Managing of resource revenues in oil-rich CAREC countries: Case Study of Azerbaijan

1. Managing of resource revenues in oil-rich CAREC countries: Case Study of Azerbaijan Center for Economic and Social Development (CESD)

2. Goals of The Project The specific goals are; To analyze the management of resource revenue in Azerbaijan; To examine different facets of revenue management specifically looking at each countries' resource fund, and their savings and stabilization mechanisms, investments abroad ; To find out how resource revenues impact regional integration in CAREC; To outline the best practices for managing resource revenues which can be applied to other CAREC countries; To develop policy recommendations for the management of resource revenues to the government of Azerbaijan.

3. Objectives • To analyze how much of the oil revenues should be saved (invested) or spent bearing in mind the potential for economic overheating, and other Dutch disease ramifications. Where should these savings be placed? • To list the best practices from Azerbaijan and Kazakhstan regarding to oil revenue management. • To determine how much of the saving and the stabilization functions each funds should assume, and what are the implications for the funds’ asset management strategy. • To determine the costs and benefits of domestic and foreign investment, and develop the funds' strategies for diversification. How much of the oil revenues should be invested domestically, and under which circumstances? Should the funds invest in corporate equities or in government T-bills and bonds?

4. Literature review • The historical record of managing resource revenues has been extensively researched and extensively reviewed (e.g., van derPloeg, 2007). • Cross-country evidence suggests that countries can escape the resource curse (Sachs and Warner, 2007) and turn the windfall revenue into a boon if they have good institutions (Mehlum, Moene and Torvik, 2006), are open to international trade (Arezki and van derPloeg, 2008), or have well-developed financial systems (van derPloeg and Poelhekke, 2008). • Macroeconomic effects of commodity booms in cross-country studies, so it is useful to examine the dynamics more explicitly. Collier and Goderis (2007, 2008) use global data from 1960 onwards and find that, for the first few years following an increase in the price of commodity exports, non-resource output does indeed increase relative to what it would otherwise have been; people become more productive.

5. Methodology Our main sources of data will be bulletins and reports from government bodies, specifically the State Statistical Committees and the Oil Funds in both Azerbaijan and Kazakhstan. In addition to official data, reports from international and local organizations will be considered. An information bank has already been established by CESD and we will rely on information already collected in the bankwhich are following; • Asian Development Bank (Key Indicators, etc.), • National Statistic Committees of Azerbaijan and Kazakhstan (official data on oil and non-oil sectors), • Eastern Bloc Energy Ltd. (CIS and Eastern European Energy Databook, etc.), • International Energy Agency (Energy Balances of Non-OECD Countries, Natural Gas Market Review, World Energy Outlook, World Energy Statistics, etc.), • IMF (International Financial Statistics, Directions of Trade Statistics, etc.), • Oil and Gas Journal, • UNCTAD (Commodity Price Statistics, Handbook of Statistics, World Investment Report, etc.), • World Bank (Doing Business, World Development Indicators, etc.), • United Nations Economic Commission for Europe, UNECE Countries in Figures (comparative figures of CIS countries).

6. Hypotheses • The delay in the shift to the life-cycle permanent income model by governments leads to the expansion of state budget expenditures tounproductive sectors of the economy, and lowers the budget deficit of the non-oil sector, thus leaving more burdens on future generations. • When the inflow of foreign currency coming from oil exportation peaks in Azerbaijan, the indirect negative effects will outpace the direct positive effects, to the extent that overall economic indicators (for example, rapidly growth GDP, positive remainder of payment balance) are ultimately expressed in negative figures (increase of deficit of the non-oil sector, of the foreign debt, high level of inflation rate).

7. Project Progress

8. Content • Preface • Executive Summary • Introduction • Azerbaijan economy and oil revenues • Anatomy of the Oil Inflows • Is the economy ready for oil windfalls? • Income tracking of State Oil Fund of Azerbaijan Republic • Methodology •  Oil Savings and Reserve Management Frameworks •  International practices • Norway • Venezuela • Oman • Kuwait • Macroeconomic cost of fiscal volatility • Medium-term budgeting • Long-run fiscal stance • Benchmarking • Permanent income • Other models • Oil price sensitivity and income uncertainty • Evaluation of alternative models and adjustments

9. Content, cont’d • Fiscal rules, hedging and other strategy components • Rationale for funds • Possible functions of the funds • Budget or Fund • Saving or stabilization • How much risk • Management strategy for the fund • Saving or investments • Domestic investment and risks • Asset management practices • Institutional arrangements • Governance, Transparency, and Accountability • Policy Implications • VI. Conclusion • References • Annexes

10. Current Analytical Framework • Permanent Income” Approach • Determine amount that can be spent forever • A useful attempt to impose fiscal discipline • Given oil production, assumed oil price profiles • Risk is not considered

11. What is the challenge? Develop analytical framework which: • Builds on Permanent Income approach • Supports fiscal prudence • Is simple to explain conceptually • Accounts explicitly for Risk

12. Pitfalls • “Dutch disease” • A lack of focus on the non-oil economy • Poor governance and inefficient spending • Resource wealth often associated with weak government institutions • Budget fragmentation and “fiscal gimmickry” may hamper spending efficiency

13. Three main functions: • Saving (e.g. Alaska Permanent Fund, Kuwait Reserve Fund for Future Generations) • Stabilization (Chile Copper Stabilization Fund, Venezuela Macroeconomic Stabilization Fund) • Financing (Kuwait General Reserve Fund, Norwegian State Pension Fund, Timor-Leste Petroleum Fund)

14. Stabilization funds • Aim to reduce the impact of volatile revenue on the government and the economy. • Inflows and outflows are typically contingent on whether the petroleum revenue or price is “high” or “low,” compared to some historical average or pre-determined threshold. • The idea is that the fund would receive money from the budget when petroleum revenue is particularly strong and pay out to the budget when petroleum revenue is particularly weak.

15. Stabilization • By reducing the uncertainty of petroleum revenue for the budget, stabilization funds aim to make budgetary spending more stable and predictable. But: • Also suffer from the fungibility problem. Governments could make payments to the fund when the petroleum price is high, but may not reduce expenditure if they borrow elsewhere. • Rules of inflows and outflows may become inappropriate if based on rigid petroleum price thresholds.

16. How is risk managed in Azerbaijan? • Demonstrated approach with respect to financial asset management is highly conservative • More liberal spending of oil revenues is inconsistent • Need to develop a consistent and disciplined approach to risk • Value at Risk Models are in common usage among Financial Risk Management Professionals

17. Conclision