Azerbaijan’s Oil Fund finances the future
$430 million account will bring growth and stability to non-oil sectors

"Oil is not a reliable source of profits. If production is up, then oil profits are up, and I'm doing fine. But if there is no oil, what shall constitute my profits then?" - Agha Musa Naghiyev, 1849-1919, the richest oil baron during Baku's first oil boom

The government of Azerbaijan has established a new State Oil Fund to provide for economic stability and fund future economic development, particularly in the non-oil sectors of the economy. This fund is the only one of its kind within the CIS managed by an autonomous government agency. The government promises conservative, rational and transparent spending of oil profits extracted from the Caspian Sea deposits.

Tangible operations only began in mid-year, but by August assets had already totaled approximately $430 million. Within a few years, as the oil companies recover their investments and revenues and production increase, this fund is expected to grow enormously.

The concept for the fund originated with the Azerbaijani government, with encouragement from the IMF and the World Bank. Azerbaijan signed the "Contract of the Century" with many of the world’s major oil firms in 1994. In 1995, oil bonuses began to accrue to the Azeri government.

However, due to massive cash outflows resulting from the economic and political chaos during Azerbaijan’s first years of independence, the government was forced to spend its initial bonuses as fast as they were received. Nonetheless, succeeding bonuses were saved to support the country’s currency and balance of payments.

By 1997, as oil production began to increase, huge amounts of foreign currency began to flow into the country. In 1998, however, world oil prices collapsed.

As a countermeasure, the central bank built up its reserves to improve Azerbaijan’s creditworthiness. But officials also saw that there was a real need to better insulate the national economy from the effects of oil price volatility. And with huge projects to build oil and gas pipelines being discussed, Azerbaijani officials began to see that revenues from oil would soon be on a vastly greater scale than in past years.

Officials were also concerned by early signs of "Dutch disease," whereby heavy dependence on a single commodity can eventually seriously undermine other domestic industries and lead to dangerous distortions of a country’s currency. The government saw that large hard currency inflows had a tendency to undermine fiscal discipline and bring about deterioration in tax policies. Officials realized that it was necessary to manage the inflows and separate oil income from the government budget and from taxes.

"There was also a recognition that oil is a non-renewable resource," says the Oil Fund’s executive director, Samir R. Sharifov. "To have oil is a blessing from God, but it is a blessing that is not meant just for a certain lucky generation."

Azerbaijan’s State Oil Fund was established by presidential decree in December, 2000, and funding began in January 2001. The fund now has four main revenue sources:
• All "profit oil" revenues
accruing to the Republic of Azerbaijan; that is, profits from the sale of the government’s share of oil produced under off- shore Production Sharing Agreements (PSAs) signed with investing oil companies;
• All "surplus and performance" bonuses paid to the government of Azerbaijan by the oil
companies;
• The rental or sale of assets belonging to the PSAs; and
• Income from investing and
managing the assets of the Oil Fund.

As would be expected, Azerbaijani politicians have enjoyed heated debates about how to use the wealth that is expected to flow into the Oil Fund and further accrue from its investments. Some leaders favor short term needs – spending large amounts on much- needed infrastructure development, or financing large investments in the non-oil sector, or meeting urgent social needs of the refugees and the population in general.

Others Azeri leaders favor a long-term approach, allowing the Fund’s reserves to steadily accumulate for the use of future generations.

Essentially, the government has settled on a scheme that tries to meet both short- and long-term needs. "We recognized there was a need for all Azeris, including future generations, to enjoy the fruits of our oil production.

"But, given the current economic and social situations in Azerbaijan, it was also obvious that all the problems of society and those flowing from Armenian aggression could not be ignored."

The key to the government’s strategy was to set up careful guidelines for saving, spending and investing fund revenues. Moreover, the government established the fund as a separate agency, making its management both transparent and subject to international audit.

The Oil Fund must first collect revenues for five years, before major expenditures can be made. According to Sharifov, Fund assets will be invested conservatively, primarily in high-rated government bonds, both domestic and foreign; in some preferred equities funds; in U.S. agency bonds, and government-secured debts. The Oil Fund will also be a lender to the World Bank or other international development banks. The fund will not, however, be invested in real estate, precious metals, commodities or speculative funds.

Spending provisions limit expenditures primarily to interest earned in asset investments, leaving the principal to accrue. The fund will be used mostly for non-oil sector investment funding, since development of this sector is an important precondition for economic development.

"In order to attract that investment, the government needs to think about basic infrastructure development," Sharifov notes. " But it would be a big mistake to involve Oil Fund monies directly in development, although we do not exclude co-financing of some projects with international financial institutions. These should be limited to equity investments for strategic purposes. But the fund is not in the business of acquiring assets."

Spending plans will require "cross-ministerial" talks, Sharifov notes. The Oil Fund budget expresses public policy and is to be coordinated with the general government budget. "Thus, there is a mechanism to encourage coherence in investment policy.

"The fund’s objective is to find the right balance between saving and spending. And (proper) spending is important," Sharifov says, "Consumption is a very important part of a Keynesian economy – but not excessive consumption. There are so many examples of how other countries have spent their oil money inefficiently. We will not follow these bad examples."

Until now President Aliyev has authorized only two draws on the fund. The first – $36 million – is to replace World Food Program funding for Azerbaijan’s refugees. Another allocation of about $18 million was made for refugee housing reconstruction.