%

2006 585 290.0% 3.2% 15.1% 59.6%

2007 585 0.0% 2.1% 9.7% 55.1%

2008 1100 88.0% 9.5% 35.3% 88.5%

2009 4915 346.8% 14.2% 47.6% 92.8%

2010 5915 20.3% 15.6% 51.9% 90.5%

2011 9203 55.6% 17.7% 57.3% 93.7%

2012 9905 7.6% 18.3% 57.3% 93.6%

2013 11350 14.6% 19.7% 58.2% 92.3%

Source: State Oil Fund for the Republic of Azerbaijan (2014) Annual report 2013. Baku: SOFAZ, pp. 30—31, pdf; author's calculations.

Table 2

SOFAZ revenues and expenditures (2013, in thousand manats).

Indicators Amount

Revenues 13,600,400.1

1. Proceeds from sales of Azerbaijan's share of hydrocarbons (deducts the costs of hydrocarbons transportation, 13,108,016.4 banking expenses, customs clearances, independent surveyor, marketing and insurance costs, and also exclusive of the

revenues from the SOCAR's share in the projects of which it is an investor, shareholder or partner)

2. Revenues from SOFAZ's asset management 480,559.5

3. Revenues from transportation of oil and gas through the territory of Azerbaijan 8,063.8

4. Bonuses paid by investors when signing and fulfilling oil and gas agreements 1,850.1

5. Acreage fees paid by foreign investors for use of the contract areas for the development of hydrocarbon resources 1,831.9

6. Other revenues and incomes 78.4 Expenditures 12,302,663.5

1. Transfer to the 2013 state budget of Azerbaijan 11,350,000.0

2. Financing of Azerbaijan's share in the construction of the 'STAR' oil refinery complex in Turkey 372,590.0

3. Financing the improvement of the social and economic conditions of refugees and internally displaced persons 299,990.2

4. Financing the reconstruction of the Samur-Absheron irrigation system 173,933.6

5. Administrative expenses of the State Oil Fund of Azerbaijan 47,470.2

6. Financing the 'State programme on the education of Azerbaijani youth abroad in the years 2007-2015' 33,007.8

7. Financing the 'Baku-Tbilisi-Kars railway' construction project 25,671.7

Source: 'Decree of the President of the Republic of Azerbaijan on the Execution of the Budget of the State Oil Fund of the Republic of Azerbaijan for 2013', 22 May 2014,

SOFAZ's revenues envisaged under the 'Long-term strategy on the management of oil and gas revenues', which covers the period 2005-2025 and establishes the principles for the use of oil and gas revenues and the expenditure policy for this period.6 As a result, SOFAZ has played a controversial role in fiscal sustainability in the state economy because the amount of SOFAZ's transfers to the state budget has significantly increased since 2008.

The major areas of spending by SOFAZ, as detailed for 2013 in Table 2, were transfers to the state budget, the funding of social, infrastructure, and human capital development programmes, and administrative expenses. Major national scale projects, various state programmes and infrastructure projects receive financial support simultaneously from both the state budget and SOFAZ's budget which complicates public finance management and jeopardises fiscal sustainability (State Oil Fund for the Republic of Azerbaijan, 2013: 15,18).

6 'Long-term strategy on the management of oil and gas revenues',

approved by decree of the president of the Republic of Azerbaijan No. 128, dated 27 September 2004, pp. 2-3,, last accessed 23 January 2015.

Estimates by the World Bank, consistent with forecasted revenues, show that the level of permanent income that could be spent annually amount to US$7.7 billion (in constant 2007 US Dollars), i.e., 31% of Azerbaijan's 2007 GDP or 69% of non-oil GDP. The share of the state budget financed by petroleum revenues has increased every year since 2007 from 9.7% to 60.5% in 2012. Oil revenues in 2024 will be about US$8 billion less than in 2015. The return on SOFAZ investments is between 0.75% and 4.5%, therefore, the interest does not compensate for significant public spending out of SOFAZ. Non-oil growth in Azerbaijan is as high as 10%, but driven by government expenditure rather than private sector investment and, with declining oil revenues in the near future, is therefore unsustainable (Ibadoglu, Alasgarov, & Bayramov, 2013: 16).

SOFAZ's financial flows are subject to regular and comprehensive internal audits. The supervisory board, consisting of representatives from both the executive and the legislature branch, is appointed by the president to oversee the Fund's activities. It reviews its annual budget, annual reports, financial statements and audits. SOFAZ's finances are also subject to a regular and independent external audit that meets international standards. Funds

are managed separately from the country's international reserves.7

However, common oversight mechanisms or safeguards are not present in Azerbaijan: the parliament has no formal oversight and lacks independence from the executive branch. International oversight institutions, such as the World Bank or the International Monetary Fund, do not routinely monitor the Fund's management; de facto constraints on civil society organizations to advocate freely limit their ability to provide citizen oversight of Fund activities. While much information on the Fund's activities is available, oversight bodies in Azerbaijan are generally not independent, limiting the usefulness of this information for promoting good governance (National Resource Governance Institute & Columbia Center on Sustainable Investment, 2013).

As oil is a finite resource, its exploitation and eventual depletion is worthwhile only if its export proceeds are invested and lead to higher income in the long-run. The question in Azerbaijan is whether resource revenues are spent on projects and in sectors that will lead to higher longrun national income. If not, it may be more beneficiary to save a larger proportion of revenues. After all, if citizens will not benefit from long-lasting roads, electricity, clean water, access to credit, education and health services, not to mention a growing non-oil economy that lifts all boats, then future generations should at least benefit from the financial returns of investing oil revenues. When oil production starts declining and/or global oil prices drop, either the government will be forced to run a budget deficit or draw more funds out of SOFAZ. These options are unsustainable and they could lead to a debt crisis, which would lead to high costs and lower standard of living for future generations, or a return to pre-oil levels of development and poverty (Ibadoglu et al., 2013).

Beyond borrowing and drawing money from SOFAZ, a third option would be to raise tax revenues from the non-oil sector, but to date this has proven difficult since non-oil non-government growth remains weak and non-oil tax revenues linger steadily around 20% of GDP, much lower than the 30—45% in most developed countries.

Not only has the government spent more than it has received, but the share of the state budget financed by petroleum revenues has increased every year since 2007 from 10% to 62%. Few countries in the world are as resource-dependent as Azerbaijan: Over 70% of Azerbaijan's state budget and over 90% of exports come from oil and gas. At expected rates of production and given proven reserves, government oil revenue collection will be half of the US$83.86 billion it is today in just 12 years (World Bank, 2009). Dependency on the oil and gas sector is a particularly severe problem when resource revenues begin to decline permanently after 2014, oil revenues in 2024 will be about US$8 billion less than in 2015.

Increased gas revenues will not cover the loss of oil revenues. This means that without new, large-scale discoveries the government will be hard pressed to finance recurrent or capital expenditures unless tax revenues are raised from other sectors. It is also important to note that

7 Cf. 'General information', idareetme/uemumi-melumat-2.asp, last accessed 23 January 2015.

the asset management practices of the Fund clearly do not exhibit a good track record. Rather, SOFAZ has made a small return on investment, so asset management clearly is not an option when it comes to generating alternative revenues given yields in today's global economy (State Oil Fund for the Republic of Azerbaijan, 2013: 43).

In summary, Azerbaijan's government spends more resource revenues than are saved despite declining revenues in the near future. There is overspending relative to savings and the current level of expenditure growth cannot be supported by actual or projected revenues. Considering the amount of oil reserves, slow growth in the non-oil sector and weak non-oil revenue generation an aggressive budgetary expansion in Azerbaijan cannot be justified. Azerbaijan must learn from the experience of other countries with declining resource bases that have faced tough public spending choices, debt crises and domestic conflict.

5. Fiscal sustainability challenges in Azerbaijan

That means Azerbaijan faces serious risks for its fiscal sustainability in a medium to long-term perspective, influenced by oil price fluctuations and declining production levels of crude oil. Therefore, long-run fiscal sustainability is a critical challenge. Azerbaijan is now encountering the needs to ensure permanent income and a sustainable fiscal policy based on the non-oil budget. There is the need for a comprehensive assessment of fiscal sustainability over the entire time horizon through defining the indicators of public finance sustainability and identifying main risks on this issue. In the 'Long-term strategy on the management of oil and gas revenues' the following principles have been adopted concerning the long-term use of oil and gas revenues:

- 'When forecasting the amount of long-term expenditures from oil and gas revenues, the 'constant real expenditures' principle shall be used as a basis and annual limits shall be set for these expenditures that are to be made within the period covered by the strategy;

- When incomes from oil and gas revenues peak, at least 25 percent of them shall be saved;

- The regulations adopted for spending oil and gas revenues shall remain unchanged during the effective period of the long-term strategy on management of oil and gas revenues and the expenditure limits projected on the basis of the constant real expenditures principle shall be observed;

- The volume of medium-term expenditures shall be determined based on the non-oil deficit (the difference between revenues and expenditures of the consolidated budget of the country, excluding the oil sector) and taking account of the long-term expenditure limit. Sharp year to year fluctuations in expenditures are undesirable and the non-oil deficit may not be abruptly changed'.8

8 'Long-term strategy on the management of oil and gas revenues', approved by decree of the president of the Republic of Azerbaijan No. 128, dated 27 September 2004, pp. 2-3,, last accessed 23 January 2015.

The major conclusion from this strategy is that the main element of the fiscal framework in Azerbaijan is a non-oil balance guideline (adopted in 2004) consistent with constant real consumption out of oil wealth. But effective application of the above-mentioned rules has never been realized. Instead, the government relied on an ad-hoc balanced budget complemented by SOFAZ transfers (Kyle, 2014:65).

The IMF's Consultation Mission statement for Azerbaijan reported on 12 March 2013 that 'scaling down government spending, resisting pressures for a mid-year supplementary budget, and guarding against evasion from recent tax amendments would reduce fiscal vulnerabilities, and reforms to strengthen non-oil revenue and rationalize public spending would help support the credibility of the new framework' (IMF, 2013). SOFAZ can be successful in achieving efficient resource management when there are well-designed funding and withdrawal rules which are consistent with stated goals. Clear accountability procedures among the different levels of SOFAZ governance, and to the public, are important in order to prevent misuse of public resources and to gain public support for the Fund and its objectives. The success of SOFAZ is contingent upon responsible investment policies that are consistent with its policy purpose.

It is highly advisable to combine whatever fiscal deficit strategy is chosen with (a) implied target levels for net debt, and (b) a rule that any excess over that target level will result in a smaller non-oil deficit during the next period by a given percentage of that excess. The increasing amount of transfers from SOFAZ to the state budget necessitates the acceptance of fiscal policy guidelines based on clear principles for the relations between Fund and state budget.

Additionally, it is important to take into consideration all relevant monetary and fiscal factors during allocations, as well as transfers from SOFAZ. One of the crucial issues for oil-rich economies is the interaction between fiscal and monetary policy (especially, for the nominal interest rate), also proper division of tasks between the central bank and fiscal authorities (Harding & van der Ploeg, 2009: 34). There is a simple reason why natural resource revenue-fuelled Funds do usually not contribute to better fiscal policy in those countries which are heavily dependent on oil and gas exports.

The reason is that the economic considerations, which usually drive a fund's decisions, support only a specific fiscal policy and are silent on what is the right institutional framework for implementing that policy. However, the political economy of power rivalry and elite struggles can create incentives for rapid overspending of natural resource revenues relative to the ideal levels of expenditure. These adverse effects are strongest when institutions and policies are otherwise weak, where political and economic power is highly concentrated, where transparency is comparatively limited, and where there are risks of rapid changes of government. Political actors are more likely to direct oil resources for clientelistic purposes in a political regime with weak institutions. All these factors including sporadic imperious attitudes, power rivalry, and weak oversight apply to Azerbaijan (Humphreys & Sandbu, 2007: 226).

Frankel (2010) points out contradictory results of different empirical studies about links between economic dependence on oil or minerals and authoritarian government. But theoretically, autocratic regimes are more likely to establish a SWF relative to democratic ones and 'therefore, a ruler that expects to stay in power for a while, may very well set up an SWF in anticipation of being able to use at least some of the proceeds for private use in the future' (Carpantier & Vermeulen, 2014: 7). Another dimension is the quality of institutions. Studies proof the important role of institutional quality in turning natural resources into economic wealth including through SWFs. Lücke (2010: 22) points out that the oil fund in Azerbaijan strengthens 'presidential control over oil-related revenues to the detriment of parliament' and that there are no legal provisions restricting the president's discretionary power regarding the use of oil revenues. Transferring control over SOFAZ from president to parliament can improve the fiscal relationship between the Fund and the state budget.

6. Conclusion

Fiscal sustainability is the ability to continue current level of spending in the future without any serious change regarding public services and taxation and also without continually increasing the debt level. Governments can adopt fiscal institutions and fiscal rules to deal with income volatility caused by a high dependence on resource revenues. A common and important feature in this context is the creation of a SWF like SOFAZ which can accumulate and release resource revenues as deemed necessary.

In resource-rich countries, fiscal rules can assist to contain spending pressures and smooth income volatility, but they are highly insufficient to build fiscal buffers. In the case of Azerbaijan, there is a broad consensus that continued large increases in public expenditures are not sustainable and that a lack of fiscal sustainability can cause serious risks for Azerbaijan. It's quite large oil and gas resources have earned Azerbaijan large fiscal revenues in last 10 years but future fiscal revenues from oil and gas exports might be lower than currently expected due to declining production and the development of global market prices.

A sound management of Azerbaijan's resource revenues requires a fiscal framework to smooth public spending for different reasons (i.e., intergenerational equity, preserving macroeconomic stability, maintaining spending efficiency). Non-oil revenues have been weak due to low non-oil real economic growth, tax exemptions and problems in small and medium entrepreneurship, while oil revenues have remained strong.

The first issue to consider is how much of the oil money to save or accrue in the SWF, and how much to consume or allocate for state budget expansion. This requires an analysis of where that money will provide the best long-term benefit for society. Empirical evidence and expert opinions suggest that transfers from SOFAZ to the state budget in Azerbaijan should be based on stringent fiscal rule taking into account the Fund's total assets (Ahmadov, Tsani, & Aslanli, 2009). Where the SWF's activities have significant direct domestic macroeconomic implications, those activities should be closely coordinated with the domestic fiscal

and monetary authorities, so as to ensure consistency with the overall macroeconomic policies. Given the increase of the budget transfers despite the decline of the profitability rate of SOFAZ's assets management there is a need to review the coordination of fiscal and macroeconomic policies. It is crucial that in the future the government will be determined to achieve a non-resource fiscal balance with the help of a consistent programme of diversification (cf. State Oil Fund for the Republic of Azerbaijan, 2013).

These challenges can be partly overcome with the help of the permanent income approach to spending oil revenues as envisioned by the 'Long-term strategy on the management of oil and gas revenues' in Azerbaijan. If it will be applied in Azerbaijan, an important benefit would be to prevent the public finance system from extreme volatility stemming from unlimited transfers of SOFAZ to the state budget, even in the face of high volatility in oil prices or declining production.


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